Why Transfer Pricing Should Be on Your Radar and Isn't Just for Big Business

By Gordon McGuinty; Published in CPABC in Focus
Published: March/April 2017

Globalization isn’t new. The interaction of countries and, consequently, of their economies, has benefited the world since the early 20th century. Notwithstanding Brexit and the agenda of President Trump, the last few decades can be characterized by the increasing pace of cross-border economic integration. 

The global movement of capital and workers, the shift of production from high-cost countries to low-cost “economic zones,” and the gradual collapse of trade barriers facilitated by advancing communication technologies have had a significant impact on how cross-border activities are conducted.[1] Given that approximately two-thirds of all global business transactions occur among companies within the same multinational groups (i.e. related parties)[2], transfer pricing is an important issue for multinational companies big and small.

What is transfer pricing?

Transfer pricing is a term used to describe how a group of related companies prices or values its intercompany/intragroup transactions. These transactions can include transfers of intangible property, tangible goods, or services―as well as loans or other financing transactions―which can occur across local, state, or international borders. Each jurisdiction, primarily at the national level, asserts its right to tax income generated by each local related party.

How are prices determined?

Transfer prices are determined by applying the “arm’s-length principle.” This requires that the terms and conditions of related-party transactions reflect what independent or arm’s-length participants would have agreed to given the same facts and circumstances (i.e. arm’s-length pricing). This is generally accomplished by treating each related entity within a group as if it were an independent third party whose conduct should reflect external market forces. Practically speaking, this process is more of an art than an exact science.

Why is this important?

A revenue authority has taxing rights on the income generated by a corporation in its jurisdiction. In the absence of arm’s-length pricing, the tax liabilities of two companies that belong to the same multinational group but operate in different countries may be distorted. Consequently, if a transaction between related parties is deemed to have been priced differently than it would have been between unrelated parties, tax authorities are able to reallocate income or expenses to reflect the amounts that would have resulted had the transaction been conducted at arm’s length. Due to its inherent subjectivity, transfer pricing invites special scrutiny from tax authorities.

But really… so what?

Failing to make reasonable efforts to maintain contemporaneous transfer pricing documentation (i.e., an explanation of why your intercompany, cross-border prices are arm’s length) can result in a tax authority enforcing adjustments. These adjustments, in turn, may lead to additional tax payable, interest, penalties, double tax (without an inverse adjustment in the corresponding jurisdiction), prolonged disputes, loss of reputation, and wasted internal resources.

Further, in today’s environment, transfer pricing documentation does not necessarily prevent tax authorities from performing transfer pricing audits and income adjustments. In Canada, the CRA can apply transfer pricing penalties equal to 10 per cent of the net upward adjustment regardless of whether the taxpayer has turned a profit or even generated revenue. To give you an idea of the rising importance of getting your intercompany pricing right, transfer pricing penalties assessed in Canada alone increased from $58.6 million in 2012 to $478.5 million in 2015.[3] Transfer pricing penalties are typically applicable in most jurisdictions, and—in extreme cases—senior officers and signatories may be subject to imprisonment in some countries.

Determining arm’s-length prices can be a complex and labour-intensive process that involves performing functional, financial, and economic analyses that are beyond the scope of this article. Rather, the purpose here is to explain what it means to align related-party profits with relative value-creation activities and to describe what you can do now to mitigate transfer pricing risks in your business.

What it means to align profits with value-creation activities

Profit potential is a function of risk, risk is connected with decision-making, and decisions are made by people. At arm’s length, no rational economic actor would be willing to accept significant risk—and therefore profit potential—without the ability to manage that risk. Broadly speaking, key business risks are those that may disrupt a business’s ability to create value for its shareholders or other key stakeholders.

The significant people functions (e.g. “DEMPE” fuctions[4]) required to manage business risk are often referred to collectively as “managerial substance.” Having managerial substance means having employees with the experience and expertise needed to perform management functions to take on, mitigate, or lay off key risks in the business.[5] These employees are responsible and accountable for, and authorized to make, key business decisions. These decisions may or may not include outsourcing the execution of value-add activities (such as contract research and development, manufacturing, marketing, sales facilitation, and distribution activities) to related or third-party providers. As decision-makers determine the nature and extent of risks assumed and managed, it can be argued that to align profits with value-creation activities is to align managerial substance with profit potential.

The conduct of related parties within a group determines how each related party will be characterized for transfer-pricing purposes. Simply stated, limited-risk or routine entities are entitled to stable profits (for example, a fee calculated from costs with a markup or an operating margin as a percentage of sales) regardless of how the group performs as a whole. Conversely, an entrepreneurial entity employs the key decision-makers that entitle it to the residual, non-routine profits (or losses).

A common transfer pricing risk is that a revenue authority will assert that key value-driving activities are being directed, controlled, and authorized by employees in a jurisdiction where a related party has been characterized as a limited-risk entity. To address this risk, here are four sample questions you may want to ask about your business:

  1. Who is designing, directing, authorizing, and/or evaluating core business strategies?
  2. Do your “limited-risk” entities autonomously perform risk-mitigation functions that manage key business risks?
  3. What can be inferred from your employees’ LinkedIn profiles and from internal corporate communications in this regard?
  4. Does the contractual allocation of risk to a related party align with the actual conduct of the related party? That is, have any contractually allocated risks (and associated profit potential) been assigned to an entity that is functionally deficient?

An ounce of prevention is worth a pound of cure

One advantage a taxpayer has over a revenue authority is an intimate understanding of its business. This can be a valuable advantage in a tax dispute, especially if the facts are documented contemporaneously (in Canada this means within six months of the taxation year-end). Because a transfer-pricing audit can occur up to seven years after the taxation year-end in question (potentially after a new IT system implementation, for example, or after key employees leave the company), contemporaneous documentation may lend the taxpayer credibility and prevent the perception of convenient hindsight bias. Therefore, whatever the size of your business, it’s critical to document the facts on an entity-by-entity level each and every year to realize your greatest advantage in a transfer pricing audit.

What are the facts? In the event of a transfer pricing audit, an intercompany legal agreement is typically the first piece of evidence reviewed by a revenue authority, as it sets out the intentions of the related parties from the outset. Such agreements provide a starting point to understanding the related-party transaction(s) under review and how the responsibilities, risks, and expected benefits from their interaction are to be divided; these are then compared to the actual conduct of the related parties.

If an intercompany agreement does not exist, or when the conduct of the related parties shows that the contractual terms are incomplete or have not been followed, the intercompany transaction will be interpreted based on a careful review of the parties’ actual conduct.

Describing the actual conduct of the related parties requires examining all of the facts and circumstances surrounding how they interact in a commercial context—how they generate value for themselves and the group, how that interaction contributes to the rest of the value chain, and what the interaction involves. That means identifying precisely what functions each party actually performs, the tangible and intangible assets each party actually employs, and the risks each party actually assumes and manages. This process is typically referred to and documented as a “functional analysis.” At this stage of a transfer pricing analysis, the facts that are economically relevant are gathered during interviews with key employees.

During a transfer pricing audit, revenue authorities are likely to conduct their own functional analysis interviews to develop an understanding of the business. So, if you’re able to perform the functional analysis interviews up front, and you’ve carefully documented the actual conduct of the related parties as one part of your contemporaneous transfer pricing documentation, the tax authority’s functional interviews become a process of validation rather than fact finding. For this reason, you should review and update your intercompany arrangements periodically to ensure that there is consistency between the legal form and managerial substance of your intercompany transactions.

What now?

While globalization has facilitated international trade, growing sovereign debt and cash-strapped governments have arguably ignited worldwide transfer pricing disputes. Political will, influenced by perceptions that multinational corporations are not paying their “fair share” of taxes, has created a contentious environment in which transfer pricing is considered low-hanging fruit for revenue collection by tax authorities.

The many revenue authorities that adhere to the OECD’s transfer pricing guideline[6] are targeting their audits at aligning transfer pricing outcomes with value-creation activities, with a focus on identifying the important people functions. Companies must review their business models to monitor, and perhaps restructure, the relative risks assumed and the requisite managerial substance requirements on an entity-by-entity level. The goal should be to establish transfer pricing policies that are practical to administer, flexible enough to comply with multijurisdictional regulations, and—most importantly—reflect the substance of the intercompany arrangements.

Gordon McGuinty is a transfer pricing manager with the Vancouver office of PwC Canada and is currently on secondment to the Rotterdam office of PwC Netherlands. He thanks Elisabeth Finch, a tax services partner based in PwC’s Vancouver office, for her contributions to this article.


  1. See: OECD (2013), Action Plan on Base Erosion and Profit Shifting, OECD Publishing, dx.doi.org/10.1787/9789264202719-en.
  2. Rajul Awasthi for World Bank Group, “Transfer Pricing Technical Assistance Global Tax Simplification Program,” presentation given at a meeting of the European Commission and the International Tax Compact in Brussels on February 24, 2011, taxcompact.net/documents/WB-IFC-TP-RA-ITC-EU-event_Feb-2011.pdf.
  3. The Canadian Press ~ OBJ, “Penalties increasing for Canadian firms shifting profits abroad,” Ottawa Business Journal, October 7, 2016.
  4. In the context of intellectual property, significant people functions are development, enhancement, maintenance, protection, and exploitation activities.
  5. Key business risks could include research and development, market, inventory, credit, foreign exchange, regulatory, product liability, and/or warranty risks.
  6. dx.doi.org/10.1787/tpg-2010-en.

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