Ergold Ltd. is a Canadian subsidiary of a Swedish company. The company is a distributor of automated milking machines to dairy farmers in Canada. Its sole supplier is the Swedish parent company. The current transfer pricing policy between Ergold Ltd. and its parent company has resulted in losses in Canada for its years of operation since incorporation as follows:

The company does not appear to have any internal or external uncontrolled comparable transactions that would allow you to apply a traditional transaction method. In discussions with some of your colleagues in your Toronto office transfer pricing group, you have discovered that recent transfer pricing studies have concluded, using the transactional net margin method, that similar distributors operating in Canada earn an operating margin percentage of 5% of sales. You mention this to the controller. He indicates that he does not believe that there is much of a concern as he has heard that because of the company's small size there would not be any penalties applicable if the CRA were to audit. Ergold's effective tax rate has been approximately 36% for the past three years.
REQUIRED
How would you respond to the controller? How can you convince the controller that he should consider having your firm prepare a transfer pricing report to provide it with documentation to support its transfer pricing?

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Year Ended Taxable Gross December 31 Loss Revenue 2006 2007 2008 $200,000 $3,000,000 $400,000 $6,500,000 $850,000 $9,500,000