Transfer Pricing Between Canada and the US: Arm's-Length Prices for Related-Party Transactions, and the Documentation Both Sides Expect

Transfer pricing is the set of rules that govern how related companies on opposite sides of the border price their dealings with each other. The CRA and the IRS each require that transactions between a Canadian company and its US affiliate be priced as if the parties were unrelated (the arm's-length standard), because the price determines how much profit lands in each country. A management fee set too high shifts profit to the country with the lower rate; a royalty set too low does the reverse. Both agencies can recharacterize the transaction, adjust the profit, and penalize the taxpayer that did not document its pricing. The rules apply to small groups as well as large ones; the documentation thresholds differ, but the standard does not.

Full guide: Transfer Pricing for Small Cross-Border Companies: the Arm's Length Rule, the T106 and 5472 Forms, and the File That Keeps Both Sides Calm

Key takeaways

• The standard: transactions between related parties across the border must be on terms and at prices that arm's-length parties would have agreed to. Canada's rule is section 247 of the Income Tax Act; the US rule is section 482 of the Internal Revenue Code and its regulations; both follow the OECD guidelines.
• Covered transactions: sales of goods, provision of services (management, administrative, technical), loans and guarantees (interest rates), licences of intangibles (royalties), cost-sharing, and business restructurings.
• Canadian documentation: contemporaneous documentation (prepared by the filing due date) describing the transactions, the parties, the functions and risks, the method chosen, and the analysis; without it, a transfer pricing penalty of 10% of the adjustment applies where the adjustment exceeds the lesser of $10 million and 10% of gross revenue. Form T106 reports related-party transactions above $1 million annually.
• US documentation: section 6662(e) documentation, prepared by the return due date, establishing that the taxpayer reasonably concluded its pricing was arm's-length; without it, penalties of 20% or 40% of the underpayment apply to substantial or gross valuation misstatements. Form 5472 reports related-party transactions of a 25% foreign-owned US corporation.
• Double taxation relief: an adjustment by one country that is not matched by a corresponding adjustment in the other produces double tax; the treaty's mutual agreement procedure (Article XXVI) and advance pricing arrangements resolve it.

The common transactions

Management and administrative services. A Canadian parent provides finance, HR, IT, and management to its US subsidiary, or the reverse. Arm's-length pricing is usually cost plus a markup (5% to 10% for low-value services under the OECD simplified approach; higher for services that add significant value). The CRA and IRS both accept cost-plus for routine services; the markup and the cost base must be documented.

Sales of goods. A Canadian manufacturer sells to its US distribution subsidiary. The method depends on the facts: comparable uncontrolled price where third-party sales of the same goods exist; resale price method (the distributor earns an arm's-length gross margin); cost plus (the manufacturer earns an arm's-length markup); or a transactional net margin method benchmarking the tested party's operating margin against comparables.

Loans and guarantees. Interest on a related-party loan must be at an arm's-length rate (benchmarked against the borrower's credit rating and comparable debt); a parent's guarantee of a subsidiary's bank loan may warrant a guarantee fee. Canada's thin capitalization rules limit interest deductions on debt from specified non-residents above a 1.5-to-1 debt-to-equity ratio; the US's section 163(j) limits business interest deductions generally.

Intangibles. A licence of trademarks, software, patents, or know-how between affiliates must carry an arm's-length royalty, often benchmarked against third-party licences. The treaty's Article XII rate then applies to the royalty's withholding. Transfers of intangibles to a foreign affiliate are taxed by the US under section 367(d) as deemed annual royalties.

Employee secondments. An employee of one company working for the other is a service; the cost recharge should be at arm's length, and the recharge affects permanent establishment and payroll analyses.

Documentation

Canada. Section 247(4) requires records or documents made or obtained by the filing due date that provide a complete and accurate description of the property or services, the terms and conditions, the identity of the participants and their relationship, the functions performed, property used, and risks assumed by each, the data and methods considered, and the assumptions and analysis. The CRA can request the documentation on 30 days' notice; failure to produce it forfeits the reasonable-efforts defence to the penalty. Form T106 is filed annually by a Canadian taxpayer with more than $1 million of reportable transactions with non-arm's-length non-residents.

United States. The section 6662(e) regulations describe principal documents (business overview, organizational structure, method selection and rejected alternatives, comparables, economic analysis) and background documents, in existence when the return is filed. The IRS can request them on 30 days' notice. Form 5472 reports a 25% foreign-owned US corporation's transactions with related parties; the penalty for a missing form is $25,000.

Adjustments and relief

If the CRA adjusts a Canadian company's income upward (finding the management fee to its US parent too high), the US parent has been taxed on income Canada now taxes too. The parent seeks a corresponding adjustment from the IRS under Article IX and, failing agreement, competent authority relief under Article XXVI's mutual agreement procedure. The process takes years. An advance pricing arrangement (bilateral, negotiated with both agencies before the years in question) fixes the method in advance and eliminates the risk for the covered transactions; it is a significant undertaking suited to groups with material recurring transactions.

Small groups

A Toronto consultancy with a Florida subsidiary, a Vancouver software company with a Seattle sales office, a Calgary engineering firm with a Houston affiliate: each has intercompany transactions (management fees, cost recharges, licences, sales) that the rules cover. The practical approach for a small group: identify each transaction; choose a defensible method (cost plus for services, a benchmarked royalty for IP, resale price or TNMM for distribution); document it in a memo with the analysis before the first return; execute intercompany agreements that match; file T106 and Form 5472 where thresholds are met; and refresh the analysis when the business changes.

Worked example

A Toronto software company (parent) forms a Florida subsidiary to sell and support its product in the US. The subsidiary pays the parent a licence fee for the software and receives management services from the parent; the parent seconds two Toronto developers to the subsidiary for six months.

• Licence. Benchmarked against third-party software distribution licences; a royalty of 25% of the subsidiary's net revenue documented; Article XII exempts the software royalty from US withholding (W-8BEN-E on file).
• Management services. Cost plus 7% for finance, HR, and executive services, allocated by headcount; documented.
• Secondments. The parent recharges the developers' cost plus 5%; the subsidiary runs US payroll for the period through an employer of record; PE analysis for the parent documented.
• Filings. Parent: T106 (transactions exceed $1 million), contemporaneous documentation memo. Subsidiary: Form 5472 with the 1120, section 6662(e) documentation. Both: intercompany agreements executed before the first invoice.

Official sources

Under section 247, "the terms and conditions should be identical whether you are dealing with parties at arm's-length or not." Following Budget 2025 changes, "the timeframe for providing contemporaneous documentation has been reduced from 3 months to 30 days upon request," and "the threshold for penalty consideration has been raised to the lesser of $10 million or 10% of gross revenue." — Canada Revenue Agency, Transfer pricing, https://www.canada.ca/en/revenue-agency/services/tax/international-non-residents/information-been-moved/transfer-pricing.html

"Section 482 of the Code authorizes the IRS to adjust the income, deductions, credits, or allowances of commonly controlled taxpayers to prevent evasion of taxes or to clearly reflect their income." — Internal Revenue Service, Transfer Pricing, https://www.irs.gov/businesses/international-businesses/transfer-pricing

"Corporations file Form 5472 to provide information required under sections 6038A and 6038C when reportable transactions occur with a foreign or domestic related party." — Internal Revenue Service, About Form 5472, https://www.irs.gov/forms-pubs/about-form-5472

Practitioner note

Transfer pricing is the audit issue that small cross-border groups assume is for multinationals, and the CRA and IRS do not agree. A management fee with no memo behind it is an adjustment waiting to happen, and the adjustment is double-taxed until competent authority fixes it years later. We write the pricing memo before the first intercompany invoice, and we file the T106 and Form 5472 that put the transactions on the record.

See also: Planning a move? Start with the Canada-to-US tax checklist and browse every corridor by city, province, and state.

Next step

Fairlight prepares the intercompany transaction inventory and pricing methods, the contemporaneous documentation on both sides, and the T106 and Form 5472 filings. See cross-border pricing or book a call.