Can Jurisdiction-Specific Transfer Pricing Benchmark Nuances Help You Mitigate the Impact of Tariffs?

Recently, I was speaking with a prospective client who has manufacturing operations in Canada and distribution in the US. Due to the proposed tariffs by the new White House Administration, she expressed the desire to lower her transfer prices at the US entity as much as possible. 

At first, I thought to myself, ‘Is this really worth the trouble?’ While indeed in this case, lowering the intercompany price lowers the duty paid to the US, it still increases the corporate income tax paid to the IRS, which stands at 21% federally, with additional varying state tax rates. 

But upon further consideration, I realized her idea had merit. She could optimize her organization’s overall tax burden when taking income taxes in both jurisdictions and customs duties into account.

Let’s think about the various components of the overall tax burden, and the results of tariffs, if the taxpayers adjusts their transfer price to remain compliant on this front:

• Income tax in the US 
• Income tax in Canada 
• Customs duty 

Let’s assume this taxpayer must decrease the transfer price of the goods, to keep the US tested party within the arm’s length range.  The tariff is part of COGS (or OE) and included in the operating margin PLI of the tested party—which has to remain in the arm’s length range for both IRS and CRA purposes (more on this later). The taxpayer’s US income tax burden may stay the same, or it may increase. 

By decreasing the transfer price, the customs duty decreases, lowering the MNE’s tax burden on that front. Additionally, with the lower transfer price, the taxpayer’s Canadian income tax burden also decreases. 

Additionally, in this same example, it’s important to note the mismatch in arm’s length range calculations between the two jurisdictions can play an important role. The IRS uses a three-year weighted average 25%-75% “interquartile” range to determine the arm’s length margin of the tested party, while the CRA relies on a one-year full range of comparable PLIs. 

What does this mean for a taxpayer with this fact pattern? They could technically increase their US distributor’s operating margin aggressively, to the high end of the IRS interquartile range, and still fall comfortably within the CRA’s range, thus mitigating any exposure to potential transfer pricing adjustments.  

The mismatch in transfer pricing regulations combined with tariffs presents an opportunity to optimize their overall tax burden—assuming the taxpayer thinks through all the various layers or risk and reward, such as anti-dumping considerations, diverted profits, and foreign tax credit implications, among others. But is this a viable strategy in a post-BEPS world? Or, is it base erosion?  That is something that every taxpayer and administration will have to decide for themselves.