Transfer pricing

Transfer pricing has become not only a major tax planning opportunity for multinationals, but also an important consideration when streamlining and remodelling business structures. For the tax authorities, it’s fast becoming a major headache.

Transfer pricing, the accepted mechanism for allocating profits between subsidiaries for tax purposes, is an accepted part of compliance life. However, it has become much more important as advances in technology (particularly the internet) have enabled more opportunities for business restructuring and remodelling.

Business structure

The starting point for such remodelling is, and has to be, the preferred and most effective business structure. However, once that is identified, the question as to where to locate different parts of the structure inevitably takes into account the various tax issues. The idea is to create a tax-optimised supply chain. “There are opportunities around intellectual property, procurement, manufacturing, distribution and sales,” says John Henshall, a transfer pricing partner at Deloitte. “You can do it piecemeal, or look at the whole thing.”

“Many businesses have worked out that if they can centralise and streamline procurement so everyone is buying the same paper and pens, etc, there’s lots of money to be saved. That saving isn’t always in the price of the goods; big savings come from the [reduced] cost of buying. Those savings will drop to the company that’s doing the buying, in whatever territory.”

As Henshall points out, that territory could be Japan, with its 51% corporation tax rate, Italy (50%) or the UK (30%). But a different approach to centralised purchasing could see up to half of that profit being realised in, say, Switzerland (effectively 7%, though the published tax rate is much higher) or even Belgium, where it is possible to make the effective rate below 10%.

In order to attract inward investment, both Switzerland and Belgium have laws and practices that allow a reduction in the profits to be subject to tax locally, for which it is possible to get advance agreement. The full tax rate is still applied but to a smaller amount of profits, resulting in a lower effective tax rate.

Charging group members

How that procurement service is charged to other group members has a major impact on the amount of profit taxed in the lower tax jurisdiction and hence the overall group tax cost. A traditional transfer pricing approach, cost plus, might be used where the centralised procurement is effectively just a managed service.

However, if the business identifies that a key driver of its competitive success is its ability to achieve significantly lower purchasing costs than competitors, the purchasing function becomes a true value-adder. A different transfer pricing mechanism can be justified, with group members being charged up to, say, 50% of procurement savings.

“The prices paid must be arms’ length,” says Mark Schofield, an international tax partner at PricewaterhouseCoopers, musing on a theoretical situation where a UK group decides to set up a procurement operation in the Bahamas. “That pricing is affected by who is taking the commercial risk. There could also be credit risk, foreign exchange risk and financing risk. The degree of substance is important too – moving a whole procurement team, as opposed to some of the function. The people who carry out the real intellectual skill of the operation can be reflected in the transfer pricing too.

“There is a lot of work where groups are looking at the whole value chain and how you operate your business model,” adds Schofield. “It’s businessdriven as opposed to tax-driven, but there are tax opportunities and consequences from looking at the value chain.” One model used by some groups is that of the commissionaire. “It was used quite a lot by US groups in the 1990s,” says Schofield. Instead of a traditional model where group company A sells to B, which then sells on to the third party customer, A becomes a principal and B a commissionaire, or agent. “B could just be a limited-risk agent where substantially all the risk is taken by company A,” explains Schofield. This changes the relationship between company A and B, and potentially the profit allocation and tax charge.

At this point it’s worth remembering that the business rationale must come first. “A US company setting up a European HQ might select the UK because it’s seen as politically stable and everyone speaks English,” says Charles North, KPMG transfer pricing partner. “No doubt, however, tax can have a big part to play. There has been a massive increase in the number of US companies, but also Japanese ones, who are basing significant bits of their European operations in Ireland, which has a relatively low tax rate compared with many other countries in the EU, and they speak English.”

Henshall stresses that mistakes can be made by people who get carried away looking at the tax advantages. He cites an example of a store-based retailer that switched overnight to internet-based sales, gaining a more efficient tax structure. “They killed the business, because people needed to touch the goods before they bought them,” says Henshall. The internetbased structure had to be reversed.

Business model

Another key requirement for success is that the new business model really must be introduced. “If you set up a function in, say, the Cayman Islands, it must be genuine,” says North. “There must be real people there doing that real function.” The new business model must also actually operate in the manner intended. “If you bend things for tax in a way that people at the sharp end think is silly, they will work around it,” says Henshall. That will destroy the tax benefits, because the authorities will see the changes claimed have not really occurred.

Transfer pricing arrangements are subject to audit. Governments don’t enjoy seeing a falling corporate tax take as a result of new business models and the resulting transfer pricing mechanisms. “They hate it with a vengeance,” says Henshall. The UK is one of a number of countries in the Organisation for Economic Cooperation and Development pushing for action to deal with falling tax takes.

“A lot of the developing countries have got more interested in it [transfer pricing] as they look to protect their own tax bases,” says Schofield. “India introduced transfer pricing rules in 2001,” confirms North. “That’s quite a strict regime for documentation and [potential] penalties.”

Convincing authorities

One of the challenges for business is to convince governments and tax authorities that their new business models and transfer pricing structures are for genuine commercial reasons, rather than tax planning alone. Locating intellectual property-related activity in, say, Switzerland or the Netherlands (possible 5% tax rate) rather than the UK, makes sense, however. “It’s a breach of the fiduciary duty of the board not to consider these locations,” says Henshall. “How do they explain it to shareholders if they are giving money away?”

One of the problems for UK companies is that the controlled foreign company (CFC) rules provide an extra barrier to group tax efficiency. “The CFC rules are designed to stop people pushing activity abroad, particularly to lower tax jurisdictions,” says Henshall “That whole set of rules is under challenge before the European Court.” Henshall argues that it cannot be right for non-UK headquartered groups to be able to choose locations freely while UK groups cannot. “Businesses headquartered in other jurisdictions might not have these restrictions,” he says. “They are going to take these advantages, be more profitable than you [a UK group] after tax, and have more money to invest after tax and therefore outcompete you. The CFC rules are bad for UK plc because our companies are disadvantaged.”

While the outcome of the CFC rules challenge still lies in the future, UK g roups do have to take account of them. For example, the CFC rules (in simple terms) require that where a centralised operation set up in, say, the Bahamas just services group companies (and no external clients), then the profits generated in the Bahamas will be taxed as if generated in the UK. This wipes out any transfer pricing impact immediately. However, there are some “get-outs”.

For example, the CFC rules will not necessarily apply if it can be shown that the overseas operation was established not for reasons of tax avoidance, but for commercial reasons. Henshall gives the example of a company wanting to centralise its procurement operation and choosing Switzerland, where it had some vacant space. Centralising the function there would be cheaper than finding new premises in the UK.

This is a sound commercial reason and should not be caught by the CFC rules. “UK companies are slightly disadvantaged by the CFC rules, which make things more complicated,” says Henshall. “They can’t do as much, but they can get there.”

UK leads audit taskforces
A survey by Ernst & Young among financial services companies around the world found a growing expectation that transfer pricing policies would be challenged.

More than eight out of ten respondents felt there was a greater than 60% chance that their transfer pricing policies would be challenged by tax authorities in the next two years.

The UK, US and Japan have been most active since 2000 in auditing transfer pricing policies.

In future the UK is expected to be most active, with 68% of respondents anticipating transfer pricing challenges from there in the next two years, followed by the US, Japan, France, Germany, South Korea, India, Canada and Australia.

“Tax authorities around the world have been stepping up efforts to enforce these rules, as it’s a way to increase tax revenues without raising headline tax rates,” says Stephen Labrum, E&Y partner and transfer pricing specialist.

Making waves offshore

Household names such as Tesco are costing the Treasury millions by taking advantage of a 20-year-old piece of legislation and the internet to defend their market share in consumer goods, writes Michelle Perry.

Under EU law, companies that set up operations with a third party in the Channel Islands are permitted to sell goods valued at less than £18 to UK customers without charging VAT. Other retailers to jump on the bandwagon include Amazon, Boots, Woolworths and Dollond & Aitchison who are selling anything from DVDs and CDs to contact lenses at more competitive rates than you’d find on the high street.

The companies don’t have to register with authorities in Jersey (pictured above) or have employees on the island. Instead they can pay a fulfilment company to pack and post the goods, which are normally sent individually in order to avoid VAT. CDs from Jersey retail at half the price of those on the mainland even after postage and packaging costs. Goods must physically come from the Channel Islands and are treated by UK authorities as zero-rated. However items often don’t even reach a warehouse in Guernsey or Jersey and are sent directly off a cargo boat stationed in port, to Great Britain.

From the consumer’s point of view the process is simple to navigate. Clicking on the CDs/DVDs button on Tesco’s home page brings up a link to Tesco Jersey where new releases such as X&Y by Coldplay retail at £7.97 including free delivery. If you click deeper into the website Tesco explains why the CDs are so cheap.

With competition from online music retailers such as CD-WOW, part of the Hong Kong-based Music Trading Online, which sells CDs for £8.99 including p&p, it’s not difficult to see why UK plc is taking advantage.

The practice is totally legitimate but with the government’s current crackdown on tax avoidance and estimated VAT losses reaching tens of millions of pounds annually, the Revenue won’t be looking favourably on those whom it thinks are abusing the law.

If the Treasury decides to take a softer stance it could reduce the price at which VAT is charged to £10 and so cut out the attraction of moving offshore. Alternatively, it might pressurise the European Commission into closing the loophole.

A similar situation occurred recently with magazine distribution from the Aland Islands, off Denmark. In March 2005 the Danish government, however, obtained a derogation from the EC to ban the import of magazines, citing tax losses of €6.2m.

UK authorities might be able to avoid such a step, say tax advisers, because they have managed to persuade Jersey to curb the licences it grants to large UK retailers. But if large UK companies are creating links with established companies in Jersey, it will be difficult to keep track, let alone stop it.

Guernsey where HMV recently established operations, hasn’t made equally placatory sounds. A spokesman for the island’s commerce department said that HMV was an isolated case of a large UK retailer setting up shop, and there was no evidence that UK companies were establishing operations to avoid VAT liabilities.

The Treasury says it is keeping the situation under review and looking at all the options available to halt any abusive practices. The National Audit Office is also carrying out research to find out exactly how e-commerce is affecting tax revenues at home.

For companies there are reputations to consider. “Because of these developments, there’s a number of reasons that would make one consider whether it’s worth setting up offshore,” says John Ward, a partner at Ernst & Young. “If the level of leakage grows, authorities might be driven to do something.” The rise in internet trading since the turn of the century has already prompted changes in EC legislation and more could be on the way.

In 2003 the EC forced non-EU companies trading in the European Union to register for VAT purposes.

Authorities gave businesses – in particular, providers of broadcast or electronic products – two options: they could either register in every state where consumers bought their goods or in just one state. To avoid an administrative nightmare and reduce their VAT liabilities, online providers have tended to opt for the latter, in a low-VAT country such as Luxembourg.

To curb the trend of companies relocating to lower tax jurisdictions, the commission recently proposed to revert to the original tax rules, that a business must be registered for VAT purposes wherever their consumers are.

Lower taxes fuel economic battle
“A big issue for me is tax competition and the way that countries such as Poland, Latvia and Estonia are using tax rates to attract investment,” says PwC partner Mark Schofield. “The UK has advantages in infrastructure, political stability, etc, but as those countries catch up, tax becomes an important issue. It’s important that the government looks at this to make sure the UK remains competitive.”

ECOFIN, the European Council of finance ministers, has adopted a Code of Conduct designed to prevent favourable tax measures available only to nonresidents which unduly affect the location of business activity in the EU. However, there is no problem with favourable tax rates open to all.

Examples of attractive locations include Ireland, which applies a tax rate of just 12.5% for all manufacturing. “This is one reason the Irish economy is booming,” says Schofield.

One country’s actions can also affect another’s. “Poland has a proposal to drop its tax rate, to make itself attractive to investors,” Schofield notes. “Germany then said it was dropping its rate as well, Poland being on its border.”