Doing business online allows companies to reach exponentially more customers than could otherwise. But the complexity of transfer pricing means they may open themselves to exponentially more risk, including running afoul of emerging global regulations. Transfer pricing specialist David Whitmer explains.
Transfer pricing has long been a challenging issue for multinational entities (MNEs) with operations and sales spanning multiple jurisdictions across the globe, but in the digital era, the level of complexity has increased and expanded.
Any business transacting in the online space across borders could now be considered an MNE and is, therefore, affected by transfer pricing rules. At the same time, national and international efforts to ensure the right amount of taxes are paid to the appropriate tax authorities are being ramped up. Companies must stay alert to rules which are evolving and develop suitable strategies to mitigate risk.
What is transfer pricing?
Transfer pricing is the process of setting the prices charged between associated enterprises (such as a parent and a subsidiary, or between different divisions) in cross-border transactions. Most countries implement transfer pricing rules to prevent businesses with cross-border reach from artificially shifting profits out of their jurisdiction to avoid paying taxes there and into another jurisdiction where taxes may be lower. In essence, this is about making sure that the tax base reported in a country is consistent with the economic activity undertaken in that country.
Ultimately, the tax outcome should be the same as if non-associated enterprises had engaged in the same transaction under the same circumstances. This is known as the arm’s length principle.
The concept relates to tangible transactions (involving the transfer of physical goods or property between related entities), intangible transactions (including intellectual property, confidential information, know-how, trademarks and trade names), service transactions (such as research and development, technical, management and administrative or marketing services) and financing transactions (e.g., the provision of loans, guarantees or other financial arrangements).
The traditional economy vs. the digital economy
Under the old economic model, before digitalization, providers of goods and services traditionally had to have a brick-and-mortar presence in the locations where they made their sales, for obvious reasons. But in cyberspace, it’s possible to have global reach without any physical presence in a country. This creates a risk that the tax systems in many countries may not adequately capture all profits derived from the digitalization of businesses.
For example, digital shop fronts have replaced real-life stores, with centralized warehouses servicing multiple international locations, altering supply chains. Smartphone apps are ubiquitous and can represent high-value intangible property through which substantial profits can be earned. The Internet of Things (IoT) is generating huge amounts of data, which can be used to create valuable IP, and innovations like leveraging big data analytics, artificial intelligence (AI) and blockchain are contributing significantly to profits. Moreover, remote working and cloud computing is changing the profile of where services are rendered or where sales are made.
All of these factors have a bearing on how value is created. Careful planning and continuous monitoring are required to ensure companies remain compliant as the landscape changes.
Regulations ramp up
To combat the estimated $100 billion-$240 billion lost in tax revenue annually due to artificial profit shifting, the Organization for Economic Co-operation and Development (OECD) is leading the charge on implementing base erosion and profit shifting (BEPS) rules, creating a 15-point action plan and a two-pillar framework.
The two most relevant actions in the plan are Items 1 and 8:
- Item 1 aims to ensure that businesses operating in the digital economy are properly taxed in the jurisdictions where they generate profits, even if they have no physical presence there.
- Item 8 seeks to prevent related companies from moving intangible property, which can be very hard to value, to other businesses in the same group, and focuses on the challenges inherent in determining the value of these assets.
Building on these actions, the two-pillar strategy is known as BEPS 2.0. Pillar 1 is the most relevant to transfer pricing. It provides for the reallocation of a proportion of the largest MNEs’ income to market jurisdictions where they carry out business and generate revenue, so that they pay some of their taxes in those countries (under the nexus test).
The OECD has published transfer pricing guidelines on which most countries’ transfer pricing rules are based, although interpretation, application and administration may differ between countries. Several countries have also introduced their own digital service taxes (DSTs), and there are concerns that this fragmented approach could cause problems of its own, such as the potential for double taxation.
However, the implementation of Pillar 1 is expected to lead to DSTs being discontinued over time. Some-135 countries have now committed to the two-pillar plan.
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Read moreDetailsPlanning is vital to mitigate risk
Global and digital businesses need to understand their position, think about what factors will affect transfer pricing across their business, and adjust their practices accordingly. If they get it wrong, they could incur income adjustments, additional taxation, interest, and penalties. As part of robust planning, MNEs should consider:
- Assessing existing policies and developing best practices: Are existing transfer pricing approaches still sound, justifiable and supported by appropriate documentation? Do intercompany arrangements already in place need to be amended?
- Conducting a compliance cost/benefit analysis: Compliance can be costly, but so too, of course, can be non-compliance. Therefore, it’s essential that transfer pricing strategies are based on informed decisions that mitigate risks in the most effective yet efficient manner.
- Identifying value creation: Evaluating what impact digital transformation has had on the group’s value chain is vital to ensuring that profits are allocated in a way that adequately reflects the economic impact of its various business activities.
- Identifying IP ownership jurisdictions: Working out who holds the rights to any valuable intangibles created through digitalization (and where they are based) can have a major impact on transfer pricing outcomes. Further, does it make sense to transfer IP ownership within the group?
- What structures should be put in place: For instance, should they use representative offices to establish a presence on the ground in a particular location, which can assist with compliance with local regulations? Or should they establish a resale entity to distribute goods and services in specific markets to mitigate permanent establishment risk and transfer pricing adjustment risk? And/or would cost-sharing work, so that investments and costs related to intangible assets are split between associated entities? If so, how would the benefits be derived?
As they weigh up these issues, MNEs will also need to think about a multitude of other questions, such as: What contribution remote workers are making in terms of servicing multiple jurisdictions and how that value should be allocated. How the use of innovations like automation, AI and augmented or virtual reality is affecting revenue. How data is being acquired and how it is being used to deliver value. The list goes on.
The reality is that digital businesses providing sales and services on a multinational scale need to make sure their transfer pricing strategies are optimized at all times and remain compliant with both international and country-specific regulations — no small undertaking in the current environment. Analysis, modeling and benchmarking will often be required in order to value intangible property and formulate suitable transfer pricing methodologies.
It’s clear that approaches developed more than 100 years ago for the traditional brick-and-mortar economy now need to adapt to become workable for the digital era, and we’re now in a new and extremely challenging phase for transfer pricing.
Companies need to be proactive and agile with their planning in order to strengthen their position — both now and in the future.
David Whitmer is national transfer pricing lead at CBIZ and transfer pricing lead at Kreston Global. He previously was a transfer pricing senior manager at BDO USA. 
