Understanding the tax implications of inter-company transactions is critically important for businesses. Mike Whitacre interviews Malcolm Joy, Frazier & Deeter’s Global Transfer Pricing Practice Leader, to get a better understanding of one of the most complex aspects of tax planning for multinational businesses.
Learn more about Frazier & Deeter’s Global Transfer Pricing Practice: https://www.frazierdeeter.com/services/tax/transfer-pricing/
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Untangling the Technical: What is Transfer Pricing and Value Chain?
This transcript was assembled by hand and may contain some errors.
It has been edited for readability.
Mike Hello everyone and welcome to Untangling the Technical. Untangling the Technical is Frazier & Deeter’s podcast in which we take a look at complex topics to break them down for business people navigating today’s ever-changing tax and regulatory environment.
I’m Mike Whitacre, one of the leaders of Frazier & Deeter’s International practice, and today we’re excited to have Malcolm Joy here with us. Malcolm is the leader of the firm’s Transfer Pricing Practice, as well as our UK tax practice. Malcolm, welcome to the podcast.
Malcolm Nice to be here.
Mike We invited Malcolm to the podcast to talk about one of the trickiest areas of operating a multi-national business – transfer pricing. Malcolm, could you get us started by giving a quick overview of what transfer pricing is and why it is important?
Malcolm Transfer pricing is the mechanism for allocating profits and losses across different countries within a group. We look at how companies within a group engage with each other when they operate across borders. We look at the different activities that take place, the assets that are used within the business, the nature of the contractual relationships within the group and also with third parties and finally the way risks are shared out within the group. And obviously the allocation of profits which results from this analysis will be of great interest to the tax authorities in each country as they will want to make sure that they are getting an appropriate share of the profits allocated to their country.
It is an important area in tax – it is always coming top of surveys of the most important international tax matters facing businesses. It is a judgmental area – there is no single right answer, and the adoption of a different methodology or even small adjustments in pricing can lead to very significant differences in the amount of profits allocated to a country.
Mike Could you walk us through an example?
Malcolm Sure. I’ll give you an example of a UK based tech start up that is expanding into the US – we’ve been doing a lot of these in the last year since we opened up our office in London. Exactly the same principles apply for US businesses expanding into Europe or elsewhere. What we usually see is a UK business entering the US market is they start off by simply selling to customers in the US. If the UK company doesn’t have a taxable presence there then it doesn’t need to worry about transfer pricing. But as soon as it has created a taxable presence in the US through say a subsidiary or permanent establishment then it needs to start thinking about transfer pricing – even if the operations there are quite small.
We will start by asking them about the business model and then we will get into the detail of what exactly the US subsidiary will be doing – will it be contracting with the US customers or will the UK parent still be contracting with the US customers. Will the US subsidiary just be providing a sales support activity, or will it employ more senior people who will be involved in the strategy, the ownership of key customer relationships or will they even contribute to technical development of the product.
Once we have a thorough understanding of how the business will operate we need to decide on an approach for transfer pricing. For very straightforward sales support activities it may be acceptable to apply a simple cost-plus solution with no benchmarking of the pricing, but that is relatively rare. Usually we will need to look at other ways of approaching the transfer pricing – perhaps through benchmarking the net margin of the US subsidiary and comparing it with other similar groups, or if the US subsidiary is contracting with the customers we may end up paying a royalty from the US to the UK and if we do that we will then need to demonstrate why the royalty rate we have chosen is appropriate. There are a variety of ways we can approach the transfer pricing and a variety of inter-company contractual arrangements we can advise on – but for the smaller businesses that are going international for the first time we try to keep the approach light touch and simple to operate. There is no need at that stage to go overboard on documentation etc. but it is important to get ahead of the curve and make sure you have thought through the approach to transfer pricing before you are on the end of an enquiry.
For larger or more sophisticated businesses what we are often doing is refreshing transfer pricing – looking at whether the existing policy is still appropriate for the business and refreshing the benchmarking – which is really something you should be doing every few years anyway.
The different approaches to transfer pricing can have very different outcomes in terms of profit attribution so one of the things we will be keeping an eye on is whether the end result of the transfer pricing policy is an allocation of profits between the different countries which is broadly in line with where the value is being created. If it looks wrong, then all is not lost – there are a range of things we can do to help bring things back in line. Some of the options that are out there are more complicated, but what we are always trying to achieve is a balance between tax efficiency, alignment with the business, ease of operation and compliance with the tax rules in all the countries where the group operates.
Mike So if you are doing a full scope transfer pricing project what would that look like?
Malcolm A full scope transfer pricing project would really involve 4 separate stages:
Firstly, we would design the policy by gaining a fuller understanding of how the business operates and conducting interviews with a range of key members of staff. This would help us identify where the most significant activities take place, who has beneficial ownership of the main assets (tangible and intangible) used in the trade, which companies in the group are effectively bearing the different business risks.
On the back of the first stage we would have identified the intra-group transactions – provision of services, sales of products, licensing of intangibles within the group etc. that need to be priced. The way we price these things is by accessing databases of externally verified information on similar transactions.
The third stage is to make sure all of these intercompany transactions are set out in appropriate intercompany agreements which are drafted by the lawyers.
The final stage is to produce OECD format transfer pricing documentation which will be expected by many tax authorities around the world. This comprises a master file for the group and local files for each country where the group operates.
For smaller businesses it is not essential to do all four stages – you definitely need to do stage one and get your lawyers to help you with the intercompany agreements in stage 3 (otherwise you don’t have a valid basis for making the intercompany charges). Some kind of benchmarking is usually required in stage 2, but the OECD format documentation in stage 4 is more of a nice to have for a lot of the smaller international groups.
Mike Suppose you have operations underway and you’ve never thought about the tax impact of inter-company transactions. When you start working with a client in that situation, what do you typically find?
Malcolm We see a range of responses when we start talking about transfer pricing. Sometimes we see people using structures that would never result in one of the companies generating a profit – it is essentially just a cost centre. That is never going to be acceptable to a tax authority and would create a lot of problems if left in place for any length of time. Sometimes people tell us they keep transfer pricing very simple and just charge a management fee as a percentage of revenue, but if there is no basis for this charge and there is no justification of the % used, then there is a big risk that it would get challenged. Maybe not in year one, but a challenge in year three could result in several years worth of adjustments with a lot of difficulty in getting a corresponding adjustment on the other side of the transaction.
Sometimes people think they are ok on transfer pricing because they have based their approach for intragroup transactions on an approach and pricing structure they may be using for third party distributors. On the face of it this seems to be ok, but in reality, there are usually many reasons why that approach will not give the best answer to the company. It is also not uncommon for us to be working with a CFO who has been brought in from elsewhere and has been through a transfer pricing enquiry in the past. They then know how painful they can be and are keen to get on top of things. In some countries it is effectively guaranteed that your transfer pricing will be reviewed by the tax authorities as they have a rolling programme of reviews
Mike So if a business is thinking about expanding into a new country, what should they do before they start?
Malcolm You really need to think through your approach to transfer pricing sooner rather than later. The longer you leave it the harder it becomes to change. One of the things that tax authorities like to see is consistency – both consistency in approach between different countries and also consistency in approach from year to year. If you end up having to change your transfer pricing policy because it wasn’t properly thought through from the start then it is likely to draw attention.
Mike You and I have worked together for many years and I know one of your areas of expertise is value chain. Could you explain the concept of value chain analysis for anyone listening who may not be familiar with the concept?
Malcolm Understanding how value is created in a group is an important part of achieving the right transfer pricing outcomes. The traditional and authorised approaches to transfer pricing are largely what I would call bottom up approaches. You identify individual transactions or look at individual companies in the group and price the individual transactions or perhaps you price the net margin of one of the companies. If you stand back and think about what transfer pricing is trying to achieve it is looking at allocating the profits of a group in line with where the value is created in the group. It is not uncommon for this bottom up approach to produce results which do not achieve this alignment. A value chain analysis uses methodologies which are recognised in the transfer pricing guidelines to give a top down perspective. It is not a substitute for a valid transfer pricing methodology, but it can be used very effectively to support a particular approach or to enable a group to change from one methodology to another. They are not for everyone, but in the right circumstances they can be very powerful.
Mike Any international tax professional knows that tax regimes are constantly changing. Are there any recent developments that logically should cause businesses to think about reviewing their transfer pricing?
Malcolm The most major overhaul we have ever seen of the transfer pricing rules has been taking place over the last 5 years. It followed on from the BEPS programme which the OECD undertook on behalf of the G20 – BEPS standing for base erosion and profit shifting. It was really a recognition that the international tax system needed to be updated and transfer pricing was one of the main areas of focus in this initiative. We are still seeing the changes from that programme come through and there is still a lot of lively debate at the OECD and elsewhere on how transfer pricing should be modernised. Many tax authorities around the world have been gearing up with more resources to focus on transfer pricing enquiries as they know there is a lot of tax revenue at stake.
The other thing I would say is that not only are the rules continuing to evolve, but businesses themselves are incredibly dynamic. The majority of business I work with look very different today to how they looked even two or three years ago. A transfer pricing policy will only work if it is aligned to how the business operates. I always say that even once you have a robust policy in place you should at least review it every year to make sure it is still appropriate for the way the business is operating and also in case there have been any significant developments in transfer pricing rules in the countries where you are operating.
Mike Malcolm, thank you so much for being on the podcast today. This is clearly one of the most complex areas of tax planning, and we appreciate you sharing your knowledge. In case we have listeners who want to reach out to you directly, I will mention that Malcolm’s email is great, so you email address is Malcolm.firstname.lastname@example.org and they can also find usual contact details at either www.frazierdeeter.com and www.frazierdeeter.co.uk
Malcolm That’s right. Thank you for having me on the podcast.
Mike Thank you listeners for joining us for this edition of Untangling the Technical.