Risk & Economy » Tax » 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

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

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

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

“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

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

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

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

“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

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

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

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

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