You may have noticed that transfer pricing (TP) has recently been making quite a few headlines globally. As regulators and tax authorities crack down on perceived base erosion and profit shifting (BEPS) abuses, many household-name multinationals have found themselves in the hot seat. TP planning may have an influence on where jobs, capital and intellectual property (IP) are deployed in the context of a multinational group, so transfer pricing cases can become quite political. Substantial reputational damage, not to mention additional taxes, interest and penalties, are at stake, and getting things wrong in certain jurisdictions may even be treated as a criminal offence, potentially involving jail time.
To further complicate the landscape, with best intentions the Organisation for Economic Co-Operation and Development (OECD) has published hundreds of pages of new interpretive and administrative guidance. Tax authorities all over the world are grappling with the guidance and how best to implement it. While many authorities have implemented dedicated TP audit programs, they have also become inundated with TP controversies in the courts. The backlog of Mutual Agreement Procedure (MAP) double-tax relief requests, in which two tax authorities try to negotiate a settlement on behalf of the taxpayer, is also ever-growing. Compounding these issues is the fact that there exists a serious supply shortage in the TP labour market, which impacts taxpayers, advisors and tax authorities alike. It takes at least a decade to develop a practitioner in this highly technical, nuanced and difficult area, and all parties are on the hunt for talent.
Somehow, this little-known sub-specialty of international tax has become one of–if not the–most important and highly scrutinized areas of corporate taxation today. What used to be of concern only to the largest multinationals has trickled down as an important compliance obligation even to small-to-medium enterprises (SMEs). If you are responsible for overseeing the tax function in the context of an international business, the time has come to get your transfer pricing house in order.
Our "10 Practices You Need To Implement Today" succinctly summarize the transfer pricing governance framework that every multinational should be following.
#1 – Understand your obligations
Transfer pricing requirements can be broadly categorized into two types of obligations: a) pricing requirements and b) documentation requirements. In most jurisdictions, pricing requirements amount to a simple standard: all transactions must be transfer priced in accordance with the arm's length principle. The standard is akin to a 'market value', and applies to all transaction types–including transfers of tangible goods or capital assets, service fees, sales or licenses of intellectual property or intangible rights, financial transactions (such as loans, guarantees, derivatives), and others.
The obligations that often cause the most confusion, however, relate to documentation. In most jurisdictions, documentation obligations exist only as a penalty protection incentive. There is often no requirement to file a TP report, but having one on file (i.e., retained in the company's records) prior to the tax return deadline may afford protection from TP penalties in the event a tax authority disagrees with the underlying pricing. In most jurisdictions, the documentation obligation is a carrot–not a stick.
That said, jurisdictions differ in their approach and it is crucial to understand precisely what must be filed (or exist in the file for penalty protection purposes), and by when. The OECD's new Master File / Local File / Country-by-Country reporting guidance also greatly complicates the landscape, as many jurisdictions have invoked the guidelines into their laws–often creating dual documentation frameworks for taxpayers to comply with. There often exist legacy transfer pricing documentation requirements plus Master File / Local File obligations.
#2 – Develop a requirements calendar
If your business operates in several jurisdictions, plotting your TP documentation requirements onto a timeline can be quite the exercise. This is particularly true of medium-to-larger multinationals which may breach Master File / Local File documentation requirement materiality thresholds. Such entities may be subject to multiple layers of documentation requirements. Unfortunately, the materiality thresholds differ substantially by jurisdiction, which makes the assessment complicated. Further, as noted earlier, certain obligations are more important than others. Some are carrots, others sticks. Knowing which is which is critical, as certain non-filing penalties are automatic.
#3 – Assess risk and prioritize
A complete requirements calendar provides you with the baseline information necessary to assess risk and prioritize next steps. Your attention should next turn to evaluating TP risk factors on a jurisdiction-by-jurisdiction, or legal entity-by-legal entity basis (depending on the tax regime of the jurisdiction, as some allow consolidated tax filing). Risk factors should include: the nature and size of the operations, the profit position, the materiality of cross-border intra-group transactions, the transfer pricing penalty regime, the existence or lack of a tax treaty, tax authority audit history and the nature of the transfer pricing policy itself. Certain transactions warrant full penalty-protection documentation, others do not. It is not realistic to document everything, and of course it would be a best practice to mindfully allocate resources to the transactions that matter.
#4 – Hire the right TP advisor, and early
The trouble is that completing a robust risk assessment requires insights into the TP landscape within each market / jurisdiction in which your company operates. Such insight is obviously difficult to come by, and so reaching out to the right transfer pricing expert can be tremendously valuable. But an important caution: one needs a global TP advisor who is used to working across the spectrum of jurisdictions. An effective global TP advisor must have a large network of foreign contacts; and, most importantly, must be familiar enough with foreign regimes to meaningfully engage in global compliance planning discussions without reaching out to the foreign contacts for every little thing. Many TP advisors are experts only in their particular jurisdiction, and are not very helpful from a global perspective.
#5 – Develop the compliance plan
With a robust compliance calendar and risk assessment, you will find yourself in a position to develop a compliance plan. The elements of a compliance plan should include: what transaction(s) to document, to what degree, pursuant to what standard (i.e., OECD or other?), the timing of when the work will be done, deadlines, whether to hire a professional advisor (for instance for a limited benchmarking analysis or even for a full transfer pricing study) and other elements. Most importantly, the compliance plan should prioritize appropriately depending on transactional risk profile and the penalty regime.
#6 – Don't forget the purpose of the TP laws
The purpose of the laws is to ensure taxpayers set appropriate prices for their cross-border intra-group transactions–not to prepare transfer pricing reports for the sake of preparing transfer pricing reports. From this perspective, it can often be worse to document transactions to meet perceived (or actual) documentation requirements than to do nothing at all. Presenting cursory, templated and/or hastily-prepared documentation to an inspector is a bad idea. Presenting a benchmark range wide enough to drive a bus through is also a bad idea. Inspectors review dozens of TP reports per year and will see right through a cursory effort. Worse, cursory efforts may highlight inconsistencies in the implementation of the underlying policies (for instance if compared to the accounting record), may misrepresent facts and may ruin reputational goodwill with the inspector.
Poor quality TP studies are the surest way to start a tax authority examination off on the wrong foot and all-but-guarantee a long, painful audit. Transfer pricing is a complex valuation area, and any advisors or vendors of off-the-shelf-solutions who tell you differently have been drinking their own cool-aid for too long. In many tax authority audit cases, it is best not to scramble and to simply own up to the fact that a robust documentation package does not exist. Focus on having a constructive and transparent discourse with the examiner. Focus on giving that examiner comfort in your TP governance framework, and help him or her understand why you had not allocated resources to documenting a particular transaction. Of course, this advice presumes that you have confidence in your underlying TP policy.
#7 – Pricing policy, pricing policy, pricing policy
So what about the TP policies themselves? Should your tangible goods be transferred at standard cost plus 20 percent, or 25 percent? How should shared corporate costs be reimbursed by the affiliates who benefit from the corporate services? What royalty should be charged for trademark exploitation rights? We have focused our article thus far on the documentation standards and the compliance plan–but it is the underlying transaction pricing that is most important. Do not get confused by the OECD's 'transfer pricing methods' or the elaborate economic analyses that you might find in a TP study. The surest way to set appropriate TP policies is to engage the folks within your organization in sales/pricing and/or operational roles, then to pair them up with your accounting group for implementation, as well as the right external advisor for a TP sign-off. It is the sales and/or operations folks working in concert with your accounting team who will come up with a practical TP policy that will work for your business, not an external advisor. Do not get the order of those operations wrong. An elaborate TP policy from a PhD economist may look great in a TP report, but will get you nowhere if not implemented correctly (or worse, if not implemented at all).
#8 – Implement administrative best practices
Implementing several best practices will keep your underlying TP policies on-side. Develop internal pricing policy documents that outline for folks in sales, operations and accounting how the transfer prices are to be set, and how exceptions to standard pricing (if any) are to be treated. Document large and recurring transactions through legal agreements (for instance, a management support service agreement or a distribution agreement). Create invoices for all significant transactions. Set up separate general ledger codes for differing transaction types. Set up cost centres for centralized corporate functions. Implement consistent shared cost allocation practices. The list goes on and is case-dependent–but the point is that establishing an appropriate pricing policy in theory is only half the battle. Implementation is the other half–so devote to it appropriate time and resources.
#9 – Keep things current
It is a best practice to continually update your TP policies, as business circumstances change. Describing to a tax inspector that your TP policy was unchanged since 1999 does not make the most favourable impression. Ensure a policy review exercise is performed each year for material transactions, and book year-end true-up adjustments, as necessary, to correct the pricing based on circumstances. This requires (some) periodic communication flow between the operations and accounting groups, and that communication must occur before books are closed, so that adjustments can be booked if necessary, not afterwards during tax-filing season.
#10 – Show off your TP governance framework
Finally, be proud of your governance framework and, when the time comes, show it off to your auditors and tax authority inspectors. Drafting a document that outlines your governance steps, processes, procedures and controls will go a long way to giving auditors and inspectors comfort. We have tremendous success in dissuading detailed tax authority examinations by simply presenting our clients' governance framework.
The TP landscape is complex–but with a little up-front planning and investment, managing it does not have to be. To learn how Grant Thornton can help you establish a TP governance framework that is right for you, contact us. Our advisors have the global experience, network of contacts and operational knowledge to help you get ahead–and stay ahead–of an evolving TP regulatory environment.