The OECD has mandated the "Masterfile" concept for the transfer pricing documentation of taxpayers. Deceptively, the requirements for this Masterfile are presented as a simple list of a number of items that must be reported. While many of the items are innocent looking, several pieces of information should be considered very carefully, as they will have massive repercussions on the test of the transfer prices. Moreover, this information will be available to tax authorities around the world.
The new documentation rules
In its effort to tackle "Base Erosion and Profit Shifting" by transfer pricing, the OECD established a new international three-tiered documentation standard, depending on the implementation in the respective countries. This standard was launched beginning in tax year 2016 and 2017.
In theory, the idea of the "Country-by-Country table" is to provide an overview of the financial results of the group, while the "Local Files" for the respective entities are where the OECD expects the actual test of the transfer pricing of the group. Lastly, the "Masterfile" document is supposed to provide an "overview of the group".
The challenge of multiple perspectives
The overall concept of the three-tied documentation sounds simple and, to some extent, reasonable. However, in reality this presents a significant shift in transfer pricing documentation that will trigger a lot of challenges in audits and litigation in the future. The fact that the Masterfile will be consistently available for different tax authorities alone will likely lead to much more scrutiny. By nature, some tax authorities are inclined to perceive the same information differently, and filter out all items that are not favorable to them. Especially nuanced situations where several entities contribute substantial value to a transaction will be difficult to show appropriately for two sides at once.
This challenge becomes more important as many multinational groups have not yet documented transfer prices in all countries, or at least has not yet coordinated this activity. The central tax departments therefore often do not even know which potential issues may arise when all tax authorities have access to the Masterfile data.
Therefore it is essential to perform a worldwide review of the state of documentation. This short but in-depth exercise provides an overview of the functions and risks, the people, the equity, the margins and the profits of each entity, and most importantly, the current gaps or mismatches in the existing documentation.
The outcome of this global review must be analyzed and discussed with the local tax department, the local and central management, and the usual local tax and legal advisers.
The deceptive nature of the Masterfile
The OECD envisions that the Masterfile only provides an overview of the business and the group, and somewhat deceptively present the required information as a list. On first glance, this list includes relatively easy to present information, such as the legal structure of the group or the consolidated financial statements.
Included in the list of information are some items which are ambiguous, curious, or critically important for transfer pricing purposes, even though these facts might not be readily apparent to taxpayers:
The surprisingly ambiguous
One of the Masterfile requirements is to present the "supply chain for five largest products" (and any products or services amounting to more than 5 percent turnover). Somewhat surprisingly, the OECD has not included very detailed information about what constitutes a "product". A product could thus mean a single stock-keeping unit, such as a promotion-packed 250g sugar-free cereal, a broader product line, such as any package of the same sugar-free cereal, a product category of any cereal, or even a business line, such as human foodstuffs.
Given that the OECD has decided to remain unclear on this point, taxpayers have some choice, to either be very specific or comparatively broad, depending on what better describes their business. The downside of that, however, is that it is harder to demonstrate compliance to tax authorities quite as easily.
While the Masterfile is not supposed to go into detail on the individual transfer prices, the OECD does task the taxpayer to provide an overview of intercompany transactions and transfer pricing policy on services, cost sharing, the development of intangibles, and financial services.
The list itself is not that surprising – except for what is missing from it. Taxpayers do not have to present information on the transfer pricing of goods, which for many taxpayers is by far the most significant intercompany transaction.
In many cases it can make sense to go beyond the Masterfile requirements and present this information anyway; especially if one wants to set the stage for the transfer pricing test in the local file for the physical goods. Although of course in other situations taxpayers may simply decide to follow the requirements.
The most important aspects of the Masterfile, and the ones that are potentially dangerous to the taxpayer, are not entirely obvious. They might be difficult to identify because they are not centralized in one place, but distributed throughout the list. The OECD Masterfile requires, for example, that taxpayers describe:
- Important drivers of business profit;
- Brief written functional analysis;
- Description of the MNE's overall strategy for the development, ownership, and exploitation of intangibles; and
- List of intangibles that are important for transfer pricing purposes and which entities legally own them.
These items have immediate and significant implications for the test of the transfer pricing which is supposed to be made in the local files! If the functional profile in the Masterfile does not match the logic of the transfer pricing method in the local file, tax authorities potentially have the opportunity to disregard the evidence provided by the taxpayer. Further, if the business drivers do not match the intangibles and the functional analysis, the entire logic of the taxpayers' transfer pricing could be called into question.
Unfortunately, these are not purely hypothetical cases. The information requirements in the Masterfile are extensive, and it is easy to overlook the importance of individual items on the list. Additionally, when different stakeholders (central and local management, and advisors) manage the Local Files and the Masterfile without coordination, this situation can easily lead to dangerous mismatches.
An unfortunate example
We have been faced with an example of such mismatches when recently tasked with reviewing the documentation that was prepared by the previous advisors of an industrial company in the machinery goods sector:
The managers of the operational business provided a detailed account of the important business drivers and identified that local planning and adaptions were a distinct selling point. The machinery had to fit the production lines of the customers, so typically local engineers in the respective markets customized the plans before the machinery was custom-built. While this local focus was a clear advantage for the customers of the group, it was unfortunately not fully reflected in the transfer pricing tests in the Local Files. There the local companies were seen as "routine" sales companies and benchmarked against independent parties, many of which did not perform such customization functions.
While this local focus was a clear advantage for the customers of the group, it was unfortunately not fully reflected in the transfer pricing tests in the Local Files. There the local companies were seen as "routine" sales companies and benchmarked against independent parties, many of which did not perform such customization functions.
The situation was further complicated by the fact that, arguably, an important intangible was the centrally provided software which the local entities used to make the adaptations to the machinery – and that this software had not been mentioned in the Masterfile.
The best practice
The situation described above could be resolved relatively easily, as the company had not yet submitted the final documentation, and it was still possible to provide a consistent description of what the group did and how it accordingly tested their transfer prices.
The essential learning was that a coordination of Masterfile and Local file is crucial and that several items in the Masterfile must be very carefully thought out. In particular, the functional ownership in intangibles, the usage of intellectual property, the provision of services, and financing, including cash pools, must be considered.
Experience shows that this process must be reviewed and coordinated centrally, sometimes by an independent advisor to avoid conflicts of interest.
Accurately produced Masterfile documentation and corresponding Local Files are more work intensive than traditional documentation, but they help to survive tax field audits.
The Masterfile and Local Files form the basis of every field tax audit and tax investigation of the entire group over the next years. It is prudent to prepare the ground for any investigation with a good Masterfile.