The global war of talents and a new era of a digitally connected global economy – just to name two challenges multinationals are increasingly facing. To react to these trends, multinationals are forced to work more and more in virtual teams spread across the globe. Cross-border matrix organizations have become the new normal in many multinationals to better respond to these challenges. This is accompanied by shift in the global tax policy that puts more emphasize on allocating taxable income along the value chain based on value creation, the latter represented by (high-skilled) people located in different tax jurisdictions. Thus, transfer pricing policies and respective processes need to be established, so that the new way of interconnectivity beyond borders is properly reflected.
How can multinationals prepare best?
Individuals present their skills and find work using digital platforms such as LinkedIn. By doing so, they build a global personal network and participate in globalization directly. A huge pool of technical labor evolves in the emerging markets. In 2016, roughly eight million science, technology, engineering, and mathematics graduated in China and India.1 In contrast, 568,000 graduated in the United States and 173,000 in Germany.2 As an outcome, Western European and U.S. multinationals increasingly source the best talent globally. The great advantage is the flow of ideas, talent, and inputs that spur innovation and productivity.
The growing complexity in the world of multinationals make traditional hierarchical structures more problematic as they become more specialized and require employees with specific areas of expertise. Furthermore, agility has become a core virtue as organizations need to be able to respond quickly to new changes in the market environment. Hence, multinationals foster the change of their operational structures from divisional or functional structures to complex matrix structures.
A matrix organization heavily affects individuals and teams working in the matrix, as information flow and decision-making are different and disregard traditional hierarchies as well as country borders. Individuals typically report to at least two managers, e.g. a functional manager and a product/service offering manager. (see diagram)
Transfer pricing impacts
Working beyond borders in global or regional teams being responsible for a specific product range, service offering or global customer may be advantageous from a business perspective. From a transfer pricing perspective, an organizational structure beyond country borders – and especially beyond legal entity borders – significantly increases the complexity with regards to the delineation of intercompany transactions as well as to the proper allocation of taxable income.
Multinationals tend to implement a traditional intercompany service charge for cases in which individuals or teams work cross border in a cross-functional dimension. Often times, the above mentioned service charges are determined on a cost plus basis using the salary costs (and potentially some overhead costs) of the employees as well as an arm's length cost mark-up for low-value added services – often around 5%.3 This may be appropriate for cases in which only low value added services are rendered,4 but may not be sufficient for functions providing a competitive edge.
When implementing a matrix organization, multinationals should carefully consider the transfer pricing impacts with regards to a potential exit charge as it presumably leads to reshuffling and relocation of responsibilities. Following the new OECD's guidance, taxable income should follow the significant people who are key for value creation. If this is the case, the cross-border relocation of responsibilities and the corresponding taxable income might be considered as a transfer of "something of value"5 or a transfer of functions, which would require an arm's length compensation for forgone future profits. The exit tax trap also threat to existing matrix organization as any cross-border personnel change is suspected to lead in a shift of profits. For example, what would be the transfer pricing consequence if the head of R&D for a specific product group based in country A, who is deemed to be key for the allocation of income assigned to the R&D function, retires and the successor is hired in country B?
Another challenging question is, where intellectual property ("IP") is generated within a matrix structure. In local hierarchical structures, this question can easily be answered in many cases because a significant part (if not all) of the activities related to Development, Enhancement, Maintenance, Protection & Exploitation ("DEMPE") of IP is performed in the same country. This is definitely not the case within multinationals operating with a global matrix structure.
Finally, matrix structures tend to increase the risk of constituting artificial permanent establishments (agency, service or management permanent establishments). Exemplary, one could think of a matrix structure in which global responsibilities for certain customers (e.g. key account management) are established. Increased scrutiny from tax authorities can be expected and multinationals should be prepared to show that neither contracts are signed by a foreign employee nor should the foreign employee play the principal role leading to the conclusion of contracts that are routinely concluded locally without material modification. In this regard, we currently see a trend that tax authorities (automatically) review in detail e-mail correspondence to identify potential permanent establishment matters within multinationals.
Statutory duties of local management
From a business perspective, main advantages of a well running and efficient matrix organization are i.a.
- a flexible, efficient allocation and sharing of resources
- an increased flow of information
- cultivating a culture of co-operation, communication, openness and tolerance
However, matrix organizations require a redefinition of authority and flexible styles of management. A successful matrix organization strives to maintain equality on the vertical and horizontal axes of the matrix. In general, a matrix structure requires a new understanding of authority and the introduction of new systems and processes to set the right boundaries of accountability and responsibility.
In many cases this could contradict with the legal duties and obligations of the local managing director. Even though the respective manager within the matrix organization could be responsible for strategic and operational activities, the local managing director should have the right to intervene. In order to be able to adequately intervene, the local managing director needs to have access to relevant information.
In any case, it is highly advisable for the local managing director to introduce prevention measures as well as a monitoring system to ensure that important decisions are not taken and relevant measures are implemented without informing the local management respectively proper involvement of the local management.
Working in a matrix structure – what to consider from a transfer pricing perspective
The ground rule for every cross-border matrix organization is: acting instead of reacting.
To be able to implement proper measures from a transfer pricing perspective and avoid unpleasant surprises in the next tax audit, the tax department should make sure to be informed or have access to business decisions, which may have tax or transfer pricing impacts.
Considering the tax department is sufficiently informed, the following should be taken into account when entering into a matrix structure or running a matrix structure:
- Clear processes have to be implemented. This should include a profound and documentable approval process as well as a policy with regards to the delegation of authority. It should also include monitoring and communication processes for local management as well as a policy for the implementation of reporting lines.
- Sound legal agreements should be concluded, which specify rights and obligations. Agreements should also consider the contractual definition of IP generating (DEMPE) activities and respective allocation.
- Transfer pricing impacts with regards to a potential exit charge should be considered. Starting point could be to compile information on which legal entity is potentially benefitting and which entity is losing when entering into the matrix organization.
- Robust documentation should be prepared and maintained.
Entering into a matrix structure is in most cases a pure business decision and not a decision taken by the tax department. However, this decision indeed could have diverse tax consequences. For multinationals, considering the above mentioned measures is highly recommendable and will put them in a better starting position for discussions with tax authorities.
- World Trade Organization, 2019, "Global Value Chain Development Report 2019", p. 148.
- Source: German Federal Office of Statistics.
- See OECD (2017), OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017, OECD Publishing, Paris, section 7.61.
- OECD Guidelines 2017, section 7.45 ff.
- OECD Guidelines 2017, section 9.10 ff.