Transfer Pricing – Why it Matters
Tax is in the headlines like never before. Corporate social responsibility, tax governance, enhanced tax transparency and “fair share” tax accountability are topics that continue to be hotly debated and attract global attention. The enhanced level of global interest and focus on tax transparency have been the driving forces for tax reform in recent years.
The Organisation for Economic Co-operation and Development (“OECD”)1 on 5 October 2015 released the final reports under their Base Erosion and Profit Sharing (“BEPS”) project. The primary objectives of the BEPS project are as follows:
- Eliminate double non-taxation due to base erosion and profit shifting;
- Give countries the tools they need to ensure that profits are taxed where economic activities generating the profits are performed and where value is created; and
- Give business greater certainty by reducing disputes over the application of international tax rules
The OECD estimates BEPS practices cost countries 100-240 billion USD in lost revenue annually, which is the equivalent to 4-10% of the global corporate income tax revenue. Thus, as countries are concerned with maintaining and protecting their tax base and ensuring there is “fair share” tax accountability, there is a demand for greater transparency globally. The guidance has been hailed as a game changer that has altered the transfer pricing outcomes in many situations and requires certain multinational enterprises (“MNE”) to undertake additional analysis and prepare an increased level of transfer pricing documentation (i.e. Master File, Local File, Country by Country Report). At present this guidance has been effectively implemented in most countries around the world.2
What is transfer pricing and why does it matter?
Generally MNEs routinely engage in related party transactions such as the sale of tangible goods, provision of services, loans and advances, rentals of tangible property, and transfers of intangible property. In all cases the price charged between the parties is known as the transfer price. As a result, transfer prices are used to calculate how profits should be allocated among the different parts of the MNE in different countries, and are used to determine how much tax the MNE pays and to which tax administration.
In light of BEPS, transfer pricing has become an area of increased concern and scrutiny for tax authorities. The concern exists because MNEs can use transfer pricing to artificially shift profits from one jurisdiction to another to reduce taxation. For example, to lower their taxes, MNEs can shift profits by underpricing products or assets transferred from an entity located in a high-tax jurisdiction to a related party located in a lower-tax jurisdiction, thus increasing the profits reported by entities located in low-tax countries. However, MNEs must adhere to the international standard for determining transfer prices and adequately document and support their transfer pricing positions (to mitigate risk).
The international standard and how do we arrive there?
The international standard for determining transfer prices is the “arm’s length” principle. A transaction between related parties meets the arm’s length standard if the results of the transaction are consistent with the result that would have been realized if unrelated taxpayers executed a comparable transaction under comparable circumstances.3 Broadly, the transfer price should correspond to the price that unrelated parties would agree upon in an open market.
To determine the proper application of the arm’s length standard, a review of the allocation of risks is critical. From a U.S. perspective, Internal Revenue Code Section 482 regulations require review of many aspects of intercompany transactions when determining appropriate transfer pricing outcomes, notably the functions performed, the assets employed, and the risks assumed by the respective parties. Ultimately, this is a facts and circumstances based analysis and it includes reviewing the terms of contracts between the parties and the economic substance of the transaction(s) between them.
What’s the risk?
In the U.S., Section 482 gives the IRS the authority to adjust taxable income between two related parties to more accurately reflect the income earned by each party. The purpose of this type of adjustment is to ensure that transactions within a controlled group are not used to distort tax liabilities of individual group members, essentially preventing the attempts of MNE’s to use transfer prices to shift as much profit as possible to low-tax jurisdictions, thereby avoiding paying higher taxes in the U.S. In other words, it prevents BEPS. For this reason, transfer pricing has attracted the attention of tax authorities worldwide.
Despite a series of high-profile losses related to transfer pricing in tax court (e.g. Amazon), IRS Commissioner Charles Rettig reaffirmed his commitment to pursuing transfer pricing-related cases during an April 1, 2019 speech at a Tax Executives Institute conference in Washington, D.C. Rettig stated, “This is not a commissioner who believes that the IRS loses because a judge rules against us in a transfer pricing case. It’s a commissioner who thinks the IRS loses if it doesn’t keep bringing those cases.” Similarly, as highlighted in the press regularly, tax authorities outside the U.S. are tackling transfer pricing. Apple, Google, Starbucks, Fiat Chrysler have all been embroiled in lengthy and costly disputes resulting from a challenge to their transfer pricing, and the list continues to grow. Thus, MNEs large and small should take notice and expect increased scrutiny and enforcement in the U.S. and abroad.
The “Proactive” way forward for MNEs
In the BEPS era transfer pricing undoubtedly is subject to challenge and the onus is on the MNE taxpayer. As such, financial executives should focus their attention on mitigating transfer pricing related risks where and when possible. Action is needed now because failure to act could have both financial and operational impact. Defending a MNE’s transfer pricing under audit can cost hundreds of thousands of dollars in legal fees, require company time and resources that are needed to run the business and potentially result in tax adjustments, non-deductible penalties and interest and in some cases, an unwanted blow to the MNE’s reputation.
The most effective and cost efficient way a MNE can mitigate transfer pricing risks is to obtain a transfer pricing study reviewed by each jurisdiction it is designed to cover. A transfer pricing study is an in-depth review of the company’s pricing policies and related documentation. It is usually conducted by a third party provider and it can provide a number of benefits including:
- Reducing taxes and penalties by ensuring that the company’s transfer pricing policies comply with all requirements in the local jurisdiction, including meeting local documentation rules;
- Providing support for recording no tax liabilities for tax exposures in the company’s financial statements pursuant to ASC 740 (formerly FIN 48);
- Identifying opportunities to reduce the company’s global effective tax rate by restructuring multinational operations; and
- Identifying ways to increase global supply chain efficiency by relocating operations or reorganizing legal entities.
In conclusion, while transfer pricing is undeniably subject to challenge, if proactively approached and documented, results generally stand up to audit.
Baker Newman Noyes has a team that focuses on transfer pricing issues and can assist in the documentation and planning for such transactions. Please contact Stuart Lyons, lead of BNN’s international tax practice, or Andrea Reilly at 1.800.244.7444 if you would like to discuss further.
1 The OECD is a forum in which the governments of 36 democracies with market economies work with each other, along with more than 70 non-member economies, to promote economic growth, prosperity and sustainable development.
2 The OECD does not have the ability to legislate; instead, their guidelines set forth a common approach to be adopted by countries in their local legislation.
3 The arm’s length principle is incorporated into section 482 of the International Revenue Code, the regulations thereunder, and U.S. income treaties.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.