CRA summarizes how to delineate a transaction for transfer-pricing purposes

As part of his responses to questions posed at the 27 February 2024 CTF Transfer Pricing Roundtable, Frédéric Bourgeois set out a conceptual framework used in analyzing transfer-pricing issues. Here is a summary:

“Delineation” of a transaction

Consistent with the transfer-pricing guidelines (TPG), the delineation process requires outlining what has actually occurred between the parties, not simply a description of the legal agreement.

While the inter-company agreement can be a good starting point, what is needed is a detailed outline of what the parties actually did in terms of functions, assets consumed, and risk assumed; what they did for one-another, did separately, and how all this resulted in the creation of value in the business.

Commercial rationality of a transaction

Commercial rationality is another process that is linked to the transfer pricing analysis. It can really be understood as an economic test. It asks whether arm’s length parties acting in a self-interested, commercially rational manner, would have entered into the transactions with stated terms and conditions under the economic circumstances that they are each operating under. Each party would take into account the options realistically available for their business in their decision-making as to whether to enter into a transaction and what should be the terms and conditions of the transaction.

Therefore, commercial rationality requires consideration of the reasonable expectations of the best possible outcome for the entity. For the purpose of documenting commercial rationality of a transaction, taxpayers should provide an economic discussion to explain the nature of the transaction and should include consideration of the history of the arrangement and the activity of the broader market to justify the tested party’s decision.

Ultimately, the purpose of the inquiry is to determine whether the arrangement would have been agreed to by unrelated parties. As stated in the TPGs, the key question in the analysis is whether the related party arrangement exhibits the commercially rational terms and conditions that would be agreed between unrelated parties under comparable economic circumstances.

Who bears the risk?

Lastly, on the concept of who bears the risk, CRA would not, at first, differentiate between inbound (Canadian subsidiary) and outbound (Canadian parent) transactions. The transaction is analyzed in its totality. Generally, duly staffed and funded incorporated businesses are responsible for the risks that are inherent in their business and have the financial capacity to bear the risk. Any interaction with a related party carries compensation for the services that are provided, commensurate with the risk of providing the service as determined by a comparability analysis.

Generally, CRA sees risk as linked to the functions and assets. That is, the risk follows the functions and the assets, and the taxpayer’s efforts to decouple risk from functions and assets, as if risk were some form of commodity to be traded, is troublesome and not in CRA’s view how the TPGs should be interpreted and applied.

Neal Armstrong. Summaries of 27 February 2024 CTF Transfer Pricing Roundtable under s. 231.1(1), s. 247(2), s. 247(3) and s. 271(4).