Transfer Pricing Strategies for Canadian Startups Going Global

Melinda Nguyen-Raybould 

Thank you, Hessie. 

Hessie Jones 

So. You know. Maybe I’ll ask you, how did you get into this in the first place? What was your interest in in this area? 

Melinda Nguyen-Raybould 

So it’s funny enough, I’ve never met anybody in transfer pricing that got into it intentionally. My background is in economics and I did my undergraduate work in. So at one point I was looking for potential jobs aligned with my education. Umm this field of transfer pricing came up. Had a friend that was doing it. He explained it to. It’s on really interesting and sounded like a great way to apply my skills, so that’s how I kind of by mistake ended up in transfer pricing and I’ve been. It for. About 24 years now. 

Hessie Jones 

So by mistake, you’re actually doing a pretty good job. I like to think so. So let’s start with the definition of transfer pricing. I alluded to it a little bit earlier, but I’d like this to come from you. So tell me. What is it and why it’s relevant to start-ups who want to expand to the US or even internationally? 

Melinda Nguyen-Raybould 

So transfer pricing is something that is primarily relevant to multinational enterprises. So that’s any. Group corporate group. Entities legal entities in more than one country or legal. So what dress pricing deals with is the pricing intercompany pricing from one legal entity in the group to another legal entity in the Group of tangible goods, services, financial transactions or intangibles? So any of those things could be sold or provided from 1 entity in a group to another entity in a group in a different country. And there is a price that needs to be attached to that. Good service, intangible or financial? So that’s what transfer pricing deals with? 

Hessie Jones 

1. And so why does it matter to startups?

Melinda Nguyen-Raybould 

So it matters because transfer pricing impacts how much profit is left in each legal entity in these different tax jurisdictions. So for example, if you think of profit. As a pie and a pie that needs to be shared amongst all of the different jurisdictions where you have legal entities. The piece of pie that you get is entirely dependent on how you structure and how you price these intercompany transactions. So if you’re selling a good from your Canadian parent company to your US subsidiary, if you increase the price. From Canada, you decrease the profit in the. So it matters because it may impact the amount of tax you pay overall, your your effective tax. Rate and it matters to both the US and Canadian tax. So the IRS and CRA, because it affects how much of the pie they. To. So it matters to you because you’re trying to manage your effective tax rate and it matters to the tax authorities because it affects how much. Tax from your profit. 

Hessie Jones 

1. I want you to explain this. This notion of this arm’s length principle, because this ends up being some kind of cornerstone, I believe.

Melinda Nguyen-Raybould 

So the arm’s length principle principles really the foundation of transfer. So the idea of the arm’s length principle is that any intercompany transaction within your multinational needs to be priced. At the same terms and conditions that would have existed in identical circumstances between two third parties. So not you know. Not necessarily what you might view as a market. There’s a lot of things that go into that and and lots of factual determination that goes into it, but it’s basically to say you’re not allowed to just make up whatever price you want. You have to adhere to this concept of the arm’s length principle. So that it would have been the same terms and conditions if you had been transacting with a third party. 

Hessie Jones 

1. So let’s go a little bit into what are the different types of a transfer pricing methodologies. I know you told me that there are many, but can you just talk a little bit about this?

Melinda Nguyen-Raybould 

So maybe at a high level, certain countries will follow the OECD guidelines and the OECD guidelines specify certain transfer pricing methods that apply to to these various categories of transactions that that could be put in place. Some of these, some of these methodologies are what we call transaction based methodology. And some are what we call profit based methodologies, which is a more indirect test of the price. the US is not one of those countries that follows the OECD guidelines. They have their own set of methodologies for tangible goods and services intangible. It’s very confusing because you have. Often times in different jurisdictions, different methodologies that you need to juggle. 

For example, something like the OECD comparable uncontrolled price. Is probably closest to what you might. Think of as a market price. Excuse me. So comparable control price is a comparison of an identical good service or intangible. In identical terms, conditions, business circumstances, etcetera. So you may ask a question. Give me a second. So you may ask a question. How much is the price of an apple? And so if you are trying to apply the comparable uncontrolled price, you need to understand well what kind of Apple is it a red apple? It a green apple. Is it a honey crisp apple? It a fresh. Is it you know, a 2 month old Apple? Where are you selling this apple? It being sold in. Germany is being sold in Toronto. Is it being sold in Alaska? And then finally, at what level market is it being sold? It. Sold out of retail level to a customer. Is it being sold wholesale? So all of these, all of these factors will play into how you determine what the comparable uncontrolled prices and what prices you can use. To compare to your apple so. It literally needs to be in Apple’s to apples comparison. 

Hessie Jones 

So let’s take for example. The software technology software industry, because this is what’s most relevant to many of our startup. We deal with intangible assets like intellectual property and software and patents and the so when it comes to pricing. How does transfer pricing impact what technology startups use when they sorry, when they when they price their services abroad, taking these kinds of things into consideration?  

Melinda Nguyen-Raybould 

So it really depends. So the foundation of kind of transfer pricing determining how you comply with the arm’s length principle is the facts and the facts and the economic circumstances. For example. We refer to something called a functional analysis. So that is what functions are each entity to the transaction undertaking. What assets are they employing? Who owns the? Who has, you know, machinery, intangible, tangible assets, and what risks they’re. So that’s all very important into making that determination and we also have to consider the broader economic circumstances and the business strategies you’re employing. So for example. Strategy to try to penetrate the market and push out your potential competitors is your strategy to. Build your presence first and make your brand known with first generation product before you launch a different product. There’s a bunch of things that come into play. And then once we understand those facts, we can look at what is the appropriate methodology that we need to apply based on our understanding of the facts. So it can vary from you know company to company. Can have 10. Clients or companies that have the same transaction in place and have 10 different answers because of facts and circumstances are a little bit different in each one. 

Hessie Jones 

Do you have you know whether or not, let’s say, IP registration? In your home, in your domestic country. It is different than if you had also registered it in the country that you want to expand to. 

Melinda Nguyen-Raybould 

So I I think maybe what’s helpful to understand in terms of pricing, is that the concept of registering your I PS is a legal concept, right? Legal registration and ownership is kind of one aspect that we look at in transfer pricing. We also look at what we call economic ownership. So who? Has contributed to the value creation of IP, so you may have registered the IP in your home jurisdiction and you may legally. Feel that it? And you, you know, in a certain jurisdiction. But if the work to develop, it has been done in a different jurisdiction and it has not been compensated for and that other entity is like an investor who’s put sweat equity into developing the IP now. They partially economically own that. And we do see that a lot with startups where we have kind of messy shared ownership of IP between jurisdictions because nobody thought about well, do we need to worry about compensating that other edge. As a contractor, do service provider so we can maintain our economic ownership along with our legal ownership in a different jurisdiction. 

Hessie Jones 

1. Yeah, that sounds really complicated. So I’m gonna throw another one at you because most of them there are a lot of businesses that intact that have a business model, known software as a service and so. What? How do you price something like this when? Let’s assume that? From a cost of goods sold perspective. The the entities that are even working maybe are finding the cost of goods sold but the employees are situated either remotely domestically or they’re spread all over the world. How does that? Play into the transfer price, or does it?

Melinda Nguyen-Raybould 

It. So there’s a couple of things. Again, going back to this concept of we need to understand the facts. So in terms of the facts, are these employees of you know you could have employees of the Canadian company spread? Over the world. Right. Or contractors that work for the Canadian companies spread all? The. So who are they employed? Employed by? Would be the first. Factually, we need to understand that. Secondly, let’s say if they’re employed by these legal entities. Exactly. Are they? What functions are they undertaking? And how are they contributing to the? So that’s another thing that we need to understand. So if we have employees who are employed by legal entities spread throughout the world, that means that if we look at that pie again, the concept of splitting up a pie. We may have to give at least a sliver of the pie to each of these jurisdictions because they’re doing something to economically contribute to the business. That’s what that really. But we also looked again to where these WHO employees these employees and whether they’re employed by the local legal entity or whether they may be, let’s say, an employee of the Canadian company who’s living. In living in Mexico. 

Hessie Jones 

1. Got it. So earlier I alluded to the fact that the the Canadian legal I guess are taxing as well as I guess are laws so are sort of unified or harmonized across our provinces. Different in the. See this all the time. But even from a taxing perspective. There there are, what, 13,000 jurisdictions? A taxing jurisdictions, and they’re all different or modified depending on, you know, sales. Sales and other taxes, but even between a a county and state level. So tell me about, I guess the implications of pricing implications are there at the federal level or the state level specifically let’s say in the US?

Melinda Nguyen-Raybould 

Mm hmm, so I I sort of at a broad level and starting at the federal. So your transfer pricing will impact the overall amount of tax that your US entity will pay at a federal level to the IRS. Often times, with the States and other jurisdictions below the state. They look to your federal income first to then decide how they’re going to tax it at the state level. So while transfer pricing is primarily concerned on a cross-border basis with with how we how we. How we’re taxed at the federal level, it can have a trickle down effect of how that income is now taxed at the state level. And then in addition to that, there’s there’s a kind of very interesting arm of transfer pricing within the US where certain States and is becoming much more of an area of focus now are looking into state to state transfer pricing. So while we’ve been mostly talking about, let’s say, a Canadian company that sets up a, a subsidiary in the US and selling products to the US. Within the states in the US, you could have a legal entity, say in Virginia. Selling products to a legal entity in California, and there may be intrastate transfer pricing issues and at the state level, a lot of these jurisdictions have been hiring and. Employing more examiners to look at the state by state transfer pricing issue. 

Hessie Jones 

OK, so I want to get into a scenario when there’s a potential that an entity exposes itself to tax penalties because of non compliance. So let’s use the same scenario while we’re talking about a startup that that wants to enter the the US in the smart Home devices area. They decided in Canada that they set up a subsidiary in Florida. For the corporate. Rate in Florida is much lower than it is in Canada. They proceed to sell the product. From Canada to the Florida entity and then from Florida, they sell it across the US. A much higher price than they would do domestically. What it could be the potential problem here. 

Melinda Nguyen-Raybould 

So the. Of your scenario right there is that the US might be earning a lot of profit maybe, let’s say very little profit or no profit in Canada. So my answer to the. Is it always? So whether that scenario that you presented is a problem really depends on. What functions each of these entities are performing? What assets are employing and what risk state? Risk they. So an example of where this definitely would be an issue. Is if you have a legal entity in the US that is a shell corporation, there’s no employees in it. There’s no meaningful functional activity going on in that corporation, and you’re using that corporation just as a means to sell to your US customers. It takes splash title of the goods while it’s being shipped directly from the Canadian company. It’s it’s not doing anything yet. Earning a lot of profit. If the. Canadian authorities CRA were to audit the Canadian company. They might look at this and say, well, we disagree with selling this at such a cheap price to the US entity and we think that instead of say, $10 per unit, the price should have been something more like. Dollars per unit. And therefore your your profit or your piece of the pie should have been much bigger than what you actually left here, and we will reassess you and adjust that price. And then tax you on the additional profit that we think you should have. In cash. And so then there’s a the rest that you have to pay additional tax when you don’t expect it. B. If that adjustment is large enough, there could be potential transfer pricing penalties. So in Canada, if you have an adjustment that breaches a penalty threshold, which is the lower of Canadian $5,000,000 or 10% of your gross receipts. That adjustment amount will be subject to a 10% penalty in addition to any tax additional tax that you. And then on top of that, you now have the problem of, well, you’ve already paid a bunch of income tax to the US and now you have income that’s been double taxed. There is a process common authority process that you can go through to recover the tax that you paid on that income to the US. However, that process is lengthy, it’s expensive, and it’s definitely not something that you want to tie up your time and resources as doing as a as a start. 

Hessie Jones 

1. So you mentioned some of the penalties are there more than that, I guess that it would everything is is situation dependent, but I would assume it that there are much more. Penalties depending on what kind of exposure. Of the situation has happened.

Melinda Nguyen-Raybould 

Yeah, so, so on the other hand, like if we flip the jurisdictions around. There could have been penalties in the US, so if we were, you know, we just switch the scenario and flipped it around. If we’re dealing with, let’s say, royalties, other things that are subject to withholding tax, there could be additional withholding tax owing depending on how badly you got the answer wrong, there could be. Other penalties as well, so there’s a lot of different implications, not just the transfer pricing penalties, but you could have kind of ancillary additional taxes or penalties owing from getting your transfer pricing well. 

Hessie Jones 

1. So what do startups need to do to equip themselves to make sure that they remain compliant, especially in once they determine that I want to do business in this market, what do they need to do?

Melinda Nguyen-Raybould 

So I think the first thing is being aware that transfer pricing is an issue and that it exists and that as soon as you start. Setting foot with another legal entity in another jurisdiction, whether that’s us or someplace in Europe or someplace in Asia, you now have transfer pricing whether you want to acknowledge it or not, you have a transfer pricing issue. So that’s the first part is acknowledging that once you start setting up new legal entities outside of your home country. The second is is really to like. We engage with an. So this is this is a complicated field. We like to think of ourselves as a black sheep of tax because it’s very much a field based on economics. It’s very difficult. I often talk to. To start to say, you know, we’re using a market. You know, we just price this at the same same price we’re using in the market or this is the. Price that we see. Often times, the way that we get to what the actual price should be is very complicated, and there’s a lot of factors that you may not be aware of. It’s it’s a little bit of you don’t know what you don’t know. And what may seem kind of common sense and reasonable and rational to you may not actually work from a trust pricing perspective because we go into levels that you may not kind of really understand. The the biggest thing is, you know, being aware that this is an issue. When you’re going to another jurisdiction and setting up a new legal entity, you should talk to your advisors. And understand what the potential transfer pricing issues might be so that you can proactively manage both your effective tax rate and make sure that you’re not causing any major penalty risks through non compliance or potentially creating. You know, penalty risk or an exposure that you know on exit if you’re trying to get acquired 5, five years down the road, that a potential buyer might say, oh, I don’t want to inherit that mess or leave you having to make representations. Against any of these tax liabilities. 

Hessie Jones 

1. So it’s fair to say that as much as startups may understand some of these concepts that we’re talking about today, they can’t do it on their own. They’ll need the experts right?

One last question and I think this is this is the question that interests a lot of our startups because of the latest news that came out of the US where there could be a potential imposition of a 25% tariff on Canadian products and services and this will have potential consequences. Well, it will have consequences. Know that. It’s going to have consequences for any startup who wants to sell into the. So can you tell me a little bit about the sectors that are that are primarily impacted by this and what are some of the, what are the implications for startups who? Who had planned on actually expanding next year? 

Melinda Nguyen-Raybould 

So the issue and full disclaimer, I’m not a customs and trade expert, but you know the the issue is that the value of a good coming into the US is important so. In in that world, there’s a whole different set of methodologies they used to value a good coming into the US. Us. But oftentimes, we’re starting from the transfer. So if you’re selling, let’s say, your smart home device from your Canadian parent company to your US distribution subsidiary, the price that you are selling that smart home device at will have an impact on how much of that. What value can be subject to duty or different tariffs so that that’s kind of our transfer pricing intersects with that? It’s, I think as I understand it, maybe a little bit unclear what sectors may be affected by that and that’s to be seen. But anybody that’s selling a product in a company, cross-border to the US. Will need understand how they personally are affected by it and and probably start thinking about how best to prepare for that now. 

Hessie Jones 

It’s definitely going to be a competition and they may be priced out of the market, who knows? It’ll be. Well, I think. All we have time for. And I I thank you so much, Melinda, for joining. This is a complicated topic. I’m I’m starting to realize that as I even was researching this. A little while ago that wasn’t as easy as it seems. Pricing pricing strategies domestically is a whole. Different kettle of wax when you actually go internationally. So thank you for. For providing us with your wisdom and knowledge on this topic. 

Melinda Nguyen-Raybould 

Thank you for having me. 

Hessie Jones 

No problem. And so for our audience, if you have topics that you want us to explore, please e-mail us at communications at altitudeaccelerator.ca. Tech Uncensored is powered and is produced by altitude accelerator and we are hosted on Spotify and you can find us. Wherever you get your podcasts in the meantime. Until next year, everyone have fun and stay safe.