As corporation tax is levied on individual companies rather than multinational groups as a whole, compliance and planning has historically been tackled on a country by country basis. There are some circumstances when it may be necessary to consider wider international issues affecting a particular country, such as the impact of controlled foreign companies legislation, but it is rarely necessary to consider the group, or sub-groups as a whole.
There is, however, one area of tax where this is untrue – transfer pricing.
This is simply the pricing of flows of goods and services between companies within a multinational group. This is an issue which is growing in importance as more tax authorities view it as a good way to raise revenues or as an area where revenues are under threat from other countries. Furthermore, the OECD has recognised it as an area which gives rise to a significant risk of double taxation. The only thing worse than paying tax on income which does not exist is paying it twice on income which does. Transfer pricing, as a weapon in the hands of a tax authority, can give rise to both.
Currently, transfer pricing is perhaps the one area of tax which is consistently providing the world’s tax authorities with the largest adjustments to the tax returns of multinational taxpayers. Large adjustments are known to have been fought and made in the US, Canada, Australia, Japan, the UK and Germany to name but a few. Countries which have recently introduced legislation to give their tax authorities greater power to attack transfer pricing include France, Spain, Italy, Mexico, Brazil, Korea and New Zealand.
Given that these are also some of the world’s largest economies, the significance of transfer pricing as an issue should not be underestimated.
Another important issue is the length of time transfer pricing challenges can take – the timeframe is often measured in years – as well as the amount of work and sheer cost involved in defending them.
The difficulty is that transfer pricing is an area which usually gives a tax authority a fairly liberal right to enquire into group matters beyond the knowledge of the local company and to ask some of the most difficult questions. These are not just how much, where and when but open-ended ones such as why, who else and compared with what?
Almost every multinational has had some part of its international transactions challenged at one time or another. Those parts which are most frequently attacked are the most visible: intercompany charges such as royalties and service fees. Consequently, these are the areas to which a group tax department will often pay particular attention and over which it is likely to have the most control.
The next most frequently attacked are sales of goods, including finished goods, semi-finished goods and components. This is a key area because the volumes of such sales are usually far greater than those for service fees and small percentage adjustments can give rise to huge swings in local taxable profit. Nevertheless, this is often one of the most difficult areas for a group tax department because a change in the intercompany pricing of goods is the one most likely to interfere with commercial interests such as performance measurement or bonuses. In addition, the sort of information which often forms an important part of a defence is that which the tax department is least likely to have: for example, data on product-line profitability, technical specification, cost of manufacture, prices for comparable goods and market data on individual competitors.
The next most likely area for attack is that relating to technology and intellectual property and, in particular, how related costs are borne around the group. This, too, is an area which can lead to large adjustments and it is intrinsically difficult because it is often governed by history.
Broadly speaking, intellectual property rests where the costs were borne and, once borne, it is difficult to make a change without triggering transfer pricing questions relating to the transfer of that property whether by sale or licence.
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An attack, when it comes, will be made by one tax authority against a company (or companies) in a particular country – unless the Scandinavian authorities launch one of their famed multi-country audits. Consequently it is easy to regard such an attack as a local compliance issue. This ignores a number of broader issues each of which can prove to be expensive.
First, there is the fact that a settlement, once reached, will usually have a knock-on effect for the future and, in an age of increasing co-operation and exchange of information between tax authorities, may affect more countries than just the ones on either end of the transaction in question.
Second, there is the difficulty inherent in effecting a corresponding adjustment on the other side of the transaction. Failing in this will give rise to double taxation, but no country regards itself as obliged to give one. No treaty makes agreement between the two tax authorities obligatory and more fundamental problems such as time limits can get in the way.
Third, a transfer pricing policy often stands or falls by the coherence and consistency of the arguments used to defend it. Leaving matters to the local country concerned means a defence, unless well planned, may lack the necessary support and assistance from the centre and may fail to capitalise on information already found and used in other countries which may have seen the same problem.
What these factors mean is that a fairly firm grip needs to be taken by a group tax department on the transfer pricing exposures which may exist and this may require a closer working relationship with the operational parts of the group than is sometimes the case.
The group will need a good practical approach on how those exposures are to be met or mitigated, on managing time limits (which often means identifying potential bilateral questions early in the tax audit process) and on how to marshall a consistent defence (which includes knowing where to find the relevant internal and external evidence to support it).
Where this is done, the compliance costs of meeting transfer pricing attacks in individual countries will often be reduced and, where evidence and documentation for a defence has been prepared in advance, the tax audit process may be much easier and shorter than would otherwise be the case.