Holiday shopping, Canadian retail prices and transfer pricing controversy

Volume No. 14-07

If you grew up near the Canada-U.S. border, you may remember getting flyers from U.S. grocery and department stores in the mail, offering bargains for the holidays. The internet now allows instant price comparisons and greater choice for Canadian consumers. For a number of years, Canadians have been telling their governments that our retail prices are unfairly high compared with exchange-adjusted U.S. prices.

The federal government is now preparing to give the Competition Bureau new powers to persuade U.S. multinationals with Canadian retail operations to lower prices or achieve parity (somehow defined). Let’s hope Industry Canada talked to the Canada Revenue Agency before getting too far into drafting legislation, as one unintended consequence may be Canadian transfer pricing controversy.

Exchange rates and transport costs are variable, making a U.S. purchase a relatively better or worse deal than a Canadian purchase at different times. Tariffs, distribution and retail operating expenses, and the profit that Canadian retail subsidiaries of U.S. multinationals must report for tax purposes are relatively more fixed.

If a Canadian subsidiary sets its transfer prices for goods purchased from its U.S. parent by reference to its operating margin (as it not uncommon), a lowering of Canadian retail prices by government fiat will (all else being equal) lower the taxable income of the Canadian subsidiary. U.S. parent companies will be faced with a choice between keeping their customers and the Canadian government happy, and keeping the CRA happy with its subsidiary’s transfer prices.

Good company managers, who don’t allow the tax tail to wag the business dog, will likely vote to keep their customers happy and avoid bad Canadian press. A PR victory will come at the expense of either the U.S. treasury (if the parent cuts its transfer prices to maintain Canadian subsidiary profit), or the Canadian treasury (if the parent keeps its transfer prices the same, or does not make the subsidiary whole for its loss)[i]. When one or both tax authorities lose, there are more audit disputes, Advance Pricing Arrangements to monitor and renegotiate, and double tax cases to work out through our tax treaty with the U.S.

Here’s hoping the Canadian retail market remains worth the transfer pricing effort for many of our foreign-owned retail establishments.

[i] We’re feeling the spirit this holiday season, and we know you like numbers. Here are some numbers to illustrate the argument:

 

  A B C
p 3 2.5 2.5
q 100 100 100
Sales 300 250 250
COGS 225 187.5 225
Gross profit 75 62.5 25
SG&A 60 50 50
Operating profit 15 12.5 -25
       
Gross margin 25% 25% 10%
Operating margin 5% 5% -10%

Scenario A is the current state. Q*C(TP) is Canadian subsidiary Cost of Goods Sold and depends on the transfer price C(TP) charged by the parent. SG&A includes salaries, and let’s assume CRA has settled a prior-year audit based on a 5% operating margin. The company continues to follow this guidance (correctly, let’s assume) when doing its annual transfer pricing analysis and documentation under paragraph 247(4)(b) of the Act.

When the retail price p falls by 17% in response to government consumer protection regulation, and sales remain at q=100, the company has some choices to make. Under scenario B, the parent decreases C(TP) to maintain gross profit and the subsidiary also decreases SG&A (perhaps by reducing Canadian payroll) from 60 to 50. This maintains the Canadian subsidiary’s net profit ratio. It remains to be seen whether the IRS believes the decline in C(TP), representing a reduction in U.S. company profit, is an arm’s length outcome.

Suppose the U.S. status quo view on the transfer price wins out, and C(TP) remains the same at 225. Sales remain at q=100. Despite cost-cutting in the short-term by the Canadian subsidiary, a loss of 25 results. We expect the CRA may question this extreme result, and argue for an operating profit that is within an arm’s length range after adjustments for comparability. Good written documentation of the facts and circumstances will help explain the position taken.


THE NON-ARM’S LENGTH NEWS is provided as a free service to clients and friends of Cadesky and Associates LLP. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky and Associates LLP cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.