Chad Martin, BaseFirma Denver
Despite recent headwinds in global trade caused by supply chain bottlenecks and geopolitical conditions, multinational enterprises (MNEs) continue to grow in number, size, and economic importance. Companies in industries ranging from financial technology to biopharmaceuticals are seeking to profit from a more targeted and localized approach to selling into foreign markets, made possible by rapid advances in connectivity and collaboration technology. One of the most common (although often unanticipated) challenges to international expansion for new or growing MNEs is transfer pricing: planning and executing transactions between entities within the MNE group that comply with local and international tax rules.
What is transfer pricing?
Simply put, transfer pricing refers to the prices charged between entities within the same MNE group for goods, services, intangibles, and financing. For decades, national tax authorities have imposed myriad rules and regulations on these intercompany transactions to prevent potential abuse; for example, applying inflated transfer pricing in flows from low-tax jurisdictions to high-tax ones in order to shift taxable income and therefore minimize effective tax rates.
Transfer pricing laws and regulations
Most tax authorities around the world (Brazil is a notable exception) rely on the “arm’s length principle” as the guiding standard for transfer pricing rules. In short, this principle holds that the pricing between group entities should be conducted as if the transactions were being conducted on the open (i.e., uncontrolled) market. Simple though this may sound, different interpretations of the arm’s length principle across tax administrations means that complying with transfer pricing rules can be extremely complex and burdensome. By nature, cross-border transactions fall under the jurisdiction of at least two tax authorities, meaning that transfer pricing standards for the same transaction may risk tax controversy or double taxation. Income tax treaties may provide some relief for the latter risk, but the burden of potential audits and inquiries still weighs heavily on MNEs, especially those entering new geographic markets.
Transfer pricing basics for international expansion
One of the most common questions from MNEs grappling with transfer pricing for the first time is where to start. Even with a solid understanding of the basic principles of transfer pricing, start-ups or newly-expanded MNEs face challenges that established companies generally don’t; for example, a high level of uncertainty as to how the international business will evolve, what relationships will form between group entities over time, and accurately forecasting segmented and consolidated profitability beyond the very near term. An exhaustive list of every scenario a new MNE may face when entering a foreign market is beyond the remit of this brief overview. However, this article seeks to provide in-house tax teams with a succinct and useful list of top priorities as relates to transfer pricing in new jurisdictions. These priority areas include:
- Policy planning
- Intercompany legal agreements
- Implementation and execution
- Documentation and compliance
The pages below contain an assessment of each priority area from the perspective of a new MNE. For simplicity’s sake, the regulatory and legislative context is centered on US (IRC S. 482/Treas. Reg. 6662) and Organisation for Economic Co-operation and Development (OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations) guidance, which together represent a significant share of the world’s transfer pricing standards.
When entering a new tax jurisdiction, the first transfer pricing-related task for an MNE is to devise a transfer pricing policy that complies with that jurisdiction’s transfer pricing regulations (and ideally the regulations applicable to group entities that will transact with the local entity). At a high level, this involves the following steps:
Transaction mapping: create an inventory of all anticipated intercompany relationships the new entity may have with other group entities. Start with the obvious such as tangible product sales/purchases, intercompany loans, etc., but don’t forget to consider “implicit” transactions which can be much more challenging to identify. These often include beneficial services received from MNE headquarters and the right to exploit intangibles economically owned elsewhere, among others. A general rule of thumb for deciding whether a relationship may constitute an intercompany transaction is the “would-buy” test: if the relationship did not exist, would either entity theoretically have to purchase the service/benefit from a third party?
Regulatory review: before creating any intercompany policies or agreements, a taxpayer should first familiarize itself with the transfer pricing regulations in the host jurisdiction, with specific reference to the transaction categories identified in the step above. For example, if the local entity will receive intercompany services from headquarters, what are the transfer pricing methods prescribed in local regulations for such transactions? Does local tax law allow for the full deductibility of such payments, and/or does it require specific materials (e.g., invoice records) to remit or deduct payment? Depending on the complexity of the jurisdiction and the type of transaction, advice from local transfer pricing experts may be advisable for this stage.
Transfer pricing structuring: the most important step of the policy planning phase is to devise an intentional and adaptable transfer pricing structure. This incorporates information gathered in the previous two steps to establish an arm’s length transfer pricing methodology for each intercompany transaction identified.
Establishing a transfer pricing methodology for a given transaction generally begins with a qualitative assessment of the functions performed, assets employed, and risks borne by each entity involved in the intercompany transaction in order to determine a framework for allocating profit between them. This qualitative assessment often takes the form of discussions with relevant operational and management personnel. Note that the MNE may often exercise some discretion during this stage, specifically with regard to the risk (e.g., financial/market risk, inventory risk, etc.) assigned to each entity, which in turn affects the appropriate profit allocation. To ensure effective implementation, it is also important for the tax team to communicate potential policies to stakeholders in other internal teams, such as accounting, treasury, and the local entity’s operational team, to preemptively identify any downstream issues potential policies may present. Based on this analysis, the taxpayer then sets policy prices, rates, markups, or margins that reflect third party behavior (often determined with reference to searches for comparable companies and/or transactions).
As an example, consider a simple model in which a manufacturing company establishes a local country distribution entity. Depending on the facts and circumstances established in the functional assessment, it may be appropriate for the manufacturing entity to sell to a group distribution entity at an arm’s length markup on costs. Alternatively, if the local distribution entity performs generally routine activities and bears little risk, a resale-minus pricing policy that targets an arm’s length overall operating profit may be most appropriate. The policy chosen could have a significant effect on the future allocation of system profit between the two entities; therefore, if possible, a taxpayer should incorporate potential transfer pricing models into legal entity-level forecasts to assess and anticipate the impact.
It is crucial to understand that the internal transfer pricing policies described above often differ from the methodology applied to demonstrate year-end compliance with the arm’s length principle, especially when an indirect (profit-based) method is applied to document transfer pricing results. In other words, it is often simplest and most reliable to prove that transactions were conducted at arm’s length by showing that an entity earned a level of operating profitability that is in line with that of companies engaged in similar activities and bearing similar risks. However, it is often impossible to prospectively price transactions throughout the year on this policy, so the MNE may use another transfer pricing method (e.g., applying a standard markup on cost for product sales) in order to effect the result that will ultimately be assessed by an indirect transfer pricing method.
The initial capitalization of the new entity may have transfer pricing implications as well. It is important to note that intercompany debt financing is typically governed by transfer pricing rules, specifically with regard to the determination of an arm’s length interest rate on intercompany loans. Furthermore, the structure should be forward-looking, seeking to accommodate future functions (and thereby transactions) that may eventually apply to the entity. This can be particularly challenging in the age of remote employment as hiring or relocations in countries where a given activity was not originally anticipated to be performed can complicate pre-existing transfer pricing policies or require an MNE to quickly develop new policies. For example, a start-up may have a software development hub in Poland but then proceed to hire developers on an ad-hoc basis in other jurisdictions, thereby confounding the existing transfer pricing model. Avoiding compliance risk or administrative hassle in the modern age of global and remote-first workforces requires close coordination with operational decisionmakers as well as a transfer pricing structure that can anticipate, or at least adapt to, changing circumstances.
A common area of confusion among start-ups is how to appropriately allocate start-up losses: i.e., initial losses incurred while a new entity establishes itself in the local market. The correct policy for initial operating losses is highly dependent on the MNE’s overall transfer pricing framework and requires the qualitative assessments outlined above; however, the following considerations apply when determining the policy:
- Decision-making authority with respect to the new operation: generally speaking, new entities which are set up and significantly managed and directed by central personnel in another jurisdiction may be seen as more entitled to pass on start-up losses to the entity that employs the decision-making personnel.
- Future up-side potential for an entity bearing start-up losses: tax authorities are often highly skeptical of a policy in which an entity bears start-up losses but earns a limited, fixed return in future years.
- Third party behavior in context of the start-up losses: start-up business cycles vary significantly by industry. For example, many pharmaceutical companies incur losses for years before generating revenue and profit, while companies in other industries expect margins in a relatively short timeframe.
Concurrent with the policy planning phase, it is important to coordinate with legal personnel to ensure that the policies established are memorialized in intercompany legal agreements signed by each entity involved in the transaction(s). However, the mere existence of an intercompany legal agreement is not in itself sufficient to justify a taxpayer’s transfer pricing practices; the agreement must include terms and conditions that would be reasonably agreed to by two or more unrelated entities. While intercompany agreements vary significantly across MNEs and transaction types, below are several tips for drafting effective and defensible contracts:
- Consider local jurisdiction requirements: some jurisdictions require specific content in intercompany legal agreements, while others require agreements to be registered with the government if future intercompany expenses are to be deemed deductible. Given these local nuances, consult with in-country experts before executing an agreement.
- Be specific but allow for flexibility: the agreement should clearly state the transfer pricing policy that each entity is agreeing to, and the terms and conditions required in order to ensure compliance with this policy. Agreements governing intercompany loans, for example, should specify detailed scenarios such as default risk, prepayments, and convertibility. However, if the transfer pricing policy is subject to periodic change (e.g., a target markup that is set with reference to an annual benchmarking study), consider language that accommodates this fluidity, or otherwise specifying the markup in an appendix that can be updated without requiring the original agreement to be amended. Contingency and force majeure clauses and provisions for automatic renewals may also promote comprehensiveness and durability in executed agreements.
- Keep a database of all intercompany agreements: this may seem obvious, but many taxpayers struggle to respond to tax authority request for intercompany legal agreements. Having agreements clearly organized in an accessible location, and regularly refreshing and consulting them as business changes and new transactions arise, is an essential housekeeping practice.
Implementation and execution
Perhaps the most challenging aspect of maintaining a successful transfer pricing framework is the operational aspect: ensuring that periodic and annual financial statements and filings reflect results that align with the established transfer pricing policies. As mentioned above, an effective operational transfer pricing strategy begins with early, direct, and regular coordination between the tax team and personnel who touch the intercompany process, from those raising purchase orders to those preparing period trial balances. Implementation of transfer pricing policies should feature prominently in the policy planning process, and MNEs using external advisors to assist with policy planning should insist on alignment between the planning and implementation processes. A few common pitfalls in operational transfer pricing are outlined below; consider these areas when prioritizing where to focus effort and attention:
- Systems capabilities and alignment: before adopting a transfer pricing policy, assess the readiness of your financial/ERP system(s) to execute the policy. For example, if a taxpayer selects a transfer pricing policy that relies on detailed segmentation of an entity’s functional or business units, it is crucial to ensure that the ERP system is configured to accommodate this level of detail. Similarly, if a fixed markup on standard cost is chosen as a transfer pricing policy, ensure that systems are pulling standard cost information from the same source as that from which the operational personnel preparing the invoices are referencing.
- Accounting differences: consider the impact of differing accounting practices on transfer pricing results, especially for the entities involved on either side of a transaction. Common differences that cause discrepancies in realized transfer pricing results include revenue recognition, lease accounting, and asset valuation, among others. Timing differences arising between intercompany revenue recognized by a selling entity vs. intercompany cost recognized by a distribution entity may also result in incongruity in results.
- Interaction between transfer pricing and other aspects of the financial supply chain: the impact of transfer prices is often not limited to income taxes. Common areas of required alignment include customs/VAT (e.g., declared value vs. transfer price) and withholding tax, among others. This speaks to the need for early, direct, and regular coordination not only between the tax team and other functional groups (accounting, treasury, etc.), but within the tax team itself.
Documentation and compliance
Many tax administrations require transfer pricing documentation to be prepared contemporaneously with the filing of the corporate income tax return. Some administrations (including the US IRS) do not require transfer pricing documentation, but provide benefits to taxpayers for preparing it, such as relief from potential penalties in the event of a transfer pricing adjustment. Still others (particularly in Latin America) require the documentation to be submitted along with the corporate income tax return. Before commencing intercompany transactions, a new MNE should be aware of the transfer pricing compliance obligations applicable to each relevant jurisdiction and develop a plan for timely preparation and submission.
Common transfer pricing-related compliance documents include the following:
- Transfer pricing documentation; this is typically either a country-specific documentation report or a “Local File” modeled after the OECD Transfer Pricing Guidelines
- Transfer pricing Master File modeled after the OECD Transfer Pricing Guidelines
- Transfer pricing annexes or forms accompanying the local corporate income tax return
- Country-by-country report modeled after the OECD Transfer Pricing Guidelines
- Country-by-country report notifications
Depending on the jurisdiction, some or all of the above deliverables may have transactional or other materiality thresholds. In these cases, it is important to monitor materiality regularly to determine whether new requirements may apply. Further, while they theoretically should conform to the standardized format/content outlined in the OECD Transfer Pricing Guidelines, Local File, Master File, and country-by-country report requirements may also vary across jurisdictions, therefore requiring the taxpayer to research local nuances in each relevant jurisdiction.
Considering the impact of transfer pricing prior to entering new jurisdictions can benefit an MNE in a number of ways, including reduced risk and enhanced operational and financial efficiency. Transfer pricing rules are complex and vary across jurisdictions, but many of the same best practices exist across most jurisdictions, industries, and transactions.
Below is a high-level sample transfer pricing checklist summarizing the considerations outlined above, which we hope serves as a starting point for taxpayers seeking to expand into new jurisdictions.
|Policy planning||Map intercompany relationships (current and future)|
|Review local transfer pricing regulations relating to applicable transactions|
|Hold discussions with management and operational personnel to understand each entity’s functions/assets/risks|
|Consider transfer pricing implications of initial financing for the new entity|
|Determine transfer pricing structure and methods, and policies for each transaction|
|Communicate potential policies to stakeholders in other internal teams, such as accounting, treasury, and the local entity’s operational team|
|Forecast entity results under different scenarios|
|Revisit transfer pricing policy in the event of business changes|
|Legal agreements||Review jurisdictional requirements for agreements|
|Ensure agreement accurately reflects transfer pricing policy|
|Ensure each transaction is governed by a signed agreement|
|Establish agreement database/repository|
|Implementation and execution||Coordinate with internal operational/finance personnel on transfer pricing process|
|Assess ERP system capabilities|
|Check for accounting differences that may impact transfer pricing results|
|Consider transfer pricing effect on other aspects of the financial/tax supply chain|
|Documentation and compliance||Determine transfer pricing compliance requirements and deadlines in relevant jurisdictions|
Check for applicability of any of the following common TP-related documents, forms, and filings:
· Transfer pricing documentation report/Local File
· Transfer pricing Master File
· Transfer pricing annexes or forms accompanying the local corporate income tax return
· Country-by-country report
· Country-by-country report notification
· Monitor and reevaluate compliance requirements on a regular basis
Chad Martin leads BaseFirma’s Denver Office, where he specializes in US and international transfer pricing advisory in areas including planning, implementation, compliance, and controversy. He has nine years of experience serving multinational clients across all major industries. He can be reached at Chad.Martin@BaseFirma.com.