Understanding the arm’s length principle critical for effective transfer pricing

Executive summary

Transfer pricing rules can appear challenging to navigate, particularly as regulatory authorities in Canada are poised to more thoroughly investigate cross-border operations. Becoming familiar with the arm’s length principle—and how to implement it—is critical for Canadian businesses to ensure tax compliance.

Transfer pricing audits are expected to increase as Canadian businesses ramp up cross-border operations and governments look to ensure taxpayers are paying their fair share.

As regulatory authorities further scrutinize related-party transactions, it is critical for businesses to understand the arm’s length principle and its appropriate application.

This is particularly relevant for transactions where entities in a multinational group transfer goods or intangibles, provide services, or financing to related parties. According to subsection 247(1) of Canada’s Income Tax Act, the amount paid for these goods and services, or the terms and conditions agreed to in their commercial or financial relations should represent the price others would pay if they were dealing at arm’s length with each other.

While the arm’s length principle is crucial in transfer pricing, the Income Tax Act does not outline how prices are to be determined. Instead, the Canada Revenue Agency (CRA) endorsed the methods of determining an arm’s length transfer price used by the Organisation for Economic Co-operation and Development (OECD).

Definition and case law

Article 9 of the OECD Model Tax Convention provides, where “conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly”.

The transfer pricing rules found within the Income Tax Act are built on this premise—but the concept of the arm’s length principle has faced legal tests in Canada.

In Canada v. GlaxoSmithKline Inc., the Supreme Court of Canada emphasized that establishing arm's length prices must consider the “economic and business reality” of the transaction. In this case, the court endorsed the use of a “reasonable range” as a means of supporting and establishing arm's length prices.

Businesses should consider the respective functions, risks and assets of a Canadian entity in relation to a global group of companies when determining arm’s length prices. These prices should also be established with regard to the independent interests of each party to a transaction.

In the Queen v. Cameco Corporation, the Federal Court of Appeal affirmed the Tax Court’s decision and held that the comparability analysis is the crux of the transfer pricing rules and the transactions entered into by the parties were commercially rational. The Tax Court also noted that it needs to reasonably consider whether the transaction or series was entered into primarily for bona fide purposes other than to obtain a tax benefit.

Utilizing the OECD guidelines, the Tax Court confirmed that the presence of a tax benefit does not render a transaction non-arm’s length. Instead, it determined an analysis must be done to consider whether the transaction or series aligns with commercially rational behavior between independent parties.

The concept of tax benefit in subparagraph 247(2)(b)(ii) of the Income Tax Act is akin to the tax benefit analysis found within the general anti avoidance rule at subsection 245(1), but without the misuse and abuse analysis.

This interpretation reinforces that the arm’s length principle must take into consideration the economic justification and behavior of independent parties—in addition to whether a tax benefit exists.

T106 reporting

When a Canadian entity is conducting non-arm's length transactions with a non-resident entity, it will trigger a Form T106 filing requirement. For tax years or fiscal periods beginning in 2022 and later, the de minimis threshold for reporting the transactions has increased from $25,000 to $100,000. Recently, the CRA updated its Form T106 for tax years or fiscal periods beginning after 2024. Changes include:

• Questions regarding the ultimate parent entity of the reporting person or partnership as defined by subsection 233.8(1) of the Income Tax Act, as well as confirming whether they are a member of a multinational enterprise group and are required to file a Country-by-Country Report and which jurisdiction the report is filed

• The question of whether the existence of an advance pricing arrangement (APA) was removed from the T106 summary and included as a transfer pricing method.

• Questions to identify the type of non-resident under foreign law and specify whether the non-resident is treated differently for tax purposes in the jurisdiction of residency. New categories requiring applicants to indicate the type of relationship between the nonresident and the reporting entity were also added.

Transfer pricing audits and contemporaneous documents

During an audit, the CRA will request contemporaneous documentation as defined by subsection 247(4) of the Income Tax Act.

Contemporaneous documents are reviewed by the CRA to substantiate that a taxpayer's transfer pricing is in accordance with the arm's length principle—or that a taxpayer has made reasonable efforts to determine arm's length transfer prices or allocations.

Some of this documentation includes:

• The property or services to which the transaction relates.

• 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.

• The identity of the participants in the transaction and their relationship to each other at the time they entered into the transaction.

• The functions performed, the property used or contributed and the risks assumed in respect of the transaction, by the participants in the transaction.

• 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.

• 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.

Transfer pricing audits begin with a request for contemporaneous documentation and the taxpayer has three months after the request is made to submit contemporaneous documentation to the CRA. Timely maintenance of contemporaneous documents is necessary to demonstrate reasonable efforts were made to determine and use arm’s length transfer prices or allocations. Failure to do opens the taxpayer to adverse audit outcomes and penalties under subsection 247(3).

Businesses concerned about compliance can engage tax professionals who specialize in transfer pricing to help navigate these complexities.