As businesses expand across borders, they must understand the complexities of transactions between divisions, subsidiaries and companies that are under the same ownership but operate in different tax jurisdictions. For organizations with a significant global presence, navigating country-specific compliance requirements can be extremely resource-intensive and overwhelming. Transfer pricing — determining the price charged for goods and services exchanged between related entities — is one area in which companies often exhaust time and money while still ending up penalized.
In recent years, some companies have exploited the complexities of transfer pricing in order to lessen their tax burdens, including Amazon, Google, GlaxoSmithKline and Starbucks, who have all been in the news for their transfer pricing practices. These practices have resulted in fines for certain companies and multi-billion dollar losses for tax authorities in some countries, leading to widespread overhauls in transfer pricing regulations.
Today, more than 60 governments have adopted and enforce transfer pricing rules. Unfortunately for companies operating in multiple countries, these regulations are not always consistent. For example, rules regarding qualified cost-sharing agreements and cost inclusion, as well as adjustments for the risk assumed by comparables, all differ by country. Also adding to the complexity is the fact that transfer pricing rules can be established between many different types of governmental entities, including states and municipalities; in the United States, for example, each state has its own transfer pricing rules and requirements. All of these factors make transfer pricing ripe for disputes and audits.
Failure to comply with global transfer pricing regulations can be costly. Many jurisdictions impose penalties when tax authorities have to step in and correct manipulated transfer pricing. In addition to financial burdens, there are also reputational risks. For example, U.S. companies that shirk tax obligations at home risk earning the wrath of American taxpayers at a time when anemic growth and rising inequality make the subject of overseas tax havens especially sensitive. And if U.S. companies dodge tax obligations abroad, they risk charges of economic imperialism and exploiting host countries.
Although transfer pricing rules vary by country, the preparation needed to manage the intricacies and avoid common pitfalls is consistent. We recommend that all companies consider the following tips and best practices.
Know the “arm’s length” principle. The “arm’s length” principle guides transfer pricing standards for most jurisdictions. In short, the principle means that a company should price a transaction at the prevailing market rate, as if the two entities involved were independent companies, under completely separate ownership.
Although most countries use this principle, a few countries, such as Brazil, have statutory safe harbor rates for certain goods and services. In the case of an emerging industry product, where there is an investment in the market, the decision needs to be made regarding which entity should bear the risk of that development. Be sure to familiarize yourself with the transfer pricing laws of all your countries of operation, so as not to get caught in the dark.
Know how countries calculate the ‘arm’s length’ principle. In addition to knowing which principle a particular country abides by, you must also understand the methodologies that determine if your intercompany pricing meets those standards. Generally, this will include a profits-based test as well as a direct pricing comparison test. When using a transactional test on the price itself, you will need to be careful that you’ve made appropriate adjustments for volume, geography, and other factors that can affect price. You will also want to make sure you are selling into the same level of market between unrelated and related party transactions.
Create thorough documentation. Prepare annual transfer pricing documentation where required. It may be time-efficient to prepare regional documentation that covers multiple countries. This can be effective where you have multiple entities performing similar functions and receiving a similar markup. You can test the markup on an aggregate approach rather than country-by-country.
Don’t forget to also prepare intercompany agreements to cover all material (especially recurring) intercompany transactions. This way, there is no question about what policies are in force. Also, be sure to regularly invoice for intercompany transactions, with clear descriptions on the invoices. You must determine the requirement in each country, the potential exposure from a transfer pricing adjustment, and match that with the resources you devote to preparing transfer pricing documentation.
Regularly assess your policy. Once you’ve created a solid plan, you will need to assess your transfer pricing documentation annually, and compare it to requirements in each jurisdiction where your business operates. An easy way to simplify agreements globally is to have one policy, with modifications made as needed to meet specific local requirements.
Always be audit-ready. Assume the worst and always be prepared. When an audit comes about, the timeframe allowed for response is often slim. Typically, audits can go back 3-5 years, making it even more difficult to have all of the correct paperwork in order at a moment’s notice. Take action to make sure you have appropriate documentation at the ready at all times. Also be sure to have an experienced advisor on call to assist with a comprehensive defense. The less time auditors have to spend getting clear answers, the less they will expect to recover as a result of their efforts.
Complying with international transfer pricing guidelines is challenging at best. As local authorities around the world become more protective of their tax revenues, international transfer pricing is under increased scrutiny, and noncompliant pricing practices are much more likely to result in tax penalties and significant interference in your business from regulatory authorities. No matter what their size, companies need to pay strict attention to ensure that their international transactions are compliant with transfer pricing guidelines in each jurisdiction, robust enough to stand up to increased scrutiny from tax authorities, and designed to mitigate unintended tax exposures.