By Les Secular
This article looks at how Transfer Pricing can impact the bottom line on financial statements, particularly in the current global economic climate, and why management should consider transfer pricing when setting their strategy for the future and their need to adapt rapidly to change.
In order to understand why Transfer Pricing is important, it is necessary to appreciate exactly what is meant by the term.
Transfer pricing is a means by which related entities within a multinational company (MNC) transact business with each other and follow appropriate accounting principles that require that expenses be recorded where the corresponding revenues are generated – the complication being that within a MNC certain functions attributable to a sale may not be performed in the jurisdiction in which the sale is made. Similarly, certain risks and the intellectual property that assist in generating the sale may be in different geographic locations. Each part of the MNC participating in the ultimate sale should receive an appropriate reward for its “efforts” in crystallising that sale. This in a nutshell is what transfer pricing is about – recognising and rewarding the efforts of connected parties related to:
• The sale of tangible property
• Services provided
• The use of intellectual property
In order to assist both MNCs and tax authorities to determine a suitable reward, the OECD introduced the concept of an arm’s length value, essentially something that applies to transactions between unconnected parties. Unfortunately, it is never that simple and the OECD guidelines contain a number of ways of determining the arm’s length value in different scenarios and suggest a variety of methods ranging from the simple cost plus method to the profit split method, this latter method being used primarily only if the other methods do not produce an appropriate result.
Arriving at an arm’s length value can be very subjective and this is where a threat lies for many MNCs; tax authorities adopt the guidelines in different ways and do not always accept each method, instead picking those they consider appropriate and issuing their own requirements. There is therefore a lack of a consistent approach despite the existence of the guidelines. The requirements in one tax jurisdiction may also change as tax authorities see other jurisdictions achieve success in increasing their tax take or as the OECD refine their guidelines.
Accordingly, the international transfer pricing environment is becoming more complex as tax authorities become more aggressive, particularly in the area of penalties. As tax takes reduce because of losses incurred in the global economic crisis, they look elsewhere for revenue and penalties are an easy win, especially when they are not governed by the Mutual Agreement Procedure (MAP) in double tax treaties. Over the past few years there have been increasing amendments to the penalty regimes. In the UK the tax based penalty has been replaced by one based on the adjustment. Previously, with a tax based penalty, companies who had losses or could apply group relief were able to avoid a penalty. Now a penalty arises irrespective of whether a tax liability exists or not. New penalty rules apply in Italy, the Netherlands, Spain, and even Russia has introduced new transfer pricing rules effective from 1 January 2012, with a 20% penalty applying from 2014.
We are thus beginning to see a rise in the number of transfer pricing enquiries, which, ultimately, could result in significant tax adjustments locally and a rise in the number of Mutual Agreement Procedure (MAP) requests/Advanced Pricing Agreements (APA) applications, all of which can impact the bottom line.
The main action being undertaken in relation to this is more focused enquiries using either joint tax authority enquiries in more than one jurisdiction (e.g. UK/US); real time audits with local inspectors spending time at company premises reviewing the procedures; utilisation of the Senior Accounting Rules in the UK designed to ensure that companies maintain and monitor the tax accounting arrangements and the penalty amendments. One of the reasons for this drive is the increasing number of press articles that insinuate that large corporations are shifting all their profits to tax havens and avoiding local tax liabilities despite the rise in local trading activity. An example of this are the articles in the UK press earlier this year relating to Google and Amazon suggesting that they manage to generate significant levels of profits from UK and European operations but pay little tax in comparison. This will be through legitimate tax planning that should stand the test of time but it seems that tax authorities pay lip service to many major players and do not consider investigating them in case they relocate somewhere else.
Although tax authorities have powers to investigate issues, from the common man’s point of view, they do not appear to be using them in the right circumstances. It is all very well seeking to levy penalties, but these are applied, more often than not, on companies which, for whatever reason, do not have the ability or resources to defend themselves rather than those that should, perhaps, be challenged but against whom it seems the tax authorities do not want to fight due to the costs of dispute and the chance they may lose. Whilst as a taxpayer it is laudable that tax authorities are not seen to be wasting our money they should be seen to be applying the same rules to all and not what may appear to be “allowing” major companies to escape their responsibilities.
Mutual Agreement Procedure/Advanced Pricing Agreements
A shift in focus and more extensive reviews should, in theory, lead to an increase in the number of MAP requests – a procedure under double taxation agreements whereby companies claim double tax relief and seek corresponding adjustments for the additional tax arising on a foreign transfer pricing adjustment. However an MAP does not take account of penalties but only tax and, in the current economic climate, there is less incentive to apply for them; particularly, when the number of cases to date has been limited because of a lack of resources at the tax authority level. Similarly, the appetite for the APA regime is low. An APA allows companies certainty that they will not be investigated if they adhere to the various terms and conditions of an APA that has been negotiated. However, the length of time taken to agree APAs and costs – not just monetary but in terms of management time involved – restrict the ability of many companies to benefit from them.
There is also an increasing challenge to companies to not only understand the potential tax liabilities associated with various business activities throughout the world but to consider the disclosure of those potential liabilities. Under FIN 48 in the US, companies must disclose in footnotes to their financial statements a variety of information on a whole group basis relating to unrecognised tax benefits throughout the world, potential interest and penalties and, more importantly, a description of tax years that remain open for examination anywhere in the world. This information can be readily available to tax authorities outside the US and could lead to an increase in local enquiries.
Although there are a number of valuation methods relating to intangible assets, each has certain drawbacks. For discounted value there would be issues over how discount rates are determined; useful life should consider legal, regulatory, commercial and economic aspects; and the income method requires reliable forecasts. Cost is not usually recommended as marginal cost is often very low but if intangibles are transferred before they have been exploited, the cost of creating them may be a factor in determining the market price. It can be difficult to find market comparatives as IP may have distinct unique characteristics particularly in the pharmaceutical industry. Factors such as whether all legal rights are transferred or just some will impact on the valuation method used, as will limitations on applicable geography, exclusivity and the ability to restrict the use of certain rights or to reclaim them.
For tangible assets, the uncontrolled comparable transaction is the ideal method of determining the transfer price but this does not always exist and the cost plus or resale minus and the transaction net margin methods are used. The risks in using these methods lie with finding suitable comparable companies against which to benchmark oneself and whether such a comparable set will be acceptable to the tax authorities. A detailed transfer pricing study is essential.
It is also essential that a group’s internal transfer pricing policies are reviewed regularly and, if necessary, amended. MNCs are expected to have contemporaneous documents supporting their transfer pricing position and, when requested, provide such documentation to the tax authorities within a short time frame. Accordingly, every time there is a significant event within the group (acquisition/disposal/restructuring) or within the industry (significant amalgamations/liquidations/new entrants) the MNC should update its benchmarking studies and other documentation including inter-company agreements. Even where there have been no significant developments, the benchmarking studies should be refreshed every two to three years to ensure that up to date information is used in its transfer pricing documentation.
The transfer pricing documentation should also be updated regularly as, if prices are changed with retrospective effect, there can be an impact on the indirect tax (VAT) or customs duty positions and additional liabilities could arise.
Unless a MNC has a significant in-house tax department or undertakes regular transfer pricing studies (with external help), it is very difficult to keep up to date with all the developments in transfer pricing rules and regulations. It is essential that companies do keep up to date as far as possible because of the changes in the penalty regimes that now apply as discussed above and which, unlike tax adjustments which can be alleviated (to some extent) by the MAP provisions of double tax treaties or via the Arbitration Convention, there is no relief elsewhere. Any penalty is a real cost to the group.
A recent survey among multinational companies show that 75% of them are expecting a transfer pricing investigation and/or penalty requests within the next two years irrespective of whether their positions are secure or not. Companies under audit, enquiry or investigation should never panic, nor accept what tax authorities say or pay assessments without challenge. When an enquiry/investigation is started, unless there are in house personnel who have experience of handling revenue authorities, external advice should always be sought early. This is most important where there may be a lack of adequate documentation, which could then be remedied quickly. It is also worth noting that transfer pricing is not one sided: there will always be a counter party and considering the competent authority position at an early stage is a necessity, particularly as the time limits for competent authority can be short – in some cases only three years from the date of first notification by a tax authority. External advisers also have access to particular databases that could be used to generate comparability analysis that can be used even retrospectively to support a position.
As litigation can be a lengthy and costly process and there has been a lack of resources available to tax authorities, it has been possible to negotiate settlements with them. However, the subject of discrimination raises its head and tax authorities must be seen to be acting fairly for all taxpayers not just select ones. Consequently, there is now considerable pressure on tax authorities to ensure that any settlements can stand up to close scrutiny and that there is adequate evidence to support the stance adopted.
Preparation of Documentation
Although documentation supporting a return does not normally have to be supplied with the tax return, it should be prepared contemporaneously as, if requested by a tax authority, it has to be supplied within a very short deadline (30 days in many jurisdictions) and penalties applied for failure to do so.
It is thus essential that MNCs review their documentation position and satisfy themselves that they are adequately prepared in the current economic climate in which tax authorities see their current tax take reduce.
Specific Focus of Tax Authorities
Tax authorities are focusing their attention on specific areas such as the transfer, or exploitation, of intangibles and M&A transactions. Loans between connected companies, or inter-company guarantees of third party borrowings are also potential areas for adjustment, particularly where there may be losses or the level of debt is considerably larger than the equity base – with interest or guarantee payments being treated as a dividend giving rise to withholding tax considerations as well as a non deduction.
Strategy Changes and Acquisitions
With an acquisition, the transfer pricing policies of the target may not necessarily be those adopted by the acquirer and there are a number of challenges that could exist in ensuring that the enlarged group has a common policy. One particular challenge is the timing of adopting a common policy; tax authorities are prepared to allow some time to restructure but not too long. A functional and risk analysis of the legal entities in the expanded group is critical to understand and develop strategy for operational integration and ensure alignment of transfer pricing policies. Also, an analysis of ownership of intangibles and the value chain is a critical part of the integration. These latter points apply also to restructuring particularly where intangible assets are moved.
As the appetite for mergers and acquisitions grows again it is important to consider the transfer pricing implications of (and the opportunities that exist from) exploiting intellectual property (IP) in a tax efficient manner.
There are 4 common approaches to dealing with IP after a merger or acquisition.
1. Cross-licensing: Retain the IP in the existing companies and have licensing arrangements between the various affiliates.
2. IP Sale/Centralisation: Determine the value of the IP and sell to another affiliate – perhaps one created specifically for the purpose.
3. Cost sharing: Each party “buys in” to the IP of the other party.
R&D activities: R&D is undertaken in a tax efficient jurisdiction.
Each has certain attractions and disadvantages. For instance, under Cross-Licensing, some groups hold the theory that companies who retain their IP do a better job in managing, protecting and exploiting their IP, particularly as there is no requirement for valuations and no tax considerations on a potential sale/transfer. However, this eliminates tax planning opportunities, can also give rise to withholding tax and tax deductibility issues where licensing transactions involve a number of jurisdictions, and requires careful tracking and monitoring.
In light of the movement to fixed based penalties, increasing focus on intangibles and a significant increase in MAPs not matched by a similar increase in APAs, it is essential that MNCs review their transfer pricing position, particularly where there has been a recent acquisition and satisfy themselves that they are adequately protected should the tax authorities call. True Partners Consulting offers a free health-check of your position and can advise on a cost effective approach to resolving potential areas of concern.
Les Secular, Partner with True Partners Consulting(UK) LLP
E-mail: [email protected]
Tel: +44 (0)772 568 5363