Strategy

Transfer pricing: Trading places

Multinational companies in Canada are finding out that a lucrative tax loophole — transfer pricing — is rapidly closing.

Multinational companies in Canada are finding out that a lucrative tax loophole is rapidly closing. Called “transfer pricing,” it allowed companies to change the value of goods, services and intangibles such as patents by moving them between subsidiaries in different countries, effectively allowing them to reduce or even eliminate tax obligations in a particular country. But the Canada Revenue Agency, for one, is paying a lot more attention to what may seem like arcane accounting to most.

But even before the current downturn, the CRA was increasing its pressure on multinationals trying to report less revenue in Canada. Gary Zed, senior tax partner and leader of the National Transfer Pricing Group at Deloitte, has conducted surveys with close to 1,000 financial executives over the past three years and found that almost 75% of them feel that CRA enforcement is on the rise and that transfer pricing is the No. 1 issue they face from a tax perspective.

The CRA’s vigilance alone means that multinationals will need to re-evaluate their transfer pricing methodology to avoid the predicted increase in disputes between themselves and various revenue agencies. Most companies can avoid this type of conflict if they use an arm’s-length standard for their cross-border transactions. In short, the transfer price should be the same as if the two companies were independent and not from the same corporation.

GlaxoSmithKline Inc., the Canadian arm of British pharma giant Glaxo Group Ltd., maker of the popular anti-ulcer drug Zantac, has certainly felt the CRA’s sting. GSK was paying about $1,600 per kilogram of ranitidine — Zantac’s active ingredient — to Adechsa SA, a Swiss-based company that is wholly owned by its parent. At least it was before the CRA stepped in. Because generic pharma companies in Canada were paying between $200 to $300 per kilogram of ranitidine, the CRA originally added about $51 million to GSK’s income to account for the extra revenue that should have been reported in Canada.

The alleged result, says Christopher Steeves, a Toronto-based tax lawyer with Fraser Milner Casgrain LLP, “was that the amount of profit earned in Canada by GSK was substantially less, because they were having to pay so much for the active ingredient. And by doing that, they’re shifting profit from Canada into Switzerland, where the money was subject to very little, if any, tax.”

GSK fought the Canadian taxman for 10 years before being ordered to pay additional corporate taxes (a motion that GSK is now appealing). Anybody caught these days would also likely be subject to additional penalties, as Chrysler Canada Inc. may soon discover. The automaker has been hit with a $500-million charge by the federal government for taxes owed over the pricing of cars and car parts between itself and its Detroit parent.

Zed says revenue agencies worldwide have been stepping up their audit activities to ensure maximum compliance, and they are willing to take on lengthy and complicated cases. One reason for that is because the way goods and services are priced also translates into profits or losses for certain revenue agencies. “It’s not an equal sharing of profits; it very much depends on who and what generates value and profit in the first place,” Zed says.

The poor economy has also added a new wrinkle for revenue agencies. The CRA, which normally determines the profits on such transfers, is now also in the business of allocating losses. “The question becomes who bears the cost of the plant closure: is it born by the country where the plant was located, or the various components of the multinational group?” says Zed.

Fortunately, most cases are resolved in the boardroom and not the courts, says Zed. But if the economy continues to sour, an even bigger issue may become trying to collect from companies unable to pay up.