A framework for transfer pricing operations and compliance

A guide for in-house tax professionals

Sowmya Varadharajan

A framework for transfer pricing operations and compliance

Originally published in the November/December issue of Tax Executive Magazine. https://taxexecutive.org/transfer-pricing-operations-and-compliance-for-in-house-tax-professionals/

Transfer pricing has never been more important for in-house tax professionals to address, from compliance and analysis to overall tax planning. However, transfer pricing rules change rapidly and globally, largely as a result of the work of the Organisation for Economic Co-operation and Development (OECD) on the base erosion and profit shifting (BEPS) framework. The OECD’s work continues in 2023, with changes expected for Pillar One and Pillar Two, which are likely to further impact transfer pricing.

In general, the attention-grabbing headlines for transfer pricing mostly have revolved around large, well-known, name-brand organizations. However, in-house tax professionals cannot assume that smaller organizations will not be audited or targeted by tax authorities in the United States or in foreign jurisdictions. To contain costs, these small taxpayers typically settle cases rather than litigate them. As a result, selection bias exists in the reporting. Furthermore, although a taxpayer might be considered a small or medium-sized enterprise for US tax purposes, it might be a significant taxpayer in its local market, which could make it a target for scrutiny by a foreign tax authority.

In-house tax professionals must structure their transfer pricing function to get it right to prepare their organizations should they be selected for audit.

This article focuses on the operational and compliance elements of transfer pricing and provides practical guidance for developing a well-grounded transfer pricing strategy.

The transfer pricing life cycle contains five steps: implementation and booking; monitoring; evaluation and documentation; defending and resolving; and understanding and planning.

Transfer pricing design: Input from the business

It is critical for in-house tax professionals to have a pulse on the business. The best way to stay connected is to ensure that the tax team is plugged into the business operations and that the business understands the associated tax and transfer pricing risks. Most commercial and business folks see transfer pricing as a left-pocket/right-pocket transaction between two sister companies, the head office and a branch, or a parent and a subsidiary. The business typically does not understand the essential concept of a separate taxable presence. Thus, even before in-house tax professionals can navigate the operational transfer pricing framework, they should get the necessary buy-in and commitment from the business.

Later in this article we include two case studies presenting transfer pricing issues that are instructive for all in-house professionals. (See sidebar.)

Once in-house tax professionals identify key intercompany transaction flows, they must understand what steps are needed from a transfer pricing perspective. The key questions are:

Is this a significant intercompany transaction? What are the thresholds of materiality? Is this a one-off or a recurring transaction?
In general, an objective definition of what is material does not exist. Thus, a tax team must define the parameters of materiality. In general, a company’s ability to support approximately seventy-five to eighty percent of its intercompany transactions likely will be sufficient. Tax teams also are time-constrained, and it might be difficult to support each transaction. While aspiring to create a perfect transfer pricing matrix is admirable, being able to support the key intercompany transactions might be enough to create the first line of defense.
Are there additional tax issues to consider?
Transfer pricing is just one piece of the puzzle. Any intercompany transaction might have other direct or indirect tax effects as well. Direct tax issues are usually within the purview of most in-house tax professionals, but those same professionals sometimes ignore the indirect tax issues, which can be substantial.
What is the extent of documentation for transfer pricing transactions? 
While transfer pricing documentation takes a particular form, it is necessary to have a minimum level of documentation for all related-party transactions. Invoices, sales orders, and purchase orders might already exist, but tax authorities increasingly are keen to obtain copies of intercompany agreements and transfer pricing policy documents to outline how intercompany transaction flows should be structured and what processes should be followed.

From a design perspective, in-house tax professionals generally need to understand the transaction flow. When they do, they can make informed decisions on if and how to handle issues.

Transfer pricing documentation compliance

Once the intercompany transactions (along with their values, volumes, and transacting parties) have been identified, the next step is transfer pricing documentation, as required from a statutory perspective. The OECD’s BEPS framework introduced three-tier transfer pricing documentation. The three tiers are: 1) the master file, 2) the local file, and 3) the country-by-country report (CbCR).¹

Related-party transaction forms collect myriad pieces of information. When determining what transfer pricing documentation should be prepared, in-house tax professionals critically must understand the peculiarities of each jurisdiction in which the group operates to know what thresholds warrant preparing transfer pricing documentation as well as what constitutes “documentation.” In some jurisdictions, taxpayers might be required to prepare and provide only the local file. In other jurisdictions, transfer pricing documentation requires taxpayers to prepare both the master file and the local file.

Thresholds for preparing transfer pricing documentation can vary from none at all to revenue- or transaction-based thresholds. Despite the possible existence of these thresholds, however, tax authorities are well within their right to request support on all related-party transactions, particularly since transfer pricing can be broadly subjective and more of an art than a science.

In some cases, taxpayers might feel compelled to prepare transfer pricing documentation even though they might not be required to do so. However, if a transaction is relatively unique or if significant industry or commercial factors might have affected the related-party transaction, preparing transfer pricing documentation is a proactive way to explain the transaction to tax authorities.

The CbCR and master file are prepared at the group or parent level, whereas the local file is prepared at the individual-entity level. Thus, although a local entity might not be obligated to prepare the CbCR or master file, it is likely to be involved in providing critical economic and business data. In addition, most jurisdictions require notifications related to CbCR filings, with the potential for substantial penalties if such notifications are not done on time. For example, in some jurisdictions, the taxpayer might have to file a notification to inform the tax authority that no CbCR submission is required.

For local files, the key issue is to determine how related-party transactions will be evaluated. Should an aggregate approach be adopted where all related-party transactions are collectively tested? Or should each transaction be tested on a stand-alone basis? Although the stand-alone approach is technically correct, data limitations might exist, making it impossible to evaluate transactions individually. Furthermore, do the stand-alone results even provide the “right” answer?

Although taxpayers should put their best foot forward in preparing their transfer pricing documentation, they also should undertake a cost-benefit analysis that considers the following:

Centralized documentation preparation approach versus decentralized approach. Global transfer pricing rules and regulations are structured broadly, based on the OECD transfer pricing guidelines. For that reason, approximately eighty percent consistency in transfer pricing approaches exists across the various jurisdictions, with twenty percent variability for local flavor. Thus, a centralized approach might work well for transfer pricing documentation. However, incorporating the local flavor is necessary, since local facts, the local regulatory environment, and local industry can affect transfer pricing analysis significantly.
Use of local versus regional comparables for benchmarking. Tax authorities generally prefer local comparables, which are likely to account for local peculiarities. For example, during the COVID-19 pandemic, different jurisdictions provided tax relief and other assistance to companies. The way financial statements reflect such assistance differs across countries and, therefore, might skew results if a regional approach is taken. However, given the global environment in which businesses operate, it is unlikely that local benchmarks would lead to substantially different results than a regional benchmark would.
Financial data analysis. In undertaking financial analysis, the differences between US generally accepted accounting principles (GAAP) and relevant local GAAP requirements are a key consideration. Some countries have specific regulations or guidance that dictate acceptable transfer pricing methods, documentation requirements, and penalties for noncompliance with local GAAP. Such guidance might impact the financial reporting of a multinational entity depending on country-specific regulations. Furthermore, transfer pricing adjustments made for tax purposes to comply with local regulations might not always be allowed or recognized for financial reporting under US GAAP. These adjustments might have implications for financial statement users and might require additional disclosures. Transfer pricing design might focus on US GAAP concepts, whereas local documentation is prepared using local GAAP numbers, which can cause the transfer pricing model, process, and monitoring to conflict.

A risk matrix that identifies the key countries in which a company operates along with the intercompany transactions (values and transacting parties) is essential for evaluating overall transfer pricing documentation and compliance risk.

Which is riskier from a transfer pricing compliance perspective: a cost-plus-fifteen-percent business process outsourcing center in Malaysia (with an intercompany service fee of $6 million) or an intellectual property and cost-sharing arrangement (valued at approximately $50 million) involving the United Kingdom? Transfer pricing documentation is required for UK taxpayers only if the group revenue is greater than €750 million. On the other hand, transfer pricing documentation is required in Malaysia if revenues exceed $5 million. Thus, from a pure compliance perspective, in this example the Malaysian documentation should be prepared, but it might be more important from a risk perspective to prepare the UK documentation.

Finally, the information disclosed on related-party transaction forms varies by jurisdiction. Some forms might simply ask whether transfer pricing documentation has been prepared. Other forms ask for a summary of key related-party transaction information. Still others request confirmation on transfer pricing methodology and the existence of transfer pricing documentation. The information provided on tax forms must be accurate and true.

Tax professionals need to be prepared for what is required from a transfer pricing perspective. Tax teams are getting increasingly smaller, and organizations expect their tax teams to do more with fewer resources. Some billion-dollar companies might have a team of only four or five people to handle all their global tax matters. It is therefore necessary for organizations to approach their transfer pricing function by adopting a two-pronged strategy: rely on external advisors when appropriate and adopt the right technology to drive automation and efficiency.

The role of transfer pricing consultants

Preparing transfer pricing documentation is part of routine compliance. Most tax analysts do not dream of spending their days preparing transfer pricing documentation across multiple entities, which can be repetitive and does not add value. Transfer pricing consultants have the knowledge and experience to assemble these reports seamlessly. However, transfer pricing documentation is only as good as the information provided and therefore it is critical for tax teams to prepare the required information at the right level of detail for these advisors.

A company’s first year working with advisors is likely to involve considerable heavy lifting — a lot of details need to be shared, and advisors might ask questions to familiarize themselves with operations. Do not attempt to fix every issue that first year — instead, adopt the 80-20 rule and aim to identify key issues. The transfer pricing analysis can be progressively upgraded over the years.

In addition, all transfer pricing analysis should be prepared collaboratively. Relying solely on external advisors can be expensive. In some cases, having an external transfer pricing consultant prepare the transfer pricing report might enhance the quality of documentation and provide a level of credibility. However, if the transfer pricing analysis is relatively simple, it might be possible to collaborate with external consultants in the following ways:

co-source documentation opportunities when internal staff determines certain functions are more of a value-add (such as functional analysis development);
have transfer pricing consultants review in-house transfer pricing documentation and analysis. External advisors typically have seen similar issues with other clients and could provide additional insights into particular transactions. In addition, transfer pricing consultants will use their experience working with tax authorities to review any transfer pricing analysis with due consideration. The expertise of external advisors generally will improve the quality of the analysis;
prepare the appropriate benchmarking analysis. Benchmarking analyses are critical, since third-party references demonstrate consistency with arm’s-length standards. Even if internal references are available, it would be effort well spent for the third-party advisor to review and document the internal transactions in line with transfer pricing principles. In general, benchmarking analyses should be outsourced to third-party transfer pricing advisors, since databases are quite expensive and unaffordable for some companies, especially given the number of transactions and jurisdictions in which some companies are involved. Furthermore, third-party transfer pricing advisors stay current on recent developments and benchmarking processes to ensure that the benchmarking strategy will be acceptable to tax authorities; and
meet regularly with third-party advisors to stay on the same page about the environment and how to best respond to challenges. With the volume of changes taking place in the global transfer pricing landscape, companies are wise to stay updated on all transfer pricing developments. Hold monthly or quarterly planning workshops so third-party transfer pricing advisors can provide timely advice on managing any transfer pricing risks. This is time well spent, since addressing issues sooner rather than later will identify what needs to be done.

Technology

Technology is constantly evolving, yet many in-house tax professionals still rely on outdated spreadsheet software to model transfer pricing outcomes. Working with models built in this dated way can be tedious and manual and can result in significant errors and additional time needed to resolve any issues. Technology should be central to managing, reviewing, and storing transfer pricing analyses and documentation reports. Technology solutions are needed for:

monitoring transfer prices and profitability outcomes for consistency of transfer pricing policies and demonstrating control over processes and their maintenance;
being a repository of transfer pricing information, including intercompany agreements, financial information, transfer pricing policy documents, and transfer pricing reports; and
easier planning, because data is centrally located and dashboards can provide functional, jurisdictional, and regional awareness about profitability. Furthermore, levers can be built into a dashboard to allow in-house tax professionals to create scenarios to meet the needs of the tax function.

Several technology solutions are available, and tax professionals should evaluate whether they should rely on an off-the-shelf solution and pay annual licensing fees for access to a third-party solution or go one step further to develop an in-house solution. Third-party off-the-shelf solutions can be deployed quickly, since most issues already have been ironed out. Many third-party solutions also provide troubleshooting support. These off-the-shelf solutions might not be customizable, however, and might not meet an organization’s unique needs. In-house solutions, on the other hand, might better address a company’s particular needs but likely will take more time and cost to develop and implement. Both types of solutions have pros and cons, so companies should determine what makes sense for them.

Conclusion

A well-designed transfer pricing framework should strike a balance between aligning with business objectives, complying with regulations, ensuring fairness, and providing the necessary documentation and transparency. Regular reviews and updates are essential to preserve the framework’s relevance and effectiveness over time.

Tax departments need to develop the overall framework, but relying on outside consultants and technology solutions and automation can drive efficiencies in the process and framework.

Sidebar: Two case studies

Case study 1

A US parent company (PCo) sets up a subsidiary, Force, in a foreign jurisdiction. Employees from PCo are sent to start on-the-ground activities at Force (such as hiring the right team, identifying new clients, and pursuing market-related opportunities). The PCo employees want to continue to be remunerated by PCo. However, to measure the profitability of Force accurately and to recognize some local employment benefits in the foreign jurisdiction, these employees also receive salary locally, in local currency. The local currency decision was made by the operations team. However, this decision created a tax and transfer pricing problem when the tax team charged the costs related to the employees from PCo to Force as a management fee. Having an appropriate tax and transfer pricing structure in place could have met the business objectives while also mitigating tax risks.

Case study 2

The sales team at Tyco transacts throughout the year with the operations team at Scow, a related party in another jurisdiction, with Tyco selling a product at a significantly reduced price to Scow in order to support a joint business opportunity. However, when the group’s tax team reviews this transaction, it is evident that the related-party transaction (between Tyco and Scow) was not in line with arm’s-length principles. Had the sales team at Tyco and the operations team at Scow consulted the group’s tax team at the start of the year, they could have known what parameters to follow to ensure that the transactions complied with the applicable rules and standards.

¹The CbCR applies only to groups that record revenues in excess of €750 million.