Three-Month Transfer Pricing Letter

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Episode 45: Three-Month Transfer Pricing Letter

Release date: February 14, 2012
Running time: 7:36 minutes

In this episode of PwC’s Tax Tracks podcasts, we talk about the Three-Month Transfer Pricing Letter: what kind of documents are required to answer it, what to do once you get it, and who can expect to receive it.

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Through interviews with prominent PwC tax subject matter professionals, Tax Tracks is an audio podcast series that is designed to bring succinct commentary on tax technical, policy and administrative issues that provides busy tax directors information they require.

Three-Month Transfer Pricing Letter

You’re listening to another episode of PwC’s Tax Tracks at This series looks at the most pressing technical and management issues affecting today’s busiest tax directors.

Gerry Lewandowski: With us today is Karyn Issler, a senior manager in our Toronto office that specializes in Transfer Pricing. Karyn has a broad range of transfer pricing experience, including assisting clients with planning studies, preparation of contemporaneous documentation, and defence of client practices under audit by tax authorities. Welcome Karyn.

Karyn: Thank you Gerry.

Gerry: Karyn, I’m curious as to what exactly is meant by a three-month letter? Sounds kind of menacing!

Karyn: Well that depends on how prepared you are! This is a letter issued by the Canada Revenue Agency (or the CRA) at the beginning of a transfer pricing audit. It’s a formal written request for contemporaneous transfer pricing documentation, which taxpayers must provide within three months of the request.

To step back a bit, this all starts with the transfer pricing section of the Income Tax Act, which sets out the type of documentation a taxpayer must prepare and have on hand in the event of a transfer pricing audit. In short, the documentation must demonstrate that the taxpayer has made reasonable efforts to ensure its intercompany transactions are priced at arm’s length. If you don’t provide the documentation within the 3 month time frame and the CRA makes a transfer pricing adjustment, you miss your chance to avoid penalties, because the Act makes this a requirement of “reasonable efforts.” The transfer pricing penalty can be quite severe as it applies regardless of whether a tax liability results from any transfer pricing adjustment, so complying with this letter is pretty important. Also, there are no extensions for responding to this letter.

Gerry: So the first line of defence is being prepared. What type of documentation is required?

Karyn: Generally what’s required is a description of the transaction in terms of the property or services involved and the terms and conditions. The related parties involved in the transaction and their relationships with each other should be provided. Other information includes a description of the functions, assets and the risks assumed by the Canadian taxpayer, the data and transfer pricing methods and analysis used to determine the transfer prices. The assumptions, strategies and policies the taxpayer used to determine the prices should also be described. In transfer pricing lingo, we typically group the documentation into three main sections being a functional, a financial and an economic analysis.

I should add here that the three-month documentation has to be contemporaneous, which means it has to be obtained or prepared before the taxpayer’s filing due date, or six months after year-end for a corporation. In other words, you’re supposed to have prepared the documentation long before you receive the letter. The CRA gives you three months so you can gather and compile the requested documentation. If you actually prepare it during this time frame it may be deemed not to be contemporaneous.

Gerry: So what do I do if I receive the letter but haven’t prepared the documentation in advance?

Karyn: If you’re not prepared, there are a few things you can do in the time that you have. If you get the letter, take stock of the intercompany transactions that your company engaged in during the year and the documents you have to support each transaction. Form T106, which lists a company’s transactions with non-resident related parties for the year and is filed annually with the CRA should be reviewed and documentation should be compiled for each significant transaction.

Existing internal information should be gathered into a documentation package that may pass as contemporaneous. Think of the records and documents used in your company and how these can serve as documenting or supporting the transactions in issue. I’m thinking of common documents like intercompany invoices, agreements and correspondence, business plans and organizational charts showing the relationship between parties to the transaction. You’ll need a functional analysis describing the functions and risks of each related party, and a financial analysis documenting the financial outcome associated with each of the transactions. For the most part the financial information is also readily available in your books and records, as they’re mostly financial statements and other documents prepared for accounting or tax purposes. The other parties to the transaction may also be able to provide you some documents, and your parent company may also be able to help. The parent might also be the best source for group transfer pricing policies and strategies, as these are often developed at head office.

Gerry: Who can expect to receive the letter? Are some companies more likely than others to be audited?

Karyn: Yes and no. It’s not so much the particular company or the type of company as it is the unspoken red flags that may prompt the CRA to initiate an audit. Some examples are persistent losses or profitability variances, transactions involving intangibles and royalties, which are often difficult to value, bundling or unbundling of transactions (for example services and intangibles or products that are sold together), business reorganizations including closures and changes in the functional and risk profile of the group. We also see a lot of scrutiny of management or guarantee fees (that’s financial transactions and loans between companies) and of transactions involving low tax jurisdictions.

Gerry: Now, what if a client has a transfer pricing documentation report prepared in another country that includes Canadian transactions. Can I just provide this report to the CRA?

Karyn: In theory you could try, but if it’s prepared in another country it’s unlikely that it would meet the documentation requirements under the Canadian Income Tax Act; which includes the type of information that I talked about earlier, like functional analysis, terms and conditions, the economic circumstances — these all have to be addressed. So a report from another country is certainly a really good starting point. Though it’s probably not sufficient on its own, it could be supplemented with local information.

Gerry: So it sounds like the best advice is to be well prepared and don’t just wait until the last minute to compile the required information.

Karyn: That’s correct Gerry. Well-prepared transfer pricing documentation will guide a CRA auditor to the conclusion that arm’s length prices and policies have been used for cross-border related party transactions. Such documentation minimizes the risk of a transfer pricing adjustment, provides protection against a transfer pricing penalty and helps the audit to move quickly and smoothly.

Gerry: Thank you for joining us today Karyn. For additional Transfer Pricing information, please visit our PwC website at

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