Transfer prices are prices that companies charge for goods, services, tangible and intangible assets they trade with subsidiaries and similar controlled entities in foreign markets.

According to the tax law in Canada, United States, and other developed countries, the proper transfer price is one which two parties dealing at arm's length would agree to for a certain transaction. Consequently, the resulting price is called an "arm's length price", and the principle used to determine such a price is an "arm's length principle". The arm's length principle is a cornerstone of transfer pricing methodologies used by tax administrators in the majority of countries in the world.

In a more formal way, the "arm's length principle" is based on Article 9 of the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention which states that

To put it simply, the idea is to force the related companies to sell their goods, services, tangible and intangible assets to one another at market prices for tax purposes.

In the past several years both the Canada Customs and Revenue Agency (CCRA) and the Internal Revenue Service (IRS) increased their emphasis on transfer pricing examinations. Furthermore, the new legislation imposed penalties for a failure to produce documentary evidence supporting the determination of the proper transfer price (Subsection 247(3) of the Income Tax Act (Act) and Part 7 of Information Circular 87-2R). As a consequence, even smaller companies have become concerned about the potential of a transfer pricing audit.

Despite many governments' pronouncements, the determination of proper transfer prices remains very subjective. Careful analysis is needed to judge the impact of several key factors such as the company's activities, risks, tangible and intangible assets employed, characterization of the entities and comparability of arm's length with non-arm's length transactions.

The Income Tax Act requires that the transfer pricing documentation be prepared in order to avoid the transfer pricing penalty in Section 247(3) of the Act. In the absence of the transfer pricing documentation, the tax auditor is required to assess statutorily prescribed penalty in the amount of 10% of the net adjustment of the transfer price. Because the penalty base is an amount of the audit adjustment and both the penalty and the interest are not deductible for tax purposes in Canada, the resulting amounts of tax, penalty and interest are extremely onerous.

The documentation must be contemporaneous (i.e. prepared and/or updated at each year-end) and it must be provided to the CCRA within three months of a written request to do so. Therefore, it is preferable to prepare and update the transfer pricing documentation as soon as possible. The following sections describe practical aspects of the preparation of transfer pricing documentation.

The following flowchart shows a possible approach to the preparation of transfer pricing documentation.

During the first stage of the preparation of any transfer pricing study, we have to identify which transactions are subject to transfer pricing rules. In addition, other aspects of the transactions should also be considered, e.g. residency, foreign affiliate filings, T106 filings, foreign accrual property income (FAPI) rules, impact of tax treaties, potential for Advanced Pricing Arrangements (APA), statue barred dates in all relevant countries, competent authority functions, General Anti-Avoidance Rule (GAAR), Part XIII withholding taxes, etc.

While identifying the transactions for a potential transfer pricing documentation, we can use the following broad definition of transactions to separate potential issues into more manageable parts:

• Transfer of tangible capital assets. These transactions are usually rare, but they may involve a transfer of items of a significant value. Consequently, it is necessary to consider whether any such transfers occurred. It is also necessary to ensure that these transfers are related to capital assets rather than inventory.
• Transfer of intangible assets. These transactions involve transfers of brand names, trade marks, "know how", and similar items. Intangible assets can be transferred by sharing the costs and/or benefits of the ownership of such assets with a foreign based non-arm's length entity, licensing them or selling them directly to a non-arm's length party.
• Transfer of tangible products. These transactions involve a transfer of simple goods or "bundled products" (e.g. services bundled with goods, or different goods bundled together and sold as one product).
• Transfer of intra-group services. These are services provided in a group by one company to the other companies. The service provider either allocates the expenses or charges a fee (with or without a mark-up), such as management fees, purchasing fees, administrative services fees etc.
• Intra-group loans. These are loans between non-arm's length parties. It is necessary to ensure that a reasonable amount of interest is being charged and consider an exposure to imputed interest income rules (Subsection 17(1)), deemed benefit rules (Sections 15 and 80.4), capitalization rules (Subsection 21(1)) and thin capitalization rules (Subsection 18(4) of the Act).

During the second stage of preparation of the transfer pricing study, we have to estimate a potential transfer pricing exposure, consider the costs and benefits of the study, and prepare the budget. Although it is generally easy to identify areas of potential tax exposure, it is much more difficult to quantify it. In general, two areas of tax exposure exist:

1. Transfer pricing adjustment. Such an adjustment may be proposed under different sections of the Act (e.g. Part I, Part XIII, etc.) and is basically equal to the tax calculated on the difference between the taxpayer's actual transfer price and the transfer price for the same or similar transaction between parties dealing at arm's length. The calculation formula is provided in Subsection 247(2) of the Act.
2. Penalty. The transfer pricing penalty is specified in Subsection 247(3) of the Act and Part 7 of the Information Circular 87-2R. The penalty is equal to 10% of net transfer pricing adjustment.

Although the quantification of the transfer pricing adjustment exposure is quite difficult without the preparation of a transfer pricing study, the company may want to consider the following indicators:

1. Materiality of the transaction(s). Since the CCRA usually follows the accounting definition of materiality rather than a legal definition, the possibility that a transaction will be audited by the CCRA increases with the increase in dollar value of a transaction.
2. Arm's length price indicator. The arm's length price indicator is based on benchmarks, statistical averages and other easily obtainable data such as commodity prices etc. However, it is extremely important to note that these unadjusted indicators may not be used for a transfer pricing study because the use of unadjusted industry averages is strictly prohibited by the OECD, and thus also by the CCRA.

Both of the above indicators reveal potential areas of tax exposure. They can also help us to estimate the amount of the potential transfer pricing adjustment.

After we have estimated the potential tax exposure related to the transfer pricing adjustment, we can also estimate a transfer pricing penalty. First, no penalty is applied if the net adjustment is lower than 10% of gross revenue of the company or $5,000,000 (whichever is the lesser value). Second, no penalty is applied if the company prepares sufficient transfer pricing documentation by the time of the filing due date and provides the documentation within 3 months upon written request by the CCRA. Therefore, the penalty, which applies only to a net adjustment of undocumented transfer pricing transaction(s), can be calculated as 10% of any such adjustment.

The budgeting of work follows directly from the identification and quantification of areas of the potential transfer pricing exposure. First, all the material transactions should be discussed in depth and, consequently, more time will have to be budgeted for their documentation. Second, as the preparation of the transfer pricing study necessitates input from many different departments (accounting, finance, sales and marketing, purchasing, etc.), proper budgeting and scheduling will help to avoid inter-departmental problems and delays. Third, all the significant work must be done by the filing due date to allow the company to file proper tax returns, T 106s and to comply with the legislation. Therefore, all the work should be finished no later than 6 months after the entity's fiscal year end.

The industry and market analysis provides a description of a general business environment as well as a substantial background for a functional analysis. It includes a comprehensive description of the industry together with the most significant factors influencing its development. It should also describe the generally accepted industrial and commercial practices (such as the use of outsourcing, selection of distribution channels, etc.). In addition, the analysis of the industry includes general and industry specific business statistics, data on employment of resources and industry specific financial ratios (if available).

Furthermore, the industry and market analysis usually describes the market concentration and identifies and describes general profiles of competitors, including their size, strategies and market shares. It also describes current trends in the industry and critical success factors.

Functional analysis represents one of the most important parts of the transfer pricing study. It describes the facts surrounding the relevant transaction and it is used to support the comparability and necessity of adjustments for a comparable arm's length transaction. It also identifies the sources of value in the value chain of purchase, manufacture and sale of products.

The major components of functional analysis are:

Functions. Functions are basically activities such as purchasing, inbound logistics, production, R&D, inventory management, outbound logistics, marketing and sale activities, after-sale services, supporting activities, etc. It should be specified which party performs each activity. The activities that add most of the value should be discussed more in depth than the less important activities. As the most important activities are often industry specific, it is necessary to understand the industry before developing a proper functional analysis.

Risks. According to the financial theory, risk represents the probable variability of future outcomes or returns. In addition, as the risk increases, the expected return should increase as well. Consequently, a risk bearing party should have a chance of higher earnings before interest, taxes and amortization (EBITA) than a non-risk bearing party. (Note: the risk-bearing party should have a chance of higher EBITA - over the long run the EBITA will be higher, but not necessarily over the short run). The potential risks are company and industry specific, yet the most general risks are as follows:

• Financial risk (including currency, commodity, interest rate, and funding risks, etc.)
• Credit and collection risk [including trading credit risk (such as pre-settlement and settlement) and commercial credit risk (such as default on guaranties, loans and accounts receivable)].
• Operational risk (including systems failure risk, reliability of suppliers, inventory risk and carrying costs, R&D risk, environmental and other regulatory risk, etc.)
• Market risk (including country political risk, reliability of customers, fluctuation in demand and prices, etc.)
• Product risk (including product liability risk, warranty risk / costs, contract enforceability etc.)

Only important risks should be described and quantified. It should be specified which party bears and controls the risks in the legal (contractual) terms, and which party bears the risks based on the economic substance of the transaction.

Intangible assets used or contributed. Sustainable competitive advantage is often achieved by the employment of intangible assets of the company. Some of these "intangibles" enjoy legal protection (such as patents, government issued licenses, trademarks and trade names), but others are equally important even without any legal protection ("know-how", trade secrets, corporate goodwill and credibility, exclusive import and export rights, natural monopoly or monopsony, etc.). The basic rule is that the party that developed the intangibles should obtain the benefit from the use of such intangibles either through a sale or licensing of the intangibles, or through an increase in prices of products with imbedded intangibles. Therefore, it is important to determine which entity developed the intangibles, which has the legal ownership of the intangibles, and which receives the benefit of the intangibles.

Tangible assets used or contributed. The employment of a capital asset is costly and has to be financed either internally or externally. Capital assets, such as a property, plant and equipment, would usually be expected to earn a long-term rate commensurate with the business risk assumed. With the increase in the specificity of capital assets used, the barriers of entry and exit in the industry also increase and so does the general business risk related to the ownership long-term capital assets. Consequently, the increase in the amount, or specificity of capital assets used or contributed by a company, should also increase the EBITA of this company. Therefore, one should identify the amount and specificity of capital assets employed, as well as the capital assets left idle, and quantify these amounts whenever possible. Since the indicators as ROI, ROA and EVA are often industry specific, the analysis of the industry is usually quite useful.

As stated above, a proper transfer price is one which two parties dealing at arm's length would agree to for a certain transaction. In order to compare a non-arm's length transaction to an arm's length transaction, it is helpful to characterize the entities according to the nature of their operations and complexity. Based on the nature of the operations, the following characterization is often used:

• Manufacturing operations
• Selling operations (wholesale, retail)
• Service operations

Each one of these could be further characterized based on the complexity of their operations as:

• Limited operations (e.g. contract manufacturer, limited distributor, broker, commission agent, limited service provider)
• Complex operations (e.g. full fledged manufacturer, distributor or service provider).

The complexity of operations should be perceived as a continuum -- starting from the limited operations to the complex ones, with many companies somewhere in between these two extremes. The exact location on any such continuum results directly from the functional analysis described previously. It is generally the case that more complex operations generate higher levels of profit because they involve more value adding activities, a higher risk, and they use larger amounts of tangible and intangible assets. Consequently, the complexity continuum is positively related to a profit continuum as in the following graph for a manufacturing entity:

The characterization of the entities will help us in two important ways: first, it will help us to select a tested party for the economic analysis (generally an entity with limited operations and thus a lesser number of adjustments), and second, it will help us to select comparable companies that are approximately at the same point on the continuum and thus directly comparable with the tested party.

Although the Income Tax Act does not describe any transfer pricing methods, the Information Circular 87-2R specifies such methods and provides a clear hierarchy of these methods. (For a detailed description of these methods see IC 87-2R).

The top method in CCRA's mandated hierarchy of transfer pricing methods is the Comparable Uncontrolled Price (CUP) method which focuses directly on the price of products sold or transferred. However, since the CUP method requires both functional and product comparability, it is not always possible to find similar transactions that could be used as comparable arm's length transactions. Other methods may be used in the case where there is not enough information in respect of the comparable transactions, or if it is not possible to adjust for all the material differences between the tested and the comparable transactions.

The second level of methods is represented by those that operate on the gross profit margin level, namely the Resale Price (R-) method and the Cost Plus (C+) method. The Resale Price method is usually applicable to marketing and selling operations since it arrives at a transfer price by discounting the resale price by a comparable gross margin. On the other hand, the Cost Plus method is usually applicable to manufacturing operations as it begins with the cost of products and adds the comparable mark-up to arrive at a transfer price. The methods based on gross profit margin require functional comparability, but they are less dependent on similarity of products (although it is preferable to compare products in the same industry or the products of the same general type, such as non-branded consumer electronics, etc.). Once again, other methods may be used in the case where there is not enough information in respect to comparable transactions or if it is not possible to adjust for all the material differences between the tested and the comparable transactions.

The third level of methods is represented by those that operate on the operating profit margin level, namely the Profit Split (PS) method and the Transactional Net Margin method (TNMM). The Profit Split method is generally used for highly complex and integrated entities and in situations involving unique intangible assets. The major difference between the PS method and the TNMM is that the PS method is applied to all parties in the transaction, whereas the TNMM is applied to only one party. However, whereas PS method may be applicable to unique intangibles, TNMM is generally not recommended for such situations.

Finally, where it is not possible to use any of the above methods, other unspecified methods may be used. Yet, any such unspecified method should satisfy the arm's length principle. In general, it is not advisable to use unspecified methods.

The selection of a method will depend on the functional analysis and availability of comparable transactions (or companies). If it is possible to use the internal CUP method, the selection of a method can be conducted immediately after finalizing the functional analysis. Otherwise, the selection of the transfer pricing method must be done in conjunction with the economic analysis which includes a search for comparable transactions or companies.

The economic analysis deals with a selection of comparable transactions or companies, consideration of the quality of data, assumptions and comparability factors, selection of appropriate economic and statistical methods, profit level indicators, and a quantification of appropriate adjustments.

First, it is necessary to search appropriate databases to obtain a list of companies that could be approximately comparable to our tested party. This is usually achieved by searching databases such as Moody's, Compact Disclosure, Compustat, Worldscope, etc., using an appropriate Standard Industrial Code or similar indicators. The resulting sample of companies is further narrowed down by the exclusion of companies with insufficient information.

All remaining companies are analyzed (usually using 10K and similar reports) and a functional analysis is carried out on the companies that seem to be comparable with the tested party. The functional differences (i.e. differences in functions, risks, intangibles and assets employed) between the tested entity and the comparable entities are quantified and adjusted.

Some of the adjustments are done to improve the comparability of products sold (e.g. adjustments related to volumes of sales, terms of sales and payments, credit terms, quality differences, value of intangibles embedded in the product, bundled services provided with goods or other services, etc.).

Other adjustments are done to improve the comparability of markets (e.g. adjustments related to geographic differentials, levels of market, competitions in markets and degree of concentration, exchange rate and tax rate differentials, cost differentials, potential entrants, size and efficiency of the market, bargaining power of suppliers and consumers, etc.).

Additional potential adjustments may be related to the comparability of the entities' internal operations [e.g. adjustments related to levels and turnovers of inventory, accounts receivable and accounts payable, lack of specific activities (including supporting activities), risks, intangibles, etc.].

The following difficult problems usually arise during the preparation of an economic analysis:

• Which adjustments to data still make them useful for the higher methods and when is it necessary to use lower methods?
• When is the adjustment necessary (i.e. what is a material difference between the tested party's data and the arm's length party's data) using different transfer pricing methods?

Since transfer pricing is not an exact science, there are no hard rules to follow. However, as a general guiding principle the higher transfer pricing method should be abandoned only in the following cases:

• we do not have enough data with respect to the comparable party; or
• the data is of a low quality (e.g. incomplete, inaccurate, unreliable, or highly sensitive to assumptions and factors underlying specific transfer pricing methods); or
• the data does not allow us to reliably quantify the differences between a tested company and a comparable company.

The choice about necessity of an adjustment depends on the materiality of the item. While it is not necessary to adjust small differences, all material differences must be adjusted based on commercial practices, economic and financial principles.

Although the major part of documentation consists of functional and economic analysis, there are other items that are required to be included in the documentation.

Subsection 247(4) requires the documentation to be complete and accurate in all material respects and to include all of the following:

• Description of property or services to which the transaction relates. This may include, for example, information and technical specification of a company's product, price lists, catalogues, special features distinguishing a particular product from other similar products in the marketplace, etc.
• Description of the terms and conditions of the transaction and their relationship, if any, to the terms and conditions of each other transaction entered into between the participants in the transaction. This may include, for example, a description of responsibilities of each party for specific activities such as packaging, quality control, etc., as well as terms of the transaction relating to shipping, volume discounts, penalties for late delivery, payment terms etc. These terms are best documented by a legal contract between the parties and by some evidence that the terms were complied with. Furthermore, in back-to-back transactions, for example, a round-trip transaction (i.e. where a company manufactures product parts which are assembled by a foreign subsidiary and returned to the parent for distribution) one must document how the terms and conditions of each of the transfers relate to each other.
• Description of the identity of the participants in the transaction and their relationship to each other at the time the transaction was entered into. This may include, for example, documents such as an organizational chart, description of the business and product lines, legal structure of the group, flow of goods and parts between the companies in the group, the scope of the activities covered by different contracts and arrangements inside the group, etc.
• Description of the functions performed, the property used or contributed and the risks assumed, in respect of the transaction, by the participants in the transaction. This is the functional analysis as described above.
• Description of the data and methods considered and the analysis performed to determine the transfer prices or the allocations of profits or losses or contributions to costs, as the case may be, in respect of the transaction. This is the selection of a transfer pricing method and the economic analysis as described above. Note that all the data and methods considered should be described. The CCRA expects the documentation to include the selection of a particular transfer pricing methodology, including an explanation of why the selected method is more appropriate than any higher-ranking method. It also appears that the data considered but rejected should be kept. According to the IC 87-2R, "the data and methods considered" include "a description of the comparable transactions considered and of those used in applying the pricing method, an assessment of the degree of comparability of such transactions with the taxpayer's transaction, and a description of any adjustments made to enhance the degree of comparability". As opposed to the United States approach that relies very much on statistical tools and ranges, the Canadian approach to comparability is driven more by the judgmental issues.
• Description of the assumptions, strategies and policies, if any, that influenced the determination of the transfer prices or the allocations of profits or losses or contributions to costs, as the case may be, in respect of the transaction. This includes all the factors that materially affect the determination of transfer prices. All the economic and valuation assumptions used should be fully disclosed. Furthermore, all the strategies, such as a market penetration strategy, should also be fully disclosed. Where the taxpayer implements a strategy involving a reduction in current profit (usually in anticipation of an increase in future profit), the documentation should include projections of the future benefits and their nature, and a summary of the assumptions which form the basis of such strategy. These strategies might be documented, for example, in marketing or business plans (either for internal or external use), including the budgets.

Overall, the documentation should describe all material items relating to the transfer price used. The taxpayer is allowed to "weigh the significance of the transactions in terms of their business with the additional administrative costs required to prepare or obtain such documentation" (IC 87-2R par. 188). The six points above must be followed and the taxpayer should take all the reasonable steps to ensure that their transfer prices or allocations conform with the arm's length principle.

The nature and amount of the documentation always depends on facts and circumstances of any particular transaction. Therefore, there is no "safe harbour" from the application of the penalty in Subsection 247(3). However, a structured approach to the preparation of transfer pricing documentation will minimize any potential exposure much better than a haphazard one.

After the transfer pricing policy is documented, it is necessary to implement proposed changes in prices, activities, risks and assets employment, if any, and monitor the results. The preparation of the documentation should not only help the company to comply with specific tax obligations, but it should also help the company to realign its activities, risks and assets (tangible and intangible) and to minimize the impact of a world-wide tax burden. Any such realignment is, of course, subject to a constraint given by the business objectives.

A transfer pricing study should be updated each year to reflect any material changes in the transactions under consideration. Such an update should start from a review of the functional analysis. Provided that no material changes in activities, risks, assets and their allocations have occurred, an update is generally simple and straightforward. As per a verbal confirmation from the CCRA, if there were no changes in the nature of the business and in the functional analysis, smaller companies are only expected to prepare new transfer pricing documentation about every three years (i.e. they should only update the old one). On the other hand, if significant changes in the nature of business occurred, either parts of the study, or the whole study should be done anew.

As every study must be prepared by the filing due date (i.e. 6 months after the year end of the company), it is advisable to monitor and document all the changes as they occur during the year. If it is recognized that the transfer price recorded during the year for some or all transactions did not represent an arm's length price, it is possible to record a compensating year-end adjustment to the transfer price prior to filing T106s and tax returns. This adjustment should be fully documented.

If the same fact is recognized only after the filing deadline, the taxable income should be adjusted and reported on an adjusted tax return. If any such adjustment increases the taxes payable for the year in question, disclosure is recommended under the voluntary disclosure policy, thus preventing the imposition of penalties.