Although transfer pricing dates back to 1917, the practice has grown impressively since the OECD published the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations in 1995, and its updates in 2010 and 2017. Today, transfer pricing is likely the #1 tax risk area for multinationals and its scrutiny has prompted tens of thousands of pages of interpretive guidance, precedent-setting court cases and privately-published technical thought leadership.
Transfer pricing laws are based on the 'arm's length standard', which can be difficult to put into practice. That's why transfer pricing is often considered an art, not a science. While this sentiment may be unfair to the economists and valuation experts who pour hundreds of hours into complex financial models and technical analyses, it still captures the subjectivity with which the standard is sometimes perceived. Yet, despite the difficulty of applying the arm's length standard, robust concepts, methodologies and analytical processes have been established to make pricing analyses reliable and practicable. After all, today's transfer pricing community now has nearly 100 years of practice.
Recently, however, there has been a nuanced change to the landscape that affects multinationals of every size. What has changed most in recent years is that tax authorities and auditors are shifting focus away from technical valuations and onto the overall governance of the transfer pricing function. Examiners and auditors are now paying closer attention to the way in which transfer pricing is functionally organized within the multinational group, as well as on the risk mitigation processes, procedures and controls surrounding transfer pricing.
The result of this shift is that today's tax and transfer pricing directors are being evaluated not just on the underlying accuracy of their tax positions / economic analyses, but on the overall governance of the function. This makes it imperative to demonstrate to examiners or auditors not only the technical foundation of the underlying tax positions, but proper governance as well.
To prepare our clients, Grant Thornton developed a service model that is both a roadmap and a checklist relating to best practice transfer pricing governance processes and procedures. The model (outlined below) covers five periods (representing the annual transfer pricing compliance cycle): budgeting, interim monitoring / maintenance, year-end testing, documentation, and post-filing defense.
Each period represents its own world of best practices, and each involves an entirely different set of transfer pricing activities.
Pre-financial year / budgeting
Pre-financial year procedures are critical, and arguably most important. This period involves the substantive technical work relating to establishing the transfer pricing policies themselves, as well as the set-up of the implementation and maintenance procedures to be undertaken in the remainder of the compliance cycle. Most organizations do not sufficiently invest in this period and therefore find themselves scrambling to book appropriate entries, document transactions after-the-fact, or in the worst case discover fundamental weakness in pricing policy during a statutory or tax authority audit.
Before the start of the year, it is important to adopt procedures for:
- Establishing proactive pricing policies, including for tangible product sales, mark-up factors, royalty rates, and services fees;
- Understanding customs, indirect tax, and cash-flow implications for the policies;
- Integrating transfer pricing into budgeting and FP&A;
- Preparing intra-group agreement updates; and
- Managing change and providing implementation instructions (e.g. to accounting / finance teams)
Interim monitoring / maintenance
During the fiscal year, the transfer pricing group should be in constant communication with the business (to identify new transactions / material business changes) as well as accounting/finance teams (to provide support and instruction, as needed). More sophisticated transfer pricing policy structure may also involve interim testing, variance analyses, monthly or quarterly service fee calculations, etc.
Throughout the year, apply procedures for:
- Maintaining cross-functional and cross-border communication standards / procedures (i.e., between transfer pricing and other departments, and between HQ and cross-border affiliates);
- Maintaining globally consistent invoicing and accounting standards surrounding transfer pricing transactions;
- Performing interim testing and price-adjustments, where needed and
- Addressing changes in facts / new transactions.
The year-end / pre-close of books period is likely the second most important, as it represents the cut-off to when transfer pricing entries may be made for accounting purposes. Although technically most jurisdictions allow the true-up of transfer pricing for tax purpose post close, it is obviously not a best practice to carry significant book-to-tax differences due to transfer pricing. Robust year-end testing and transfer pricing adjustment mechanisms should exist ahead of close so that book and tax is aligned.
In the fourth quarter of your financial year, look to implement procedures for:
- Year-end testing and price adjustments, including management fee true-ups and budget vs. actual cost analyses
- Establishing appropriate analyses and documentation for tax provision / statutory audit purposes
Documentation / filing
The period following the closing of books, but preceding the tax return filing deadlines, is also critical. In this period, a robust compliance strategy should exist that relates to both the (strategic) preparation of transfer pricing documentation as well as the identification of, and fulfillment of, reporting requirements (such as forms T106 in Canada, country-by-country reports, and similar mandatory transfer pricing filings / disclosures). After books are closed, you will need procedure for:
- Identifying changes to global transfer pricing requirements, filing obligations, materiality thresholds, and risk-factors;
- Preparing global transfer pricing documentation strategically, given limited resources and an ever changing global risk landscape; and
- Meeting all filing obligations and notifications, where required.
Finally, after the tax return is filed, there will exist a multi-year period in which the transfer pricing positions may be challenged by a tax authority. Transfer pricing audit statutes vary across the world but generally allow tax examiners to reassess periods as old as 5+ years. To manage tax authority reviews, create procedures for:
- Tax examiner communication, and when to get head-office involved
- Information flow (i.e., what to provide to auditors)
- When and to what degree to get external advisors involved; and
- When and to what degree to get counsel involved (for privilege).
These practices underpin an approach that has won Grant Thornton's transfer pricing group the International Tax Review's Transfer Pricing Advisory Firm of the Year (Canada) award in 2018–and can help you take your transfer pricing function beyond the pricing.