by Camilla Acevedo
When Canadian startups decide to expand internationally, one key concept that must be considered is transfer pricing, which is the pricing of goods, services, or intellectual property (IP) sold between entities within the same multinational group. As businesses expand beyond borders, understanding how transfer pricing works becomes vital, especially when it comes to managing taxes and avoiding penalties.
To help us understand these details, we spoke with Melinda Nguyen-Raybould, a Transfer Pricing Partner with MNP’s International Tax Group in Toronto. For over twenty years, Nguyen has advised multinationals and domestic enterprises that want to expand internationally.
Why is Transfer Pricing Relevant?
Transfer pricing is primarily relevant to multinational enterprises or enterprises who want to expand globally. Transfer pricing directly influences how a company’s profit is distributed across its jurisdictions, “when thinking of profit as a pie that needs to be shared amongst entities, the piece of pie you get depends on how you structure and how you price these intercompany transactions, therefore, the taxes you owed, ” Nguyen explains.
It matters to the founder, as they want to get the biggest possible piece of the pie, and to the tax authorities, who scrutinize to ensure taxes are paid properly.
The Arm’s Length Principle
A core concept in transfer pricing is the arm’s length principle. The rule directs that intercompany transactions must be priced as if the entities were independent third parties, ensuring that pricing is standardized and reflects market conditions.
This principle is fundamental and protects against potential manipulation of profits to shift them to low-tax jurisdictions. Startups should comply with it, otherwise, it could lead to tax penalties and disputes with tax authorities. More transparent pricing decisions will mitigate downstream risk.
Transfer Pricing Methodologies: High-Level Overview
There are multiple methodologies to determine transfer prices, and which one is used depends on the type of transaction and the specific circumstances of the business within a given market. In many cases, what works for one company might not work for another.
Nguyen explains the most common used methodologies, transaction based, or profit based, which are usually determined by OECD guidelines that specify standards for business activities. However, she clarifies, some countries like the US have its own set of rules.
The transaction-based methodology involves setting the price of an intercompany transaction in a way that reflects what would have been agreed upon between third parties in similar conditions. As an example, Nguyen illustrates the comparable uncontrolled price (CUP) method, commonly used under this methodology “If a founder is selling an apple, they would need to clarify which kind of apple and account for several variables when setting the price for an intercompany transaction”:
- What type of apple is it? Is it green, red, organic?
- What are the circumstances of the transaction? Where is it going to be sold?
- What are the market conditions? Is the apple being sold in Toronto, Alaska, or California?
In summary, the CUP method makes sure the price set for selling from the parent company to the subsidiary aligns with what an independent buyer might pay for a comparable product under similar circumstances.
The profit-based methodology is indirect, instead of focusing on the actual transaction price, it analyzes the profit or return that each entity in the group should earn, based on the value it contributes. Nguyen discusses how functional analysis is essential to determine pricing in cases of intangibles like IP. She points that it is important to consider what functions each entity performs, what assets they are employing, and what risks they are assuming. This approach is useful on situations where comparables are hard to find.
Why is Transfer Pricing Important for Technology Startups?
Technology startups, especially those dealing with intangible assets like software or Intellectual Property (IP) face additional challenges when it comes to transfer pricing. The valuation of these assets can be complicated, as they may not have clear market comparables.
For example, Nguyen shares, “When assessing a company’s IP selling or license, we look at it from a legal perspective but also consider the economic ownership. Who is economically contributing to the value creation of the IP? Therefore, transfer pricing is essential for determining how much value is assigned to the IP in each jurisdiction”
At the same time, the rise of digital business models has further complicated transfer pricing, with remote work becoming the norm. As companies increasingly operate with a distributed workforce across multiple regions, it is crucial to carefully consider the locations of their employees and the different tax laws and jurisdictions. Additionally, profit allocation becomes more challenging, as it is harder to determine the appropriate distribution of profits based on where value is actually being created.
The Impact of US Tax Jurisdictions
With over 13,000 tax jurisdictions, the US stands out because of its complex tax system- federal, state, and local–each with different rules. Nguyen explains “Transfer pricing will impact the overall amount of tax that your US entity pays at the federal level. This is the primary focus, but it doesn’t stop there. It is often looked at the federal income first to determine how they will tax the income at the state level”.
For the US, transfer pricing is not only for international transactions but also between different states. For example, a subsidiary in Virginia selling goods to a subsidiary in California will be subject to intrastate transfer pricing implications. issues.
For Canadian startups expanding to the US, understanding these layers of federal and state-level considerations is crucial. They must closely follow specific regulations and guidelines.
Ensuring Compliance in Cross-Border Operations: Key for Startups’ Expansion
Entities can be exposed to tax penalties because of non-compliance. Consider a hypothetical scenario, where a Canadian startup sells its products at low prices to its subsidiary in Florida and resells the products elsewhere in the US at a higher price. What is the potential issue?
Nguyen explains that while this scenario could trigger serious issues, it depends on the case, as she notes “The main problem arises if the US entity works as a shell corporation with no operations or employees. If there is very little functional activity in Florida, and it is generating a disproportionate share of profits, the Canadian tax authorities (CRA) might question the pricing transactions.” If the CRA disagrees with the transfer pricing, the Canadian company could face the following consequences:
- Reassessment and additional taxes: The CRA may require the company to pay additional taxes on the higher profit it should have earned under the adjusted price.
- Penalties for non-compliance: If the pricing adjustments exceed certain thresholds, penalties may be imposed.
- Double taxation: Since the company would have already paid taxes on the income in the US at the lower Florida rate, it could now face additional tax liabilities in Canada.
Nguyen emphasizes the time and financial burden for the startup founder can be significant if they aren’t prepared. She emphasizes that the key is to have the proper transfer pricing documentation and ensuring that all intercompany transactions are priced according to the arm’s length principle. “Set up the right processes from the start to minimize the risk of non-compliance” she says.
To minimize risk of non-compliance, startups should:
- Understand the functions and contributions of each entity, to properly allocate profit based on the value added. If the Florida entity is merely acting as a passive intermediary, it would not justify receiving a large portion of the profit.
- Proper documentation is also essential to demonstrate the rationale behind how the prices were determined and how the arm’s length principle was applied.
- Plan and consider cross-border tax implications, not just the corporate income tax but also the potential issues like withholding taxes and penalties.
As startups expand internationally, transfer pricing becomes an inevitable consideration. According to Melinda Nguyen-Raybould, the first step for any business venturing into new markets is acknowledging that transfer pricing will be a reality once you set up legal entities abroad, regardless of their location.
Navigating transfer pricing is complex and often requiring expertise in both economics and tax law. For startups, early engagement with advisors is key. By working with experts, startups can proactively manage tax rates, mitigate future risks and complications. Ultimately, staying compliant is not just about minimizing tax exposure, but about protecting the company’s long-term growth and reputation.
See to the full conversation on our Youtube Channel,
MNP is a partner of Altitude Accelerator and provides financial and accounting advice for startup founders. Please go to MNP to learn more.
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