To keep pace with the profound changes facing international tax, TP risk control frameworks must be dynamic and adaptable. Cross-functional cooperation and cross-fertilization allow tax departments to build transdisciplinary skillsets and robust TP frameworks to respond to such changes.
Over the last 20 years, tax risk management has become an increasingly important item on the agenda of multinational enterprises (MNEs). In response to greater tax awareness, ever more stringent legislative developments and growing shareholder engagement, the ability to properly identify and address financial reporting and reputational risks has become critical. Yet, considering the significance MNEs have as main drivers of global trade and the strides the world economy has taken towards consolidation, it is not surprising that transfer pricing is one of the most pivotal and sensitive areas of tax risk.
The tax and transfer pricing landscape has been changing rapidly and in profound ways. Against this backdrop, transfer pricing risk control frameworks must be dynamic, adaptable and able to provide a quick response to change. Change can be triggered by external events that are usually on the radars of tax departments (e.g. BEPS, local tax reforms) or society at large (e.g. sanitary crises, natural disasters, economic downturns). What may sound counter-intuitive is that in practice, internal events are the ones most likely to escape the attention of tax departments. Internal change triggers may relate to new sales campaigns, forecasts and projections, rolling-out of new marketing campaigns, restructuring and cost-cutting initiatives taken in foreign jurisdictions, deployment of (human) resources across the organization, legal claims and disputes, lay-offs, etc.
While designing their transfer pricing risk control frameworks, MNEs often grapple with the dilemma between thoroughness and efficiency, between sophistication and usability. In addition to these points, it is key to build in tools and processes that allow different users and stakeholders to engage and contribute by sharing information and awareness points. While transfer pricing policies are typically designed by tax departments, they are in good part applied and monitored by finance or operations personnel. Here are a few areas to illustrate:
- Trading: let’s consider a typical structure, where a trading Principal transacts with foreign sales affiliates entitled to a routine remuneration. Price setting is typically reverse engineered: selling prices and volumes are forecasted prior to year-end, a budget is drawn up with a projection of costs at a local level. Based on these inputs and a targeted profit margin, transfer prices are determined, normally with a mechanism to monitor variances through the year (i.e., ‘true-ups and downs’). From that point on, the tax department responsible for managing the policy will lack visibility on many real-life events that will directly impact the transfer pricing system. At the same time, foreign affiliate controllers, who are often unaware of transfer pricing considerations and targeted margins, draw periodical/monthly P&Ls, cash flow statements, working capital and capital expenditure analyses. They have visibility on sudden changes in sales projections, cost-cutting measures and restructuring costs that don’t go through the tax department and will steer the application of the transfer pricing policy. In short, departments need to talk. Financial controllers have first-hand ownership of year-to-date financial data and are well positioned to spot changes and trends first.
- Intra-group services: the dilemma here is often between a single, one-size-fits-all service charge and separate charges and policies for the various activities performed to the benefit of a foreign affiliate (for instance, the ‘back-office’ services). While the simplicity and convenience of bundling all costs and charging them together are compelling, several jurisdictions cap or disallow altogether deductions for ‘management fees’ or ‘headquarters fee’. In other (usually developing) countries it is not uncommon that the tax authority tries to assert a royalty component, typically levied on ‘technical’ services with transfer of knowledge (hard to define), giving rise to withholding tax liability. More generally, we see widespread challenges on the relative benefit/cost base of a specific service. Hence, having a palette of different services (with specific policies, cost base, remuneration and the like) may sound overcomplicated at first, but is probably the best strategy not to lose across the board – i.e., WHT or disallowance of everything. It is about not putting all one’s eggs in one basket. Similar to the trading example, information may be dispersed across the organization; information on which individuals are or have been present at local affiliate’s premises, their skillset, experience, function, goals & targets may likely lie with the HR department. Likewise, the tools and instruments necessary to monitor and measure the individuals and their activities may probably be available within the IT organization.
- Financial Transactions: intragroup finance has been a hot area where we see high levels of scrutiny due to potentially risky transactions, giving rise to BEPS issues. With OECD’s most recent guidance, the focus has shifted from loan pricing to the most fundamental question of whether the capital advance should indeed be treated as loan. It is more important to functionally review the treasury function, with special regard to whether the treasury department has the tools and resources to perform the necessary functions and to effectively control the associated risks. Based on the latest financial transactions guidance, when devising an intragroup finance policy, attention must be given to the external funding profile of the group and which funding sources it may tap, the cost of alternative funding options, funding mix of the lender, debt capacity of the borrower, etc. Naturally, this kind of information is likely to be extraneous to the tax professionals but readily available within the Treasury department.
All in all, transfer pricing is a multifaceted field of international tax and the information it feeds from is usually fragmentary and often dispersed across different MNE departments or even businesses. Because of this, transfer pricing management requires dialogue, coordination, holistic thinking and cross-functional cooperation. While this is not an easy goal to be achieved, especially within large enterprises, it provides an opportunity for cross-fertilization that will ultimately allow tax departments to partner with businesses and build transdisciplinary skillsets and robust transfer pricing frameworks to go from strength to strength.
What can you do?
- Take an inventory of your internal stakeholders who can provide you with the necessary information;
- Raise awareness within the organization of internal and external change triggering events to enable your early detection and response;
- Proactively analyze the potential impact of such events on your value chain; and,
- Seek advance confirmation (APAs, rulings) from tax administrations if the proposed changes materially impact your existing transfer pricing setup or your profit and cost allocation.