If the CRA was to audit Ergold Ltd., the following adjustments and tax liabilities would result — Canadian subsidiary Swedish company distributor automated milking machines dairy

Ergold Ltd. is a Canadian subsidiary of a Swedish company. The company is a distributor of automated milking machines to dairy farmers in Canada. Its sole supplier is the Swedish parent company. The current transfer pricing policy between Ergold Ltd. and its parent company has resulted in losses in Canada for its years of operation since incorporation as follows:

The company does not appear to have any internal or external uncontrolled comparable transactions that would allow you to apply a traditional transaction method. In discussions with some of your colleagues in your Toronto office transfer pricing group, you have discovered that recent transfer pricing studies have concluded, using the transactional net margin method, that similar distributors operating in Canada earn an operating margin percentage of 5% of sales. You mention this to the controller. He indicates that he does not believe that there is much of a concern as he has heard that because of the company's small size there would not be any penalties applicable if the CRA were to audit. Ergold's effective tax rate has been approximately 36% for the past three years.

REQUIRED

How would you respond to the controller? How can you convince the controller that he should consider having your firm prepare a transfer pricing report to provide it with documentation to support its transfer pricing?

SOLUTION

If the CRA was to audit Ergold Ltd., the following adjustments and tax liabilities would result:

The 10% penalty will apply because the transfer pricing adjustment for each year is greater than the lesser of 10% of gross revenue and $5,000,000, per subsection 247(3). Furthermore, if Ergold Ltd. is not using transfer prices that are based on the arm’s length principle and cannot support those prices through documentation, the company is subjecting itself to potential audit and substantial tax ($342,000) and interest liabilities. [Note that the tax could be reduced if adjustments to reduce income in Sweden are accepted by the Swedish equivalent of the CRA]. Furthermore, if there is a tax audit, the company could incur considerable professional expenses defending itself, not to mention the time involved in going through the competent authority process.

Furthermore, it should be pointed out that the tax returns for Ergold would have required the company to file T106 forms that would be used to determine if a tax audit should be performed. The company’s losses along with the T106 form indicating that all purchases are non-arm’s length would very likely trigger an audit. Anytime the CRA audits a company that has non-arm’s length transactions under an October 2006 memorandum, field auditors will request contemporaneous documentation at the outset of the audit.