Under the current economic environment many countries are confronted with the need for rigorous budget measures to meet deficit-cutting targets. The enormous government debts, resulting from the accumulated government deficits over several years, or in some cases even decades, is causing severe problems. The common denominator in the budget measures that are currently being introduced in many countries, in particular in the European Union, is the combination of serious spending cuts with tax-boosting measures. In addition to increasing tax rates and changes in the tax regulatory frameworks, an increased and more stringent focus on transfer pricing can very well be approached by governments as a tax-boosting opportunity. In order to avoid double taxation, taxpayers should be prepared and have full control over their transfer pricing in order to make sure that their transfer pricing policies can withstand the expected increased scrutiny.
Transfer pricing risks
Already for more than a decade, transfer pricing is considered the most important tax issue for multinational enterprises. There are various reasons why transfer pricing stands out as the number one tax issue and why transfer pricing issues are becoming more challenging and more controversial. The international accepted standard for transfer pricing is the arm’s length principle, which entails that the conditions (pricing) in a transaction between affiliated parties should not be different than the conditions (pricing) in a similar transaction between unrelated parties. Nonetheless, the underlying application and interpretation of this principle triggers complex questions and thorny issues.
Although most jurisdictions (especially OECD member countries) follow the arm’s length principle in regulating transfer prices, tax authorities interpret and apply this principle in different ways. International enterprises are often “caught in the middle”, while authorities argue over which jurisdiction should be allowed to tax the profits of an enterprise (ie everyone wants a bigger piece of a company’s profits). These dynamics add to the complexity of effective transfer pricing strategies, especially when coupled with the prevailing attitude held by many tax authorities that international enterprises use transfer pricing schemes to minimise or even avoid taxation. In addition, the number of countries that have introduced specific transfer pricing legislation and/or specific transfer pricing documentation requirements has grown dramatically since the mid nineties.
The already increased audit activity across the globe has resulted in more transfer pricing controversy. The resulting adjustments can be so high that some of these cases actually gain significant media attention. Such high profile cases can be found in a growing number of countries. A couple of years ago, the GlaxoSmithKline case in the United States set a new record in terms of the largest transfer pricing case ever. The increased pressure on governments to cut deficits will most likely accelerate the trend towards more aggressive transfer pricing audits.
Finally, transfer pricing compliance (ie meeting transfer pricing documentation) is becoming more challenging due to different regulatory frameworks that exist. Transfer pricing compliance is very much intertwined with effective implementation of transfer pricing planning and design concepts. The true risks embedded with transfer pricing documentation go beyond merely meeting the local documentation requirements for the avoidance of penalties or other negative consequences. The consistency of transfer pricing documentation both across years and across countries but also in relation to legal agreements, transfer pricing policies and internal communication regarding transfer pricing, the inclusion of the right and relevant data and the efforts undertaken to demonstrate how the arm’s length principle has been applied all very much influences a company’s chances of successfully navigating through tax audit reviews.
Transfer pricing under control
In light of the complexities and ambiguities of transfer pricing, even more so in an environment whereby the primary focus of governments is to meet deficit-cutting targets, it is inherently important that a multinational enterprise is in control of its transfer pricing. This can prove to be a true challenge in view of the fact that transfer pricing is typically the domain of different stakeholders within a multinational organisation.
Transfer prices are not only a necessity in cross-border transactions from a tax/legal and accounting perspective but also typically govern transactions among divisions (or separate business units) of an organisation (regardless of the legal status of the different divisions/units). The level of control that tax/finance functions on stand-alone basis can assert over transfer prices very much depends on the importance of (statutory) transfer prices from a business and managerial perspective (eg setting targets and measuring performance). In order to manage the tax related risks regarding transfer pricing, the tax/finance function typically needs to work closely with the other transfer pricing stakeholders within the organisation.
In order to have control of the tax related aspects of transfer pricing, it is critical that the fax/finance function is involved (upfront) in material intercompany transactions such that it can ensure a consistent implementation of a transfer pricing policy and manage the underlying compliance aspects.
In order to have an efficient and workable framework for transfer pricing management, it is recommendable that multinational enterprises have at a minimum the five following elements incorporated in such a framework.
» Establishing a transfer pricing policy. This should entail a clear definition of the transfer pricing policy of the organisation that is effectively communicated to the relevant stakeholders.
» Establishing a process for transaction mapping/identification. This process should enable the identification of material cross-border transactions that take place within the organization and typically necessitates communication protocols.
» Establishing a process for transfer pricing risk identification. Such a process should enable organisation to both quality and quantify transfer pricing risks and needs to be founded on clear rules that defines risk attributes and weight factors.
» Establishing a process for transfer pricing risk management actions. Such a process defines the rules and procedures for dealing with identified risks. To illustrate, for certain defined high-risk transactions, a company’s policy could be to obtain an advanced pricing agreement with the tax authorities.
» Establishing a protocol and work model for transfer pricing compliance. Such a model should provide for an effective approach to both producing and maintaining transfer pricing documentation as well as defining the responsibilities for transfer pricing documentation within the organisation.
Regulatory changes, the impact of financial reporting requirements and the increased exposure to transfer pricing related financial statement risks have all contributed to the trend towards more strict transfer pricing control frameworks for international enterprises which also resulted in the need for additional transfer pricing resource requirements across the last couple of years. The current, and expected long-term, focus of governments to meet deficit-cutting targets, including the need for tax-boosting measures, will increase the exposure to transfer pricing controversy. Such increased controversy exposure will further necessity that international enterprises have a greater grip on their transfer pricing models and underlying risks. It is inherently important that international enterprises establish effective frameworks for transfer pricing management, which includes a framework for managing and risks and a solid and consistent approach to transfer pricing compliance. When organisations realise the required level of transfer pricing control, then they will be in good shape to defend their transfer pricing positions and mitigate the exposure to double taxation, even during difficult times with governments determined to boost their tax revenues.
Danny Oosterhoff is Partner, Transfer Pricing and Tax Effective Supply Chain Management Group, at Ernst & Young, Amsterdam