IFRS: Transfer pricing considerations

By Laura Thomas, CMA

“Transfer what?”  Transfer pricing can have implications worth millions of dollars, yet it’s an area of taxation that isn’t well understood by many business professionals.  In July 2010, Canadian pharmaceutical giant, GlaxoSmithKline, won the right to appeal Canada Revenue Agency’s (CRA) landmark transfer pricing adjustment.  If the decision is reversed, it could mean GlaxoSmithKline will avoid an increase in taxable revenue of $51.5 million, plus interest and penalties.

‘Transfer price’ refers to the price charged between related companies for cross-border transactions including the purchase of goods or services, interest payments on loans, and royalties.  These prices are governed by tax law and must be reported with the annual tax return on form T106: Information Return of Non-Arm’s Length Transaction with Non-Residents.  Transfer pricing rules can be found in section 247 of the Income Tax Act (ITA).

The arm’s length principle requires that, for tax purposes, the terms and conditions agreed to between related parties in their commercial or financial relations be those that one would have expected had the parties been dealing with each other at arm’s length. For more details refer to CRA’s Information Circular 87-2R.

In conjunction with the T106 requirement, companies are expected to prepare annual documentation supporting the arm’s length nature of their transfer prices.  Documentation requirements are outlined in section 247 of the ITA and can be prepared either in-house or by an accounting firm.

With the conversion to International Financial Reporting Standards (IFRS) coming in 2011, organizations should consider the impact IFRS will have on transfer prices.  This is especially true with the CRA’s increased focus on transfer pricing audits.  Due to the economic downturn and resulting lower tax revenues coming from businesses, there has been a marked shift in the CRA’s focus on extracting tax revenues through transfer pricing.

Part of the documentation requirements for transfer pricing includes an analysis of the related company’s transactions.  A common method for analyzing transactions is called the Transactional Net Margin Method (TNMM).  In short, this method compares the net profit margin (e.g. operating margin) of a taxpayer arising from the transaction with the net profit margins realized by arm’s length parties from similar transactions.  Comparability is generally established if the taxpayer falls within the arm’s length range of results.

However, it is possible for the taxpayer’s transfer prices to change because of the IFRS conversion without any change to the underlying economics.  The conversion to IFRS may result in a change to the taxpayer’s operating results which fall within the range under one financial reporting framework (e.g. GAAP), but outside the range under another (e.g. IFRS).  This is largely due to the fact that the financial ratios are highly sensitive to accounting standards and could lead to an unreliable conclusion as to the arm’s length nature of the transactions being tested.

The Supreme Court of Canada decision in Canderel Ltd. vs. the Queen concluded that the taxpayer is free to adopt any accounting method which is not inconsistent with (a) the provision of the income tax act; (b) established case law principles or “rules of law”; and (c) well-accepted business principles.

However, taxpayers need to be aware that tax authorities may want to use the results of a financial reporting framework that are more favourable to their position; therefore, it may be good practice to document specific accounting standards that result in a significant change in profitability.  This can help address potential assertions by CRA that the significant change in profitability was the result of improper transfer prices or a significant shift of functions, risks or assets for which the affected entity was not properly compensated.

In Canada, the CRA is currently analyzing differences between Canadian GAAP and IFRS and is specifically giving consideration to the impact on transfer pricing.  This means professionals and taxpayers alike must wait to see CRA’s management of the new method of financial reporting and its application for taxation purposes.  With so much potentially on the line, all companies – big and small – should pay close attention to this area of taxation.


Laura Thomas, CMA works in the Planning & Analysis division of Financial Services at Simon Fraser University (SFU). Prior to joining SFU, Laura was a senior transfer pricing analyst with KPMG.

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