KPMG report: Building an effective transfer pricing risk control framework
A report from the KPMG member firm in Switzerland
A report from the KPMG member firm in Switzerland
Transfer pricing risk control frameworks must be dynamic and adaptable to keep pace with international tax changes. Cross-functional cooperation and cross-fertilization allow tax departments to build transdisciplinary skill-sets and robust transfer pricing frameworks to respond to such changes.
Transfer pricing risk controls
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, growing shareholder engagement, and the ability to properly identify and address financial reporting and reputational risks have become critical. Yet, considering the significance of MNEs 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.
Change can be triggered by external events that are usually on the radars of tax departments (e.g., base erosion and profit shifting (BEPS) efforts and local tax reforms) or society at large (e.g., sanitary crises, natural disasters, and economic downturns). Internal events are more likely to escape the attention of tax departments. Internal change triggers may relate to:
- New sales campaigns
- Forecasts and projections
- Roll-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
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 including:
- Trading—when a trading principal transacts with foreign sales affiliates entitled to routine remuneration: Price setting is typically reverse engineered: selling prices and volumes are forecasted prior to year-end, and 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 affect 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 profit and loss (P&L) reports, cash flow statements, and working capital and capital expenditure analyses. They have awareness of sudden changes in sales projections, cost-cutting measures, and restructuring costs that do not go through the tax department but 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, 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 fees. 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 (that can be difficult to define), giving rise to withholding tax liability. More generally, widespread challenges on the relative benefit/cost base of a specific service are seen. Hence, having different services (with specific policies, cost base, remuneration and the like) may sound over-complicated at first, but probably could be the best strategy not to lose across the board (i.e., withholding tax or the risk of disallowance of everything). Similar to the trading example, information may be dispersed across the organization; information about which individuals are or have been present at the local affiliate’s premises, their skillset, experience, function, goals, and targets may likely rest 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 an area in which there have been high levels of scrutiny due to potentially risky transactions, and in turn 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 is to be treated as loan. It is more important to review the treasury function, with special regard as 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. This type of information is likely to be extraneous to the tax professionals but readily available within the treasury department.
Transfer pricing is a multifaceted field of international tax and the underlying information is usually fragmentary and often dispersed across different MNE departments or even businesses. Because of this, transfer pricing management requires dialogue, coordination, and cross-functional cooperation. While not an easy goal to achieve, especially within large enterprises, transfer pricing management provides an opportunity for cross-fertilization that could ultimately allow tax departments to partner with businesses and build trans-disciplinary skillsets and robust transfer pricing frameworks to go from strength to strength.
Possible steps for taxpayers to consider are to:
- Take inventory of internal stakeholders who can provide the necessary information
- Raise awareness within the organization of internal and external change-triggering events to enable early detection and response
- Proactively analyze the potential impact of such events on the value chain
- Seek advance confirmation (APAs or rulings) from the tax administration if the proposed changes materially affect the existing transfer pricing setup or profit and cost allocation
Read a December 2021 report prepared by the KPMG member firm in Switzerland
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