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3 arm’s length principle issues that can arise

On Behalf of | Aug 8, 2022 | Transfer Pricing |

International transactions between related businesses can be highly complex matters. If your business is a taxpayer for Canadian tax purposes, you can run into some complicated issues regarding the arm’s length principle. 

Misunderstanding arm’s length

The arm’s length principle is a rule that ensures businesses carry out transactions with related entities outside the country fairly. It ensures parties comply with tax laws and do not profit improperly from intercompany transactions. 

In other words, when two businesses are related, they must conduct business at an arm’s length to ensure pricing for services and products is the same as what it would be when there is no relationship.

Failure to compile proper documentation

One issue you could face stems from the requirement to keep track of when you do or do not use arm’s length transfer prices. Further, the rules stipulate that you must make reasonable efforts to make or obtain documentation regarding:

  • Property and services involved
  • The parties involved in the transaction
  • The nature of their relationship
  • Data and methods used to determine transfer pricing

Compiling and retaining this documentation can happen on an ongoing basis or spontaneously before the filing-due date.

If you fail to provide this information to the Canada Revenue Agency (CRA), you could face penalties for failing to meet documentation requirements.

Not applying the arm’s length principle

The arm’s length principle does not apply in all cases involving all parties. However, if you and a related party outside of Canada make a transaction or series of transactions with terms or conditions that vary from those with unrelated parties, you could be in violation of this rule.

When these violations happen, an inaccurate amount of profit can be reported in Canada and transfer pricing adjustments can be necessary.

Avoiding these issues

Transfer pricing itself is indeed a complex issue that many companies face. And without extensive legal and tax familiarity, you as a business owner can make mistakes, intentionally or not. Further, it is not unusual for related parties to struggle when it comes to dealing with each other at arm’s length. 

However, with some understanding of what issues can arise and legal guidance, you can minimize the chances of committing an error or facing costly penalties.

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