This article was written by Jerome Tse, Fiona Beattie, Stephen Pevsner and Bill Ye.
It has never been more important for multi-national enterprises (MNEs) to consider their global transfer pricing positions.
Governments around the world have stepped up their“tough on multi-national tax” rhetoric fuelled by intense political pressure.
They have strengthened transfer pricing laws and regulations following the Organisation for Economic Co-Operation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) project, and initiated numerous global audits on transfer pricing arrangements. Transfer pricing is also more than just an international tax issue, as evidenced by recent State aid investigations in the EU.
MNEs often trade goods and services between geographically dispersed related entities. They do so for a number of reasons, many of which are not tax driven. For example, a MNE may have centralised its manufacturing operations in one country to take advantage of cheaper labour costs, or hold intellectual property in a centralised location for the worldwide group.
The related party nature of these transactions can mean parties differ from the arm’s length conditions found in the open market. Transfer pricing attempts to reset the price and conditions of these transactions to ensure that they reflect what arm’s length parties would have agreed.
By itself, the application of transfer pricing to a related party transaction does not automatically involve tax avoidance or mischief. However, with a growing shift towards digital industries and the globalisation of trade, many governments consider that MNEs have taken advantage of transfer pricing rules to achieve lower global taxation or non-taxation. For example, the Australian Senate Economic Reference Committee stated that, “transfer pricing rules effectively allow multi-nationals to charge Australian consumers whatever the market will accept and then shift the profits out of the country through transfer pricing”.
The BEPS Action Plan has triggered widespread changes to transfer pricing approaches
Aligning transfer pricing with value creation
Several items in the October 2015 OECD BEPS deliverables (BEPS Action Plan) are designed to align transfer pricing outcomes with value creation. They stipulate that tax administrators should look to substance over form in determining arm’s length pricing and conditions. This requires careful analysis of both the contractual relations and actual conduct between the parties. Companies performing important functions, controlling risks and contributing assets should be entitled to an appropriate return reflecting the value of their contribution. Those that do not contribute deserve no or minimal compensation.
New documentation requirements being adopted by Governments globally
The BEPS Action Plan recommends adoption of a three- tiered transfer pricing documentation structure. This will provide a more comprehensive overview of transfer pricing
- a master file containing standardised information relevant for all MNE group members;
- a local file referring specifically to material transactions of a local taxpayer; and
- a Country-by-Country Report (CbCR) containing information relating to the global allocation of the MNE’s income and taxes paid, together with certain indicators of the location of economic activity within the MNE group.
The BEPS Action Plan recommends that a CbCR only apply to MNEs with annual global consolidated group revenue equal to or exceeding €750 million. Other countries, especially those outside of the EU, may have a different threshold.
Since the release of the BEPS Action Plan, many countries have taken steps to implement these requirements into domestic law. The European Commission (Commission) has proposed the introduction of a form of public CbCR but at this stage the proposal has not yet been adopted.
The PRC adds a fourth report into the mix
The PRC revised its major regulation governing transfer pricing (Circular 2) and issued a discussion draft in September 2015. The formal revised Circular 2 is expected to be issued this year.
Circular 2 also requires businesses to prepare a fourth report, called a “special issues” file, if they engage in intra-group services, implement cost-sharing arrangements or violate the PRC’s thin capitalisation rule. There is no transaction threshold for the special issues file. This is an example of the layered compliance measures MNEs may face as a result of inconsistent implementation of the BEPS Action Plan.
Transfer pricing is no longer just a tax issue: State aid in the EU
The Commission is currently investigating whether various EU Member States’ tax agreements with certain MNEs provide an advantage to MNEs which constitutes “State aid”. The EU State aid rules control the circumstances in which in taxes) can be used to give one company a selective advantage over its competitors. If illegal aid has been granted, the recipient will have to repay the aid plus interest. The focus has been on certain “tax rulings” of Member State tax authorities which endorse or approve “bespoke” transfer pricing arrangements for individual companies.
The Commission has held that the tax rulings of Starbucks and Fiat endorsed artificial and complex methods to establish taxable profits which had the effect of artificially lowering taxes paid by the companies. In the ongoing investigation into Amazon, the Commission argues that a tax ruling set up a floor and a cap to remuneration for internal IP licensing and allowed a transfer pricing methodology that did not correspond with OECD guidelines. In another investigation, the Commission considers that tax rulings affecting net profit attributable to the company’s Irish branches were negotiated rather than substantiated by reference to comparable transactions. The Commission also questions the duration of the rulings and the failure to account for the increase in sales over the period.
Businesses currently benefiting from an individual tax ruling in the EU should review their positions now. Reviewing current arrangements will better enable them to assess whether State aid concerns may arise and how any such risks could be mitigated.
Dealing with transfer pricing in the new world order
The PRC steps out from the OECD’s shadow
The PRC is not a formal member of the OECD, but it is proactively participating in the BEPS project discussions and has built on a number of the BEPS project initiatives.
The PRC takes the view that Chinese companies must be properly compensated for the value created in the group supply chain. To measure the value creation benefit, location specific advantages (LSA) require consideration. Generally, LSAs include the benefit from the PRC’s growing middle- class customer base (known as “market premium”) and cost savings attributable to operating in a particular low cost market (known as “location savings”). While the OECD mentions location savings in their report, the PRC is one of the first countries to include them as a LSA.
Circular 2 also introduces concepts of legal and economic ownership of intangibles. Companies that take legal ownership of, but do not contribute to the development of the intangible, will not be compensated through an economic return on the intangible. Further, if enterprises pay royalties to a related party but the licensed intangible does not bring any economic return to the enterprises, the tax authority can deny the royalty deduction.
Substance over form needs sustained attention
The BEPS Action Plan’s focus on substance over form will put pressure on the use of hubs in low tax jurisdictions as a means of ostensibly minimising tax. MNEs will need to focus on evidencing real functions and risks in the value chain, or will face the risk of transfer pricing adjustments in the future.
It is important that MNEs not only ensure that their agreements and transfer pricing approaches are documented, but that they regularly conduct post- implementation reviews to ensure continued alignment between substance and form. Doing so minimises the risk of protracted revenue authority audits and litigation, and is good business practice.
Use the new documentation requirements as an opportunity to audit your own affairs
The CbCR disclosures may paint a misleading picture of a MNE’s transfer pricing position in some instances. It will be critical to analyse the CbCR disclosures and anticipate possible questions that may arise from global revenue authorities, especially in the first year or two of CbCR implementation. There will often be non-tax reasons to explain any red flags that are discovered. Where a transfer pricing risk is found, early internal review will give businesses an opportunity to address the issues quickly and prior to revenue authority scrutiny.
Systems changes will be necessary
The BEPS Action Plan’s three-tiered reporting requirements differ from current global standards. MNEs have already begun designing new systems to facilitate compliance. If you operate in a jurisdiction which has adopted some form of the recommendations, you must budget time and money for necessary system updates. In most jurisdictions, the reporting requirements are to be implemented for fiscal years beginning on or after 1 January 2016.
Transfer pricing – What’s next?
Transfer pricing will remain in the spotlight for many years to come. Governments globally have introduced significant measures to increase their understanding of how multi- nationals operate and will more readily apply transfer pricing laws to multi-nationals allegedly avoiding paying their “fair share” of tax.
Businesses must be proactive in preparing, analysing and substantiating their transfer pricing and, now, State aid positions. Most importantly, businesses must remain vigilant of changes to the global transfer pricing environment to ensure that their related party transactions are and remain at arm’s length, both in substance and form and that they are in a position to justify that.