Transfer pricing: The cross-border battle for profits continues to heat up
February/March 2020 Footnote
Editor's note: Updated January 31, 2020
Transfer pricing — the price paid in controlled transactions — is a topic of continued importance to multinational enterprises (MNEs) and tax professionals. The global transfer pricing environment continues to heat up as countries persist in their quest to capture their “fair share” of taxable profits; this, at the same time, is causing MNEs to strive to protect themselves from a tangled web of double taxation and nondeductible penalties and interest associated with their increasingly complex global value chains.
Transfer pricing rules continue to proliferate across the globe. Ernst & Young LLP publishes a useful Worldwide Transfer Pricing Reference Guide that covers 124 jurisdictions. Most countries adhere to the arm’s length principle under the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines), which states that the arm’s length principle is met “when the price paid between related parties is the same as the price that would have been paid between unrelated parties under the same or similar economic circumstances.” Although not perfect, the arm’s length principle has provided taxpayers and tax authorities a useful guardrail in establishing and testing the appropriateness of transfer pricing policies and outcomes.
Adding to the challenges of dealing with country requirements, regional and global authorities such as the G20, European Union (EU) and United Nations (UN) have weighed in on the topic. The G20 spawned the OECD’s Base Erosion and Profit Shifting (BEPS) initiative to promote a “fair and sustainable” international tax environment. So far, more than 135 countries are implementing 15 BEPS actions to tackle tax avoidance. The EU has pursued several large cases alleging state aid via favorable transfer pricing arrangements. Even the UN has stepped into the fray with its “Practical Manual on Transfer Pricing for Developing Countries.”
Unfortunately, the perception on “What is fair?” has diverged in many instances as different opinions have taken shape. Some argue that the OECD’s “BEPS 2.0” initiative has gone too far with its Digital Economy Task Force by proposing a view that suggests a mere digital presence in a given tax jurisdiction is sufficient to give rise to a claim on operating profit — notwithstanding the fact that many countries already collect VAT on these sales.
Inbound versus outbound
For businesses operating within the United States, if the MNE is headquartered in the U.S. with controlled operations located in foreign countries, they are outbound businesses. Alternatively, the U.S. business may be a subsidiary of a foreign-headquartered MNE, or inbound businesses. By their nature, inbound versus outbound businesses face different issues associated with transfer pricing.
U.S. inbound businesses
U.S. inbound businesses can take numerous forms, including sales and marketing activities, distribution, manufacturing operations and technology development services. With respect to U.S. inbound businesses, the key is to understand the level and nature of the U.S. activities and the level of profit in the U.S. For instance:
- Is the U.S. business earning losses? Although the U.S. Transfer Pricing Regulations (U.S. Regulations)1 allow for losses in certain circumstances, such as new market entry, persistent losses over an extended period will become challenging to defend over time — especially if the rest of the group is profitable. Moreover, in addition to risks of adjustments over time, an MNE with losses in some jurisdictions and profits in others likely subjects itself to unnecessary tax inefficiency, leading to a high global effective tax rate.
- Is the U.S. business earning low profits? The IRS is keenly aware that many MNEs based in foreign countries are motivated to target very low returns in the U.S. to minimize U.S. tax. In fact, the IRS’s Inbound Distributor Campaign is an examination program that specifically targets U.S. distributors sourcing goods from foreign-related parties that incur losses or small profits in the U.S. Accordingly, such companies face substantial risk of scrutiny by the IRS. Under the U.S. Regulations, the IRS can perform its own transfer pricing analysis. If the operating profit level of the U.S. is below the range of arm’s length returns determined by the IRS, the commissioner has the authority to adjust the U.S.’s results to the median of the arm’s length range determined by the IRS.
- Is the U.S. business earning high profits? Such MNEs may be overpaying U.S. tax. Moreover, these entities may be subject to potential adjustments in the foreign country. We have seen the German tax authorities impose adjustments on transactions between German MNE headquartered companies and their U.S. distributor affiliates — claiming that a portion of the U.S. distributors’ income should have been realized by the German parent due, for instance, to its ownership of the MNE’s key intangible property.
We typically evaluate whether the U.S. profits are “low” or “high” by performing benchmarking studies. These studies measure the returns of independent companies that perform functions like the tested party — typically the U.S. for inbound businesses. We use this analysis of operating returns of these benchmark companies to determine a defensible transfer pricing policy for the U.S. business.
U.S. outbound businesses
Naturally, U.S. headquartered MNEs operating internationally typically face more complex issues than U.S. inbound business. Whereas a U.S. inbound affiliate can focus on transfer pricing issues facing itself and other affiliates, U.S. outbound MNEs typically contend with the transfer pricing between all entities in its global value chain, including entities that may not transact directly with the U.S. business.
The characterization of the foreign entity’s roles and responsibilities has a significant impact on the appropriate application of the transfer pricing method. Many of my U.S.- based clients face the question of the characterization of their sales and marketing affiliates. It is important to distinguish between sales and marketing support services in which the entity supports the sales activities of the MNE without entering into actual agreements with customers, versus a distributor that enters contracts with customers and invoices customers directly. A service provider is typically remunerated based on a markup on its costs while a distributor typically earns a percentage of revenue (operating margin). Not surprisingly, we see foreign tax authorities attempt to exaggerate the relative importance of the local functions and risks to attract more operating profit.
Midmarket companies are not exempt. The IRS’s active Related Party Transaction Campaign targets the midmarket segment — where they expect smaller MNEs to be unprepared to support their compliance with the U.S. Regulations. We have seen the IRS attempt to impose aggressive allocations of income from an MNE’s foreign affiliate to the U.S. In one case, the IRS’s proposed adjustments would have driven the foreign entity into losses.
What are MNEs doing to cope with this changing landscape?
Caught in the crossfire, many MNEs strive to avoid double taxation (and nondeductible penalties and interest) by putting in place robust transfer pricing documentation that explains their global value chains and supports the arm’s length nature of their transfer pricing policies by applying transfer pricing methods. The OECD Guidelines and U.S. regulations specify transfer pricing methods that can be used to support the arm’s length nature of their transactions. Many MNEs have gone well beyond prior efforts by implementing transfer pricing documentation policies that comply with local requirements and demonstrate that the entities within their value chains receive their “fair share” of operating profit in accordance with the value creation.2
Robust transfer pricing support includes critical thinking about how transfer pricing might be challenged by countries seeking to claim more profit from MNE value chains.
With its emphasis on the “fair” allocation of profits and stated goal of aligning transfer pricing outcomes with value creation linked to functions in the value chain, the BEPS initiative has created some confusion and tension with the arm’s length principle. For instance, the BEPS Action 13 report mandates large MNEs3
to prepare country-by-country (CbC) reports that list revenues, profit before tax, income tax paid, capital, earnings, number of employees and assets by tax jurisdictions in which it operates. The CbC report refers to these measures as economic activity indicators. The MNE files the CbC report with its home country and it is shared with tax administrations in other jurisdictions for use in high level transfer pricing and BEPS risk assessments. Although Action 13 states that CbC reports should not be used for formulary apportionment, we expect many countries will use this information to justify tax adjustments. Accordingly, it behooves MNEs to prepare analytical models that anticipate how countries might use the data so that they can be prepared to deal with the imminent controversy.
Many larger MNEs are having difficulty developing streamlined, well-organized transfer pricing processes. Companies are looking for cost-effective approaches to achieve compliance and address transfer pricing risks such as one-sided adjustments, which potentially result in double taxation and nondeductible penalties. To fill this need, transfer pricing technology solutions have emerged to enable MNEs to create and manage transfer pricing documentation in-house. Many offerings have often fallen short due to software application rigidity and the inability to address the nuances that are specific to individual MNEs.
Moreover, we see tax authorities become skeptical when they receive reports with generic, boilerplate language — perhaps concluding that the MNE has demonstrated a lack of care.
Every MNE is unique and its transfer pricing requirements and risks need to be assessed as such, especially in the current climate. Transfer pricing specialists can assist in minimizing exposure and navigating the road ahead.
Guy Sanschagrin leads WTP Advisors’ transfer pricing and valuation practice and is CEO of Trans-Portal, a global transfer pricing management platform. You can reach him at +1 866-298-7829 ext. 702 or email@example.com. Guy extends his thanks to his colleague, Lisa Yashar of WTP Advisors, for her contributions to the article.