Tariff turbulence: Tax implications to consider

From transfer pricing considerations to federal support, keep these key issues on your radar.

Over the past few decades, Canadian and American businesses have built deeply interdependent manufacturing lines, supply chains and customer networks. However, the introduction of higher tariff rates and overall uncertainty around global supply chains has raised questions about the future of this cross-border integration, forcing businesses on both sides of the border to reassess long-standing trade and operational strategies.

We have identified some considerations to discuss with your trusted advisors. All section references refer either to the Canadian Income Tax Act (ITA)¹ or the Internal Revenue Code (IRC) of 1986, as amended.

Transfer pricing considerations and value for duty

IRC Section 482 and Section 247 of the ITA codifies the “arm’s length principle”, which is one of the foundational principles of transfer pricing as it applies to transactions between related parties. The U.S. and Canadian arm’s length standard reflects the same underlying principle: that the terms or conditions made or imposed between participants in a non-arm’s length transaction (or series of transactions) should not differ from those that would have been made between persons dealing at arm’s length. That being said, an arm’s length range of prices can often be determined for most transactions, providing some flexibility to value products toward the lower end of that range. As tariffs are calculated as a percentage of the products’ value, there may be a preference to choose an arm’s length value towards the lower end of the range. While this lower price may result in a reduced tariff for the importer of record, it does not necessarily follow that a lower transfer price will be accepted by customs authorities. Businesses may need to use the expertise of transfer pricing and customs valuation specialists to determine the impact of tariffs on them and how they could be mitigated using transfer pricing. Even though the “arm’s length standard” in the U.S. and Canada are the same, they have slightly different transfer pricing regimes. It is best to talk to a country-specific advisor when using transfer pricing to mitigate tariffs.

Potential impacts are discussed below:

Transfer pricing methodologies

• Tariffs could be an external market condition that would play a factor in the comparability analysis of transfer pricing. If the imposition of these tariffs would have impacted or affected the pricing between unrelated parties, transfer pricing benchmarking may need to be updated to reflect this economic reality. It is also important to also note that customs authorities and the IRS under IRC Section 482 often scrutinize such adjustments. Taxpayers should prepare a contemporaneous benchmarking study to support any price reductions.
• The concept of “comparable pricing” is embedded in the “arm’s length principle” noted above. Whether a price is comparable or not requires a detailed analysis between controlled and uncontrolled transactions. Controlled transactions occur between related parties, while uncontrolled transactions are between unrelated parties. The analysis considers all factors that materially impact prices and profitability. Comparable pricing is directly impacted by tariffs. Because of the lag time in adjusting comparable prices for tariffs, their effect on profitability may not be recognized immediately.

Documentation requirements

• Taxpayers will need to update their U.S. and Canadian contemporaneous documentation to support the impact of tariffs on their controlled transactions. The documentation should specifically address whether the pricing for similar uncontrolled transactions is affected by the new tariffs and any rationale for including or excluding the tariff in the cost of the transaction. Overall, taxpayers should consider which party would bear the cost of the tariff in a third-party situation and adjust the intercompany pricing accordingly. Intercompany agreements are another way to document which party is to ultimately bear the cost of the tariff.
• Inventory pricing and costing decisions (impacting transfer pricing) can no longer be made without considering their impact on value for duty and customs purposes. The Canadian Customs Act² determines the transaction value for goods with specific statutory additions and deductions. IRC Section 1059A outlines the value of a good cannot be different for tax and customs purposes. The cost base for transfer pricing could differ from that for customs value because of unbundling costs from the intercompany value (i.e., tax) of a good. Examples of costs that may be able to be excluded from the customs value include packaging, buying commissions and interest charges. Bifurcating inventory costs will need to be documented and supported. Consultation with specialists is advised to remain in compliance of the Customs Act, and the ITA, as well as the Trade Agreements Act of 1979 and IRC Section 482.

Transfer pricing implications

• Business restructurings that reallocate functions, assets and risks across international borders may require compensation for the transfer of profit potential or the termination of existing relationships. These intercompany transactions may not be subject to a tariff, but are instead an outcome of the current tariff regime.
• Decreased profitability may occur if importers of goods pass tariffs directly on to their customers, resulting in increased prices for their products. This outcome may result in decreased sales for impacted product lines as well as a decline in profitability. If the importer assumes some of these additional tariff costs total sales may not decrease as dramatically as in the previous scenario, but since costs have gone up, profits will still decline. In either case, the ultimate effect will be a reduction in profit going forward.
• Another important issue would be which entity(ies) within the global supply chain will be affected by the reduction in the system’s profit due to tariffs. The constant changing of the rules imposed by countries makes it very difficult to measure related risks. It is likely that this uncertainty will persist and the strategic activities related global supply chain will become more important and deserve a higher return because of increased risks caused by tariffs or the threat of them. Intercompany agreements should be reviewed for an indication where the tariffs are intended to be borne.
• Post-importation compensating transfer price adjustments may be required to bring an importer’s profits to a level acceptable to tax authorities. For customs authorities, while upward adjustments to the cost of goods sold generally requires that additional duties be paid, a retroactive decrease to the price of previously imported goods may result in a refund of customs duties since the importer, in theory, initially overpaid customs duties. There are specific requirements required to be in place prior to the importation that importers must satisfy in order to obtain refunds.
• An upward transfer pricing adjustment to the income of a related party necessarily produces a downward adjustment to the income of the other transacting related party, but the tax authority in the other involved country may not agree to the change. Under tax treaties, a taxpayer can request the treaty partners to endeavour to achieve a downward adjustment to the income of the related party in a tax treaty country under the mutual agreement procedure.

Penalty exposure

• Tariff-driven transfer-pricing changes can increase a client’s exposure to accuracy-related penalties of up to 20 per cent of the understatement. For example, if a taxpayer lowers the intercompany price by five per cent to reduce duties but fails to document the methodology, that taxpayer could in turn face an IRC Section 6662 penalty on the resulting tax understatement. Robust documentation and specialist engagement is critical.
• Similarly, ITA subsection 247(3) determines the penalty (for Canadian tax purposes) when a taxpayer does not comply with the arm’s length principle on transactions with non-arm’s length non-residents. The penalty is in force to encourage proper documentation to be kept on file and a reasonable effort is made to determine the arm’s length intercompany price or allocation. This penalty is calculated as 10 per cent of the net transfer pricing adjustment.

Foreign tax credits

Tariffs have no direct impact on tax credits but will indirectly impact their claim.

• Although still technically a tax, tariffs are not income taxes and would thus not be eligible to be claimed as a foreign tax credit. For Canadian taxpayers, businesses should be aware that certain goods may qualify for federal relief through the remission process (discussed later).

Impact on trade agreements

The imposition of these new tariffs will have direct and indirect impact on various trade agreements.

• The Canada-United States-Mexico Agreement (CUSMA or USMCA in the United States) may not provide complete relief or override/eliminate tariffs imposed pursuant to Section 232, Section 301, or the International Emergency Economic Powers Act (IEEPA). However, Chapter 31 of the CUSMA does provide for dispute resolution mechanism and allow for member countries to challenge trade barriers such as tariffs.
• The Trump administration has communicated that certain imported goods qualifying for preferential treatment under CUSMA will be provided relief from tariffs based on their “U.S. content”. As such, businesses will need to support and provide documentation to the U.S. Secretary of Commerce to substantiate the “U.S. content” that may be exempt from the imposed tariffs.
• The World Trade Organization also provides for a dispute resolution mechanism by allowing countries to bring forward complaints before a panel. However, the U.S. can appeal a decision to an appellate body (which is currently non-functional), indefinitely stalling the processes and preventing a resolution.

Inventory valuation for tax purposes

Potential write-down due to obsolescence caused by tariffs:

• In general, inventory for Canadian income tax purposes, is valued at the lesser of cost (including tariffs) and fair market value at the end of the year. When tariffs raise the cost of inventory, the fair market value of the inventory does not always increase in step. For exporting businesses, a tariff by the U.S. government could reduce the fair market value of inventory if the tariff cannot be passed on to U.S. buyers. As a result, Canadian firms may be faced with more inventory write-downs.
• Tariff induced cost hikes can force write-downs on finished-goods inventory. As an illustration, if a Canadian exporter is charged with a 25-per-cent tariff on steel components, writing down inventory by $X per unit would have an immediate impact on both tax and income.
• Similarly, the cost of a tariff is included in the cost of inventory for U.S. importers of record. Therefore, it may be worthwhile for American taxpayers to consider adoption of the last-in-first-out (LIFO) method for accounting for inventory. This method could increase inventory costs, thereby reducing income and income tax. That being said, taxpayers should be wary before converting to LIFO. Not only is the taxpayer required to maintain this method for a five-year period after election (Treas. Reg. Section 1.472-1), but also financial statements must conform to the method as well. Similar to Canada, the U.S. does allow for the lower of cost or market for inventory valuation purposes. A LIFO election for American taxpayers can hedge against rising costs, but once elected, as described above the election must be maintained for at least five years and requires confirming adjustments to Generally Accepted Accounting Principles financials.
• The tax treatment of tariffs levied on Canadian imports would likely mirror the tax treatment of the good imported. Tariffs levied on imported capital equipment would likely get added to the capital cost of the equipment and expensed when capital cost allowance is deducted. Tariffs on inventory would be added to the cost of the inventory and expensed under the usual rules (discussed later).

Canadian indirect taxes

Potential GST/HST³, QST⁴, and Provincial Sales Tax (PST) implications of tariffs:

• For GST/HST purposes, tariffs are included in the value of consideration for a supply. This means that GST/HST is calculated on the total amount of the payable for the imported goods, including any applicable customs duties or tariffs. Care will also need to be applied when tracking the GST/HST paid to ensure that customs duties or tariffs are not claimed as input tax credits.
• Various Provincial Sales Tax and Quebec Sales Tax legislation will also include a tariff/duty in the purchase price of certain taxable goods or services, potentially requiring self-assessment.

Cross-border reorganization

Scenario modelling should be performed on entering either Canada or the United States. For example, if the United States sales make up substantially all of the business revenue of a Canadian business, opening a U.S. subsidiary or branch and moving manufacturing operations might be a viable option.

• At a high level, if a Canadian taxpayer decides to sell their business line to a U.S. subsidiary, thus moving manufacturing to the U.S. to serve its U.S. clients, the transaction will be a taxable event. The underlying assets of the business will be disposed of for Canadian tax purposes, resulting in tax consequences depending on the type of assets sold. Please seek tax planning advice from a cross-border tax specialist.
• Alternatively, a Canadian resident can open and operate through a U.S. branch to avoid any immediate departure tax. The Canadian resident would be taxed on its U.S. branch income by the U.S., since it would be considered a permanent establishment in the U.S. The Canadian resident would then be taxed on its worldwide income under section 2 of the ITA. The U.S. may also impose a “branch profits tax”, applicable to after tax profits considered to be repatriated to Canada. A foreign tax credit would potentially be claimed under section 126 of the ITA.
• From a customs perspective, it is necessary to evaluate whether moving manufacturing to a different jurisdiction will have the desired result of avoiding U.S. tariffs. Tariffs are generally assessed based on the country of origin of a product—generally where the article was wholly produced or “substantially transformed”. As a result, importers must consider the source of the raw materials, what level of processing is occurring in the various countries and ultimately whether a substantial transformation results from the processing.

Federal support for businesses

Various measures and relief have been announced for impacted taxpayers.

For Canadian taxpayers:

• Remission process – Investigate which goods would potentially qualify for federal relief measures, from tariffs, under the request for remission process for goods that cannot be sourced from anywhere in Canada or non-U.S. sources.
• Canada Small Business Financing Program – Businesses can apply for help in obtaining loans from major financial institutions by sharing the risk with lenders.
• Pivot to Grow Loan – The Business Development Bank of Canada has $500 million for new financings, loan deferrals, advice and tools to assist affected businesses that either export to the U.S. or are impacted by the U.S. tariffs.
• Trade Disruption Customer Support Program – Farm Credit Canada will deploy $1 billion to help alleviate financial challenges with new lending. Support includes new term loans, additional credit lines and deferral of principal payments for up to 12 months on existing loans.
• Large Enterprise Tariff Loan – Large Canadian companies with significant operations in Canada or a significant workforce in Canada (that are affected by imposed tariffs, proposed tariffs and countermeasures) could be eligible for a new loan facility through the Canada Enterprise Emergency Funding Corporation.
• Trade Commissioner Services – Connects businesses looking to grow and diversify with funding and support programs available to them.
• Trade Impact Program – Export Development Canada to deploy $5 billion over the next two years. The purpose of this program is to help Canadian exporters, exporting Canadian products, reach new markets through various financial support.
• Support from the Canada Revenue Agency during difficult situations – Businesses affected by tariffs can expect to defer their GST/HST remittances and corporate income tax payments, have interest on GST/HST and T2 installment /arrears payments waived, and are provided interest relief on existing GST/HST and T2 balances owing. Relief will be provided for the period beginning on April 2, ending June 30, 2025. Interest is proposed to resume on July 1, 2025, and will accrue thereafter.

For American taxpayers:

• Exemptions may apply for imports under specified classification codes under the U.S. Harmonized Tariff Schedule (HTS). These classifications can be found in Appendix II of President Trump’s Executive Order implementing reciprocal tariffs globally. These exemptions generally are electronics, minerals or energy products. For example, semiconductors, smart phones and certain critical minerals not available in the United States are included in this listing. However, there are active Section 232 investigations into many of these industries, suggesting that these goods could be subject to additional tariffs in the coming months.
• Although no longer available for Chinese imports, the de minimis exception is currently in place. The de minimis exception generally allows products with a value under $800 to enter the United States duty free. However, there has been recent legislation proposed that seeks to repeal this exception, as well as the reciprocal tariff Executive Order providing that the de minimis exception for all other countries will end once “adequate systems are in place to fully and expeditiously process and collect duty revenue.” Practitioners should understand that these exemptions may change under reciprocal-tariff provisions and should monitor updates to the Executive Order’s Appendix II to stay ahead of potential new duties.
• Canadian and Mexican goods that qualify for CUSMA preferential duty are not subject to the 25 per cent IEEPA tariffs. Additionally, Canadian and Mexican auto parts that qualify for CUSMA preferential duty are not subject to the 25 per cent automobile part tariff under Section 232.
• It is important to note that there is a typical 90-day deadline to apply for a remission order after duty assessment, and required evidence will be specified (e.g., domestic-supplier bids).

Action plan for practitioners

To drive practical next steps, consider actioning the following:

• Engage customs and transfer pricing experts: Coordinate early on valuation and penalty-risk assessments.
• Document: Put intercompany agreements, stretch-pricing provisions and benchmarking studies in writing before importation.
• Model inventory impacts: Run Lower of Cost or Market (LCM) and LIFO vs. First-in-First-Out (FIFO) scenarios for tax and financial reporting.
• Monitor relief expirations: Track Canada’s remission deadlines and U.S. de minimis sunset dates via calendar reminders.
• Educate clients: Share a one-pager on duty exposure vs. IRC Section 6662 penalty risks to ensure board-level awareness.

Content developed and written by:

• Ryan Minor, CPA, director, taxation at CPA Canada
• Lukasz Arsiuta CPA, senior manager, tax education at CPA Canada
• Lucia Fedina, Ph.D. (Economics), managing director of transfer pricing at Andersen
• Iris Laws, CPA, senior manager, knowledge transfer strategist at Forvis Mazars, LLP (Washington National Tax Office)
• J. Michael Cornett, JD., LL.M. (Taxation), managing director at Forvis Mazars, LLP (Washington National Tax Office)
• Tanner Sledge, JD., senior associate, tax trade and customs at KPMG LLP
• Donald C. Hok, JD., managing director, senior associate, tax trade and customs at KPMG LLP
• Members of the Tax Division staff of the American Institute of Certified Public Accountants

Originally published on CPA Canada.

Footnotes

1 Income Tax Act, RSC 1985, c.1 (5th Supplement) as amended.

2 The Customs Act, RSC 1985, c. 1 (2nd Supp.)

3 Excise Tax Act (R.S.C., 1985, c. E-15) (“GST”)/(“HST”)

4 Québec Sales Tax, CQLR c T-0.1, r 2 (“QST”)