What is operational transfer pricing?
Operational transfer pricing (OTP) is the specialism within transfer pricing (TP) that ensures the accurate and efficient implementation of a group’s TP policy in its books and records.
As a very simple example, if a TP policy states that local distributors should generate a 3% operating margin, OTP constitutes all the necessary finance, tax, IT and other processes that need to take place to make this happen.
As another example, if a TP states that contract manufacturers operate on a cost + 5% basis, OTP would involve determining the sales prices at which manufactured goods are sold between different companies and then ensuring that the overall profitability at year-end is right as manufacturing costs (direct or indirect) and volumes fluctuate throughout the year.
It would also involve ensuring that any one-off or specific cost types (such as restructuring, equipment depreciation, forex or other variances) are picked up and treated correctly so that at the time of filing of the tax return all aspects of the TP policy have been correctly applied and the local manufacturer has achieved an appropriate arm’s-length outcome given its functions, assets and risks.
Whilst conceptually simple, implementing even a relatively simple TP policy can be surprisingly hard in practice. It involves ensuring multiple stakeholders including finance, tax, supply chain, legal and IT, among others, collaborate effectively and efficiently so that what needs to be done gets done.
Why is OTP particularly important now?
The TP landscape has always been complex and disputes with tax authorities can have potentially significant financial impacts. However, since the OECD’s BEPS project, there has been a broad increase in the compliance and reporting environment in which group’s operate and tax authorities have better resources and technology available to assess whether results are in line with the TP polices.
Country-by-country reporting data and details of intercompany transaction amounts, for example in local files and in international dealing schedules in some countries, are now regularly and automatically collected in machine-readable format by tax authorities for subsequent analysis. Standard audit file for tax (SAF-T) files provided in audits then allow detailed examination of core journal and accounting entries taken directly from the company’s enterprise resource planning (ERP) systems.
Putting it differently, tax authorities remain extremely interested in a group’s TP policies and now have significantly more data readily available to examine and form the basis for enquiries.
Going forward, including taking into account the G20/OECD’s pillar one and pillar two proposals, the data demands from tax authorities and requirements on businesses for reliable timely data are expected to increase exponentially. Examples of near real-time data sharing are becoming more and more common in the indirect tax environment and tax authorities have already indicated that corporate income tax and TP are likely future areas for expansion of such programmes.
Given this significant increase in the data that tax authorities will have, businesses will need to be sure that their data is accurate and that TP policies are being applied as they should be. As data availability increases it will become ever more quickly apparent to a tax authority if this is not the case.
Where a tax authority can show that a TP policy has not been correctly applied, a reassessment would be expected.
What causes OTP issues for groups?
OTP issues often come to light as the result of four distinct, but often interlinked, aspects. These are:
- External challenges;
- Internal challenges;
- Data and process inefficiencies; and
- People aspects.
These aspects are examined in more detail below.
One of the major ways in which potential issues with a company’s OTP are identified is as a result of demands from external parties. External parties challenging a group on its OTP could include:
- Tax authorities challenging calculations, cost bases and TP outcomes in tax audits;
- Financial auditors challenging TP outcomes as part of statutory audits;
- Regulators, particularly in certain regulated sectors such as financial services, challenging the speed and accuracy of the implementation of complex TP policies; and
- Joint venture parties seeking greater clarity on charges being made from regional or central headquartered companies.
These external parties effectively want groups to be able to demonstrate the accuracy, completeness and efficiency of how TP policies are implemented.
If OTP policies are challenged in any of the ways detailed above, the ability to provide formally established OTP policy documents along with detailed supporting calculations and audit trails to evidence correct implementation can be invaluable in providing reassurance to the interested party that the TP policy has been correctly implemented.
Conversely, if a group cannot demonstrate that its TP policies have been appropriately implemented this can create significant costs for a group in terms of longer audits, higher risk ratings, higher capital requirements (in the regulated financial sector) and lower recovery of the group’s central costs.
Internal challenges by stakeholders, senior management or functions
Similar in many regards to external challenges, internal challenges tend to focus on interested stakeholders asking the tax department for evidence that TP policies have been correctly implemented.
Internal stakeholders can include company boards or the c-suite who are seeking to gain assurance that the high-level TP policies they have approved have been implemented as intended. Particular focus for these stakeholders can involve seeking to control potential reputational risks that might arise if a group’s TP was found to have been incorrectly implemented.
Finance transformation projects also drive internal OTP focus as tax departments are required to document processes that might not have been wholly formalised and known throughout the organisation or define and implement new ones.
Equally, the opportunity created by a once-in-a-decade finance transformation for tax to determine its data needs also requires clarity on OTP processes, calculations and desired outcomes and an ability to explain this to systems builders or integrators.
Data and process inefficiencies and failures
Data and process issues often relate to the group recognising that it is wasting valuable time and internal resources on low value-added tasks such as repetitive mechanical calculations.
A lack of accurate forecasting and profit monitoring in-year caused by data or process inefficiencies can also lead to large year-end or post year-end adjustments which can attract significant scrutiny from tax authorities. Such adjustments can also cause significant second-order issues with indirect tax declarations and filings.
The final, classic, example of a data and process failure is the spreadsheet that has been built up over time that has become a ‘black box’ that cannot be fully understood or audited but is relied upon to generate the outcome.
For OTP to be successful, the people involved in the processes need to understand their role and responsibilities and the wider context of how what they do fits into the overall end-to-end TP process.
There can be a few challenges for OTP on the people front. These can include:
- ‘Key person’ risk where one or a small group of individuals are the only ones to have the in-depth knowledge required to make TP work. This creates substantial operational risk for the business were the person to leave;
- Lack of formalisation of processes hampers onboarding new team members or, for example in the context of shared service implementation projects, ensuring that the right people are doing the right processes; and
- Unhappy or inefficiently used senior resource required to do manual tasks due to poor OTP setup.
Facing OTP challenges head-on
Given the scale of the task, sometimes trying to resolve OTP issues can seem daunting.
To help with this issue, within Deloitte’s OTP practice, a group’s end to end OTP process is classified into the following constituent parts:
All of these are then supported by a fourth component, technology.
Using this approach to categorise the different components of an OTP process, a standard framework is then applied taking into account the ‘current’ and ‘target’ state for each of these constituent parts.
This standard framework involves first mapping out current processes, including identifying all key interfaces with other stakeholders, and then identifying gaps or issues in the current process for each aspect.
These first two ‘map and gap’ phases of the framework allow for the systematic determination of how OTP processes work currently and identifying within these what current challenges, improvement areas and key overall themes there are within the end-to-end process.
Having established this baseline, the next phase is to design the ‘target’ state for the OTP model going forward. In this phase, it would be established who is best placed to perform each task, determine timelines and assess what tasks are low value-add or repetitive which could be automated.
In defining the ‘target’ state all stakeholders, with different objectives and constraints, need to be bought in to see the advantages for them in achieving the ‘target’ state.
Finally, the transition process from ‘current’ state to ‘target’ state would be determined and evaluated. This involves creating a transition plan and managing change activities such as handing over existing tasks to new process owners, defining new responsible, accountable, consulted, informed (RACI) matrices, recalibrating department budgets and reporting lines as needed and, as the transition continues, refining and updating the ‘target’ state to take into account practical aspects encountered during transition.
This framework model allows an organisation to break down what might seem to be an insurmountable problem into individual tasks which can be spread over time allowing incremental, step-by-step progress towards a clear and understood end goal.
Critical to success
Knowing you should improve your OTP processes is one thing. Finding the resources and time to tackle what can seem a dauntingly large problem quite another.
Breaking down OTP into the constituent parts of data, people, processes and technology for analysis can help deal with the issue of scale. Ensuring all stakeholders agree to, and see the benefit from the future state, is also critical to success of any OTP project however large or small, as is strong change management.
Taking the first pace on what feels like a long journey can often be hard but generating quick wins can put a real spring in your step.