Written by: Justin K. Hoffman, CPA, CA, CPA (Illinois), CFP, TEP, B.Comm Senior Manager, Cross-Boarder Tax Services | Davis Martindale LLP
While transfer-pricing studies are a reality of international business for large corporations, for small businesses a transfer pricing study may be prohibitively expensive to their organizations. For both Canadian and U.S. tax purposes, transfer-pricing penalties occur when contemporaneous information has not been prepared to document the determination of arm’s length prices for transactions between non-arm’s length parties. The following summary provides an insight into the Canadian and U.S. penalties associated with failing to maintain contemporaneous information.
Transfer-pricing penalties are triggered when the total of all transfer-pricing adjustments exceeds the lesser of:
- 10% of gross revenue for the year; and
- $5 million CAD
If the penalty threshold is exceeded, the penalty for failing to maintain contemporaneous information is equal to 10% of the total transfer-pricing adjustment.
In quantifying the Canadian penalty, please note:
- The penalty is assessed on the amount of the adjustment NOT on the resulting tax; and
- The penalty applies to all of the adjustment, NOT just the portion more than the penalty threshold.
Unlike in Canada, the U.S. transfer-pricing penalties are assessed on the underpayment of tax that results from the transfer-pricing adjustment rather than being assessed on the adjustment itself.
A 20% penalty will occur in two scenarios:
- Transaction Penalty: The appropriate transfer price is 200% more or 50% or less than the price reported by the Taxpayer; or
- Net-adjustment Penalty: The increase to taxable income associated with the adjusted transfer pricing exceeds the lesser of $5 million USD or 10% of gross receipts
If the IRS determines that there has been a gross misstatement (based on specific numerical thresholds), the assessed penalty will increase from 20% to 40% if the adjustment is more than double the normal thresholds.
In estimating the U.S. penalty, please note:
- The transactional penalties is assessed on a transaction by transaction basis;
- The net-adjustment penalty is assessed on the total of all transfer pricing adjustments; and
- Only one of the penalties can be assessed for each transaction.
The following example illustrates the potential application of Canadian and U.S. transfer pricing penalties:
For simplicity, assume that the Canadian dollar and U.S. dollar are at par. Canco has $3,000,000 in annual sales and purchases $1,000,000 in product from a U.S. subsidiary (“Subco”). The U.S subsidiary sells $3,000,000 of products worldwide. The tax authorities determine the transfer price on the intercompany sale should be $2,000,000. Accordingly, penalties result as follows:
Since the $1,000,000 adjustment is more than the 10% gross revenue threshold ($300,000), a 10% penalty is assessed on the $1,000,000 adjustment resulting in a penalty of $100,000 being assessed to Canco.
Since Subco has $3,000,000 in gross revenues, the threshold for the 20% net-adjustment penalty will be $300,000, and the penalty will increase to 40% if the adjustment is more than $600,000. Since the adjustment is $1,000,000, the 40% net-adjustment penalty is assessed on the underpayment of tax. Assuming a 35% tax rate, the underpayment of tax is $350,000 resulting in a penalty of $140,000 to the Subco. Since the net-adjustment penalty results in the largest penalty, the IRS does not assess any transactional penalties.