In recent years, a number of transfer pricing-related disputes between multinational corporations and tax authorities have made the headlines. Of particular note is the $3.4bn settlement between GlaxoSmithKline and the Internal Revenue Service in the United States and AstraZeneca’s approximately £500m settlement in the United Kingdom.  These eye catching numbers are just the tip of the pyramid.  There are a number of other transfer pricing disputes in which tax authorities are proposing tax adjustments and penalties in the hundreds of millions of US dollars.  

Transfer pricing at its simplest is about what prices should be charged for transactions between related entities that are part of the same multinational group.  Most countries have enacted rules that govern the pricing of such related party transactions, including the sale of tangible goods or intangible property, licensing of intangible property, performance of services and loans or guarantees.  These rules which provide a theoretical construct within which multinational companies must operate, are meant to ensure that each country receives its fair share of income attributable to the multinational’s operations in that country.  The underlying principle of these rules is the “arm’s length” standard, meaning that the related party transaction should be priced similar to how unrelated parties would price a comparable transaction undertaken in comparable circumstances. 

While some multinational companies have made transfer pricing a strategic consideration and devote considerable resources to it, many others view transfer pricing as a compliance headache compounded by the fact that transfer pricing rules vary from country to country.  In this latter group, transfer pricing is often treated as an afterthought with little to no involvement or oversight by the company’s senior corporate officers.  This is usually a mistake.  Although transfer pricing may be an important compliance issue, it can also have a significant and material impact on a company’s operations and financial position.

Compliance or more
If a company only has simple manufacturing or distribution operations in a few overseas countries, transfer pricing may indeed be primarily a compliance issue. However, this scenario is true only of very few multinationals. Most global companies have complex supply chains – they operate in multiple countries where their local subsidiaries engage in a multitude of functions. As a result, they enter into a variety of inter-company transactions.  For example, a multinational may have a subsidiary in the UK that manufactures products using technology licensed from the parent and raw material inputs sourced from a related party in Italy, and benefits from centralised back-office services performed by a related party in India.  

As a result, multinationals need to pay careful consideration to transfer pricing and related tax considerations to ensure that they don’t pay more tax than necessary and/or bear risk of transfer pricing-related tax adjustments and penalties. Such considerations can have a significant impact on how a multinational structures its operations and conducts business.

For example, Company ABC, headquartered in the US, develops accounting software.  Its customer base in Europe is growing rapidly, and it feels a local European presence will help it increase market share. One approach would be for ABC to set up local European marketing subsidiaries that are compensated on a markup to their costs.  All contractual negotiations and pricing decisions would still be made by ABC executives in the United States. However, this arrangement may not provide the flexibility ABC needs to quickly or adequately respond to European market conditions.  On the other hand, having full-fledged European distribution subsidiaries that are compensated on a commission basis would leave too much profit in certain high-tax European countries and result in a higher global tax burden and effective tax rate. 

Through a transfer pricing analysis, ABC carefully parses the functions to be performed by its European subsidiaries and risks they will bear.  Based on this analysis, ABC sets up European limited risk distributors which have the authority to negotiate directly with customers and to decide pricing but do not bear any risks associated with unsold inventory, warranty risks or foreign exchange fluctuation risks (they will buy product from ABC in local currency.)  The transfer pricing analysis showed such independent limited risk distributors should earn lower profits than full-fledged distributors given their reduced business and financial risks.  

It is common for multinationals to seek opportunities to minimize tax burdens by shifting economic profits to lower-tax jurisdictions.  One approach is a cost sharing arrangement (CSA) whereby the parent company in a high-tax jurisdiction and an affiliate in a low-tax country jointly fund new research and development (R&D) investments on a pro-rata basis based on the profit potential each has from exploiting the cost-shared intangibles in its assigned territory. To facilitate the future R&D, the parent company will often transfer to the CSA the rights to leverage/exploit pre-existing intangibles that it owns.  Under the transfer pricing rules of the United States and other countries, the multinational has to determine the market or arm’s length value of such transferred intangibles and pay taxes on the transfer as if it had sold the intangibles to an unrelated third-party.  The expectation of the multinational being that the up-front cost of the tax paid would be offset by the higher future income realized in the lower-tax country, once again resulting in a lower worldwide effective tax rate.

Such planning opportunities require the valuation of the pre-existing intangibles which are often unique and for which no or limited market pricing information exists.  The valuation is further compounded by the fact that the transfer pricing rules of two or more countries need to be accounted for, and these rules may not be aligned, leading to the valuation not being acceptable to all of tax authorities involved.  This may result in the tax cost of transferring the intangibles being higher or even potential double taxation. The transfer pricing rules may differ with respect to the preferred analytical method, what specific intangibles are susceptible to transfer, guidance on how to treat the life of the transferred intangibles and whether goodwill/going-concern is considered to have also been transferred.

Multinationals may face significant tax risks when the transfer pricing/tax planning is not well-thought-out and/or does not include true economic substance.  For example, in a landmark litigation case involving the Veritas Software Corporation, the IRS argued that the true value of the intangibles transferred by Veritas to its CSA with an Irish related party was 10 to 14x that of the taxpayer’s valuation. The Internal Revenue Service recently lost the litigation on appeals, in part based on the economic substance created in Ireland by Veritas and on Veritas’ careful consideration of market evidence of the limited life of software intangibles. However, the judge also found that Veritas’ valuation did not meet the arm’s length standard and made an adjustment to the valuation.

The risks of such planning are not limited to disputes with tax authorities.  When one company acquires another company that has engaged in transfer pricing planning that has not been well-thought out or is otherwise not supportable, there is the risk that the buyer may seek to claw-back some of the purchase price through commercial litigation or any escrow that may have been set up as part of the acquisition.

Auto pilot
It is common for multinational companies to devote significant time and resources to structuring their transfer pricing and then put it on auto pilot.  Over time, facts and circumstances can change leading to unintended consequences.

Assume USCo has distribution subsidiaries that market and sell widgets that USCo develops and manufactures.  These distributors purchase widgets from USCo at a set discount off customer list prices, which initially provides them with a return on sales that is arm’s length when benchmarked against independent distributors.  Over time, prices to customers increase due to USCo’s technology innovations.  If the related distributors’ costs do not increase proportionately and they continue to purchase widgets from USCo at the set discount, the distributors’ profit margins will gradually increase and may become higher than that of independent distributors used as benchmarks.

Transfer pricing must be constantly reviewed.  Changes in facts and economic circumstances may require making changes to a multinational’s transfer pricing policy.  For example, if one company in the multinational group starts providing centralized back office services to others in the group, the transfer pricing policy must be adjusted accordingly to compensate the service provider for its activities.

Transfer pricing is a high stakes game.  Done correctly, it can enhance a company’s bottom line.  Done incorrectly, it can create substantial risk of tax exposures and penalties.  Transfer pricing should not be treated merely as a compliance issue and it is important for certain senior management time and resources to be devoted to transfer pricing issues.

Vinay Kapoor is MD of Transfer Pricing at Duff & Phelps

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