Transfer pricing at the cross roads

Author:

Michael F Patton
DLA Piper
Los Angeles

Over the past decade, transfer pricing (what related companies charge each other for goods, services, financing or use of IP) has been an increasing source of opportunity and controversy for multi-national enterprises (MNEs), large and small. According to many surveys, transfer pricing has been the number one international tax concern of MNEs for many years. Enforcement of transfer pricing requirements by tax authorities has been increasing yearly, especially in the fast growing economies of China and India. Transfer pricing examinations typically result in large tax adjustments and increasingly tax authorities are imposing penalties in connection with those tax adjustments.

In the US, the Internal Revenue Service (IRS) is emphasising transfer pricing issues by significantly increasing the number of international examination agents and economists who focus on transfer pricing issues, by establishing administrative groups within IRS dedicated solely to transfer pricing issues and by adopting a risk adjusted (tiered) approach to examinations- with transfers of intangibles and cost sharing arrangements at the highest risk level (Tier 1). In 2010 taxpayers won a major victory (Veritas Software and Subsidiaries) when the Tax Court rejected IRS adjustments to increase income by $1.65 billion as additional royalties (buy-in) for the transfer of IP used to develop products the costs of which were to be shared. Undaunted by this loss, IRS officials are vowing to seek other cost sharing buy-in cases to litigate. In addition, the President's Fiscal 2012 budget includes proposed legislation that would reverse the Tax Court's legal holdings as well as tax as current US income, excess profits of foreign subsidiaries attributable to intangibles transferred from the US to a low taxed foreign affiliate.

Focused transfer pricing examination approaches are being taken in other countries including China where the tax authorities have targeted key Chinese taxpayers for transfer pricing examinations.

Recently, the Organization for Economic Cooperation and Development (OECD) initiated a multi year project to revise the Transfer Pricing Guidelines used by member countries. This project reflects an interest by member countries in developing rules to combat what some countries view as abusive transactions seeking to shift profits attributed to intangibles away from high tax jurisdictions and into a tax favoured jurisdiction. This new project follows on the heals of an earlier project dealing with business restructuring transactions where the OECD emphasised the need for economic substance when business restructurings are accompanied by a reduction of functions, risks and profits of the reorganised entity. In addition, the US and other countries are demanding transparency under which taxpayers are required to disclose the fact that their transfer prices may be subject to significant adjustment.

With the increased incidence of transfer pricing examinations, MNEs are faced with the choice of how to manage (or limit) the risk of adjustments and of double economic taxation. Most choose to "document and defend", that is to prepare documentation explaining why controlled transactions are conducted on arm's length terms and to defend that position if challenged. If the company still faces a significant adjustment, most companies pursue administrative appeals within the country, possibly followed by Competent Authority proceedings if that remedy is available. Very few MNEs litigate transfer pricing adjustments, although there is a significant amount of transfer pricing related litigation in India where tax adjustments to treble or quadruple the profit earned on India based service transactions are becoming common.

Advance Pricing Agreements (APAs) which began in the US 20 years ago have become an accepted tool for mitigating the risk of transfer pricing adjustments. Bilateral or unilateral APAs are available in most countries with active transfer pricing examination regimes, including China, but (unfortunately) excluding India. Due in part to increased financial reporting requirements for uncertain tax positions, IRS requirements to disclose uncertain tax positions and increased examination activity, there has been a significant increase in APA applications in the US.

What are best practices that MNEs should adopt to deal with transfer pricing compliance burdens, controversy exposures and to take advantage of legitimate tax planning opportunities?

• Formal transfer pricing policies should be adopted and implemented through legally effective agreements. Whenever possible, globally consistent policies that are able to withstand challenge should be implemented.
• Transfer pricing documentation should be prepared and updated periodically to comply with local country requirements. To the extent possible, one global report should be used, with modifications to meet specific local requirements. Because many jurisdictions have different documentation requirements, a risk adjusted approach should be taken so that documentation meets local requirements (including using local comparables) in those jurisdictions where the transaction volume at issue justifies taking a country specific approach.
• At the onset of a transfer pricing examination, an experienced adviser should be consulted to assess the tax exposure and to assist with preparing a comprehensive defence.
• Risk mitigation through Advance Pricing Agreements or rulings should be considered for those countries where the transaction volumes and risks justify the time and expense involved.
• Changes in existing tax structures and transfer pricing practices should reflect the economic substance of the transactions and be supported by a business purpose.