Q&A: What does your tech startup need to know about transfer pricing before expanding into the U.S.?

You’ve worked hard to grow your tech startup — and now you may be considering setting up a subsidiary company in the U.S. to gain access to a new marketplace. However, any multinational group will need to navigate transfer pricing to achieve compliance with regulations on both sides of the border, allocate its income appropriately, and pay the right amount of tax.

We’ve sat down with MNP’s Melinda Nguyen-Raybould to discuss what transfer pricing is, how transfer pricing works, and how appropriate transfer pricing can support your tech startup.

Q: What is transfer pricing?

Transfer pricing is the intercompany pricing of goods, services, intangibles, and/or financial transactions within a multinational group. Any multinational group will have some degree of transfer pricing, and transfer pricing regulations require that these transactions take place at the same terms and conditions that would take place between arm’s length parties.

However, establishing arm’s length pricing for a transaction is not a simple process. Each jurisdiction adheres to specific guidance, especially on the transfer pricing methodologies (TPMs) that can be applied to a certain transaction. The approach to pricing a transaction depends heavily on the facts and circumstances surrounding the transaction.

Q: How does transfer pricing impact taxation?

Transfer pricing is a taxation matter because it impacts the amount of taxable income recorded in each jurisdiction. Once your tech startup reaches C$1 million in total aggregate transactions with foreign related parties, it is required to file a T106 form with the Canada Revenue Agency (CRA), concurrent with the tax return filing. This form discloses the transaction types, amounts, and TPMs used to determine pricing. This form specifically asks if the taxpayer maintains contemporaneous documentation for its transfer pricing.

The U.S. has a similar form, which is form 5472. However, there is no de minimis threshold for reporting.

Q: What is contemporaneous documentation?

Contemporaneous documentation is defined in Canada’s Income Tax Act (ITA) and in the U.S. Treasury regulations. Both delineate the required elements for contemporaneous documentation. This is the detailed evidence that multinational companies must prepare and maintain to demonstrate that their transfer pricing complies with the arm’s length principle.

In Canada, you have not made reasonable efforts to set and document your transfer prices if you have not prepared contemporaneous documentation. It is important to note that having an intercompany agreement, a management fee allocation model, or an intercompany policy document does not constitute contemporaneous documentation. Where the taxpayer has not made reasonable efforts to set and document transfer prices, penalties will apply if any proposed adjustments by the CRA breach the penalty threshold.

While the required components of contemporaneous documentation are defined by the ITA and U.S. Treasury regulations, a typical transfer pricing deliverable will include the following elements to fulfill those requirements:

Company overview

This overview describes the organizational structure, business operations, and key value drivers. It also includes other information about the taxpayer and the multinational group it belongs to, especially the members of the group that the taxpayer transacts with.

Description of controlled transactions

This section provides an overview of the intercompany transactions covered in the contemporaneous documentation. This includes the nature of the transaction, the transfer pricing policy, and the amount of the transaction in the tax year.

Functional analysis

This section describes the functions undertaken, assets employed, and risks borne by each party to a controlled transaction. The functional analysis is the factual foundation of the transfer pricing analysis and has a direct impact on the economic analysis.

Economic analysis

This analysis involves the selection of an appropriate specified transfer pricing method and the application of the method. It also includes any comparable transaction or comparable company benchmarking analysis performed to analyze the pricing of the controlled transactions. This may also include the analysis of financial statements or other relevant financial data associated with the controlled transactions. 

The U.S. and Canada both specify what transfer pricing methodologies can be applied. Both require that the most appropriate method is selected based on the functional analysis and facts and circumstances of the controlled transaction.

Other information

Information on the industry the group operates within may be included where appropriate and relevant. Other information that may also be relevant includes intercompany agreements, value chain analysis, or anything else that helps support the analysis.