Transfer pricing: commercial and practical lessons

A sound transfer pricing policy is one that:

• balances available resources against materiality and risk;
• identifies planning opportunities; and
• ensures that the commercial drivers of the business are respected and preserved.

This article looks at these three key elements of transfer pricing policy in turn.

Allocate resources commensurate with risk

Tax spend budgets have been cut in recent years – however, there is still a requirement to remain compliant with transfer pricing. This can be achieved in the following ways:

• Training in-house tax/finance teams to undertake transfer pricing reviews. By way of example – the functional interview process can be time-consuming and costly and the involvement of in-house personnel in the process can be cost-effective.
• Purchasing ad-hoc economic benchmarking software. Many clients have looked into purchasing software to prepare economic benchmarking of transactions. This can be a cost-effective solution depending on the level and complexity of intra-group transactions.
• Adopting a risk-based approach to transfer pricing policy (in line with recommendations from many tax administrations). This broadly involves assessing each intra-group transaction and operating jurisdiction to identify materiality, complexity, likelihood of an audit, and existing analysis/documentation in place.

In this way, resources can be allocated to key areas of risk. By way of example, we see a significant amount of audit activity in the UK, Germany and the US and it is common for businesses to commission separate studies in these jurisdictions.

Most tax administrations apply a de minimis/materiality threshold to transfer pricing compliance. And many tax administrations adopt an approach to the selections of cases for transfer pricing audit that looks at tax materiality and complexity. Given the limited tax resources at tax administrations, this is a logical approach to take.

Identify planning opportunities

The basic rule in transfer pricing is that taxable profits are determined by the functions performed, assets employed and risks borne in a particular jurisdiction. Multi-national businesses are able to change their functional profile in a manner that will create non-tax and tax savings.

Commercially based transfer pricing planning of this nature remains one of the only viable corporate tax planning initiatives available to multinational groups; one-off tax planning solutions with no commercial rationale are frequently caught by avoidance legislation and these manufactured solutions are frowned upon by tax administrations.

By way of example, the new US economic substance doctrine (like anti-avoidance legislation in other jurisdictions) requires an assessment of the non-fiscal benefits of a particular transaction. Such an assessment would always be undertaken when looking at a commercially based planning structure and as such, these new rules will not impact this type of planning.

The subjectivity of transfer pricing economics will always render structures open to challenge from tax administrations.

It should be noted that the level of audit intensity is due to this subjectivity. Tax administrations do not like to see the tax base eroded by planning; however, a commercial relocation of operations should never be undertaken solely for tax purposes and the non-tax commercial advantages of centralising functions cannot be ignored.

Many multinational businesses have been dissuaded from transfer pricing planning in recent years due to the number of high-profile transfer pricing settlements raised by tax administrations. Most of these cases involved an aggressive position being adopted with respect to transfer pricing – a more reasonable planning structure would not be met with the same vehemence.

By way of example – the UK Tax Authorities advise: 'As far as transfer pricing is concerned, it is generally more likely that the cases in which significant amounts of tax are at stake are those that result from manipulation rather than insufficient attention to the arm’s length principle ... Where there is no, or minimal, opportunity to secure a tax advantage through manipulation, and the business has clearly taken some steps to apply transfer pricing rules, there is less likely to be a need for HMRC to initiate a transfer pricing enquiry.'

The system for selecting audits in the UK therefore seeks to benefit businesses that are not involved in aggressive structures and are reasonably compliant. It is therefore advisable to be proactive in advance of a potential audit and at the early stages of an enquiry. Providing the necessary information in a timely and open manner can ensure that enquiries do not escalate to an audit adjustment.

It is our experience that businesses are often unwilling to litigate transfer pricing under audit due to the cost and uncertainty of outcome. Practically, litigation may involve senior finance professionals providing evidence and a settled adjustment is seen as an appropriate compromise.

Commercial drivers of the business

Cash generation has been an important goal for our clients in the past two years. Transfer pricing policy has helped to contribute to this by:

• Negotiating/re-negotiating formal agreements with tax administrations given the economic climate – certainty rulings reduce the instance of future tax audits;
• managing tax spend on advisers by taking on more work in-house,;
• selection of pricing methodologies that will assist with revenue enhancement;
• looking for planning opportunities;
• leveraging existing materials (eg updating an existing accounting valuation to provide transfer pricing compliance for intellectual property assets as opposed to commissioning a separate study).

Expansion and growth into new markets coming out of the recession should also be managed to ensure that transfer pricing policy is consistently applied – tax audits can tie up local finance resources and it is essential to have performed some preliminary transfer pricing risk analysis before the first tax returns are submitted. Many expansionary jurisdictions have low statutory rates of tax and this provides additional arbitrage planning opportunities.

Businesses are frequently looking to achieve scale leverage across the supply chain through relocation/centralisation of operations. This planning can be framed to include tax savings as there will be natural tax arbitrage with certain jurisdictions.

By way of example, the protection of competitive advantage is an important commercial driver. Multinational businesses should ensure that the development and creation of intellectual property is appropriately managed, protected and controlled. Many achieve this from a centralised location that can eliminate maverick activity and mange the growth and deployment of a strong brand.

Conclusion

Transfer pricing impacts many areas of multinational business. A simple cost-plus methodology can provide useful information to the business with respect to cost recognition. A return on sales methodology can lead to revenue enhancement by incentivising employees.

Transfer pricing policy should always be developed with the commercial drivers of the business in mind. A risk-based approach to compliance coupled with an ongoing review of legitimate tax planning opportunities will provide a strong base for a transfer pricing policy that will maximise shareholder value and generate cash for the business.

Shiv Mahalingham is a Partner with Alvarez & Marsal Taxand UK in London. He is the key UK Taxand adviser in the organisation’s global transfer pricing team and has assisted clients across several industry sectors, including financial services, and investment management. Email: smahalingham@alvarezandmarsal.com; tel: 020 7715 5234.