Global Transfer Pricing Controversies Post OECD Revisions

In an already complex and uncertain environment for transfer pricing compliance, the advent of country-by-country reporting (“CbCR”), new documentation standards and clarifications what represents “arm’s length” behavior will create significant further challenges to existing models. This underscores the need for a sound risk management and compliance strategy still further. Taking into account resource constraints (for both taxpayers and tax authorities) and the divergence in interpretation in the tax authorities across Asia’s diverse (non-OECD) nations, the authors guide you through the key trends and suggest best practice in navigating the difficult times ahead.

I. Globalization and the Perception of Tax Base Erosion

The past few decades have witnessed rapid economic development and globalization arising from the third industrial revolution, technological improvements and enhanced infrastructure. Multinational corporations (“MNCs”) have taken advantages of these forces, engaging in significant outbound foreign direct investment (“FDI”), often to access less costly resources and/or gain presence and traction in potentially lucrative new markets.

The resulting globalization of value/supply chains means that a significantly greater proportion of global trade flows are “within” rather than “between” corporate groups. Tax authorities in developed countries (in particular) or with higher headline corporate tax rates increasingly suspect potential erosion of their taxable base due to, amongst other factors, transfer pricing policies established by taxpayers for intra-group trade that do not comply with the established “arm’s length” standard. Transfer pricing is a key target for tax authorities given the increasing value and importance of intra-group transactions to the tax base as a whole, and given that transfer pricing entails living with greater subjectivity as compared to many other areas of tax. This has increased the focus on tax authorities and hence many global tax policy-setting institutions have been debating this issue.

In parallel, APAC countries, most of which are developing economies, have established specific policies to attract inbound FDI as an impetus to economic growth, creating employment with better quality jobs and expanding the skill base. One key ingredient of this policy mix entails attracting MNCs to a jurisdiction by establishing tax incentives such as preferential tax rates or super-deductions in identified sectors. This is particularly the case with countries which are manufacturing or sourcing hubs, such as Thailand, Malaysia, China, India, the Philippines and other countries. By contrast, some APAC jurisdictions that are more developed and have more advanced infrastructure, such as Singapore, also offer low headline tax rates and a number of tax incentives aimed at attracting MNCs, but which are applicable more typically in return for the establishment “Principal”/“Control Tower” type operations within the jurisdiction. In particular, MNCs with regional operations often establish operating and transfer pricing models, whereby a regionalized and centralized APAC Principal/hub acts to undertake key value-added control functions over various regional operating companies (such as manufacturers and distributors).

The existence of such tax incentives and low headline corporate tax rates placed even further scrutiny on the transfer pricing policies of MNCs, as high-tax countries feel that the existence of tax incentives provides more impetus to shift taxable profits.

II. Tax Policy Trends to Counter Tax Base Erosion and Double Taxation Risks

These trends underscore the need for coordinated tax/transfer pricing policy and implementation of such policies across various tax authorities, so that MNCs both take their fair share of the fiscal burden but on the other hand are not unreasonably exposed to double taxation risks or overly aggressive audit behavior.

Double taxation through transfer pricing may, in particular, result from (but is not limited to) tax authorities disagreeing on the interpretation of the arm’s length standard or by having different rules and standards to adhere to, and where dispute resolution mechanisms such as the Mutual Agreement Procedure (“MAP”) are ineffective. To this end, institutions like the OECD and UN have created transfer pricing guidance for tax authorities to use when conducting transfer pricing reviews as well as updating this guidance and the guidance on dispute resolution best practices under the BEPS project. However, from an APAC perspective few countries are OECD members, and whilst such countries may nominally follow the OECD Guidance, they are not compelled to do so. In fact, whilst the resulting promulgation of transfer pricing laws and guidance (e.g. Greater China, India, Japan, South Korea, Singapore, Malaysia, Indonesia, the Philippines, and others (in fact, most major jurisdictions) have transfer pricing guidelines) in APAC are most commonly based in whole or in part on OECD standards (OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations), at best interpretation differs between jurisdictions and in some cases local guidance and law diverges from the OECD standards entirely (e.g. China and India, in their transfer pricing guidelines, through their chapter in the UN Transfer Pricing manual, and through audit practice, typically diverge from OECD Countries in the attribution of location-specific advantages to entities resident in their market (for example, either applying a “market premium” or a “location saving,” depending on the operations and context).

Given that the existing (and other) OECD standards have in turn been updated through the BEPS project, the aspiration was that transfer pricing controversies would be more manageable under an appropriate multilateral framework of guidance and dispute resolution procedures. It is, however, unlikely that the updated guidance and standards will be effective in reducing the incidence of disputes, though it may result in them being more targeted for certain circumstances. Whilst the intended effect of the changes were principally to clarify how the arm’s length standard should be interpreted and how compliance should be determined, the updated guidance has in fact resulted in greater complexity and even further divergence in interpretation (in cases).

Action 13 recommendations on CbCR have been interpreted that they will provide greater transparency on how the globalization of value/supply chains and resulting transfer pricing policies affect the allocation of profits and tax payments within MNC groups. Tax authorities have enthusiastically adopted the OECD recommendations in this area and are expected to use it in their tax risk assessments and in determining what and how to audit (a general fear exists within the taxpayers that data from CbCR may be used beyond for risk assessments and increase the use of the profit split method).

III. Sources of Transfer Pricing Controversy

A. Review Processes

In our experience, tax authorities in APAC review the arm’s length nature of the transfer pricing policies set by taxpayers resident in their jurisdiction through several means.

The primary review process is the annual review of the corporate income tax return. Together with the tax return, in some countries transfer pricing documentation is also required to be submitted. In addition, many countries require specific disclosures relating to related party transactions. These often include details on intra-group transactions, the transfer pricing methods employed in those transactions, salient details of the counterparties and clarification if documentation to support the prices has been prepared (where it need not be submitted with the tax return). The tax officer first examining the return will most likely not be a transfer pricing specialist, but we increasingly see transfer pricing specialists review returns and any supporting transfer pricing documentation where there are material transactions between related parties and in many other circumstances where audits are likely. Further, there are increasingly targeted tax/transfer pricing audits conducted through separate programmes, aimed to apply particular scrutiny to the transfer pricing policies of taxpayers.

On review of the relevant information in the return, or obtained via other means, tax authorities will generally subject taxpayers to further scrutiny based on indicators of base erosion risk or by specific disclosures in the return. This is generally the case whether the review starts with a tax return review or a separate audit process.

Auditors tend to have discretion as to the conduct of an audit but it highly likely that both the triggers of an audit and the conduct of the audit process has (non-published) guidance to help direct the activities of the auditors. Audit conclusions are also subject to an internal review process within tax authorities, where the conclusions of the auditor may be modified at a later stage.

B. Detailed Risk Factors for Audits

Examples where the risk factors may be high (and therefore audits more likely) include when:

•  (a)  transactions with cross-border related parties that are of a significant value;
•  (b)  transactions are made with related parties subject to a more favorable tax treatment or with certain jurisdictions that may be perceived to be lacking in substance;
•  (c)  there are recurring losses or large swings in operating results which may be unusual given the functions and assets of the taxpayer and the risks it assumed;
•  (d)  the operating results are not in line with businesses in comparable circumstances, given the expectation or understanding of the local tax authority;
•  (e)  there is the use of intellectual property, proprietary knowledge or other intangibles in the business that results in significant outbound royalties being paid;
•  (f)  there are transactions involving R&D or marketing activities which could lead to development or enhancement of intangibles;
•  (g)  that there are payments or receipts in transactions such as related party financing or management fees; and/or
•  (h)  there are indications (examples, through engagement with tax authorities, country’s audit focus, etc.) that the transactions are likely to be subject to transfer pricing audit by counterparty tax authorities.

Further, we increasingly see audits arising based on tax authorities targeting specific operating models, particularly those resulting with a large proportion of profits residing in centralized entities in tax-advantaged jurisdictions, with countries with significant market or operations earning only routine profits. One particular example we often see is when there the operating model is based on having an intra-group sales and marketing support entity in market countries, but with sales being made from an overseas entrepreneurial entity (e.g. certain regional or global trading companies). Tax authorities in the market countries seek to scrutinize the activities of such entities, to ascertain if the local enterprise in fact undertakes a material role in making sales and the contracts for which are not materially modified by the actual seller. Such cases will likely result in a permanent establishment (“PE”) of the overseas entrepreneurial being asserted and further profits being attributed to that PE. This may be supported under the new PE Guidance under BEPS Action 7, but further profits may also be attempted to be attributed through transfer pricing adjustments, using the principles outlined in the updated OECD Guidelines.

We have seen extensive, protracted controversy in this area, which has resulted in many clients restructuring their sales model to further support the nexus of the value generating sales activity with the customer transactions, thereby creating a “reseller” model, i.e. a local distributor in market that makes sales. This example highlights the fact that both transfer pricing and PE issues interact.

In parallel, a common risk factor for audit is whether or not a restructuring has taken place, which in may result in large swings of profitability of the local entity and/or, depending on the nature and extent of the restructuring, if any change in substance has actually taken place. Tax authorities in APAC largely view this issue as one of justifying the “to-be” model relative to the “as-is” model from a transfer pricing and PE perspective, with controversy arising principally through disregarding the transfer pricing model applicable to the conversion by denying that any substantive conversion has in fact taken place. Some tax authorities also seek to levy exit charges, although there are jurisdictions (such as Singapore and Malaysia) that do not tax capital gains, and therefore do not commonly apply this approach.

C. The Most Common Local Country Assertions by Tax Authorities

While there are similar issues surfacing in many of the countries in the region, the process and interpretation may vary.

Tax authorities in countries with large markets often target the choice of transfer pricing method, which in turn depends on the characterization of the counterparty entities. This is particularly common where the local entity is remunerated on a “limited risk” and/or using the transactional net margin method (“TNMM”). The basis for auditing such a choice of method commonly focuses on the functional and risk analysis applicable to the transactions, with the assumption that the local entity is routine being disregarded on the basis that the local entity performs value-adding functions and helps generate valuable intangible assets for the group through its activities. This logic more commonly leads to the assertion that a profit split method may be more reasonable than the TNMM, or, after negotiation, that a higher remuneration under the TNMM should be applied to the local entity. In this regard, the choice and comparability of comparable companies to use in a benchmark and the application of the transfer pricing policy itself is also called into question.

In countries throughout APAC, we frequently see challenges on selection of comparables. Many countries, such as Japan, Malaysia, Korea, Thailand, India and others have strict geographic comparability criteria and in many cases reject regional benchmarking search during transfer pricing audits. This often leads to an attempt to use “secret comparables” by the tax authority, relying on information obtained from their own databases and selecting a set of comparables they feel are better suited to their local market, and that support their assertions that more profits should be earned in the local entity. Issues around location savings / location specific advantages are also been frequently discussed during audits.

IV. Anticipated Effect of Increased Transparency on Transfer Pricing Controversy

As noted, many OECD and non-OECD countries in APAC have attempted to remedy a perceived lack of transparency in how entities report results and pay tax by requiring more extensive transfer pricing documentation, including CbCR, and sharing the information with other tax authorities. Under the CbCR requirements adopted by many countries, MNCs are required to report detailed financial information and information on their activities annually in each tax jurisdiction in which they do business. The implications of this includes greater and, in particular, more targeted scrutiny from tax authorities. MNCs must therefore evaluate themselves from a tax authority’s perspective—wherever they operate—and identify areas that are more likely to be challenged.

In the event of a challenge, defending through domestic appeals or alternative dispute resolution mechanisms is a costly and time-consuming affair. Preparing for greater transparency and audits from tax and customs authorities will therefore be required of MNCs. The confidentiality of information disclosed by the taxpayers is a key concern. Greater transparency may also result in customs authorities looking at valuation of goods for imports and exports. Due to the information sharing mechanisms established through the BEPS project, MNCs are carefully evaluating how to establish their transfer pricing policies and pro-actively manage controversies, by using mechanisms such as Advance Pricing Agreements (“APA”).

V. Best Practices in Avoiding Transfer Pricing Controversy and Managing it When it Happens

Given the drive for greater transparency due to the OECD’s BEPS Action Items, it is important for MNCs to develop a comprehensive strategy to pre-empt and manage transfer pricing controversy. This is best done by establishing and following effective, sustainable transfer pricing policies and documenting effectively.

In our experience, the following represents a sample of best practice.

A. Prepare Transfer Pricing Documentation Contemporaneously

Many regional tax authorities expect MNCs to prepare contemporaneous transfer pricing documentation. This approach is recommended as it mitigates the risk of documentation being rejected on the basis of being untimely and unrepresentative of how the MNC in question determine its transfer prices prior to or at the time of the relevant transactions. It is also likely to improve the MNC’s stance with the authorities, and lead to a quicker and more positive resolution of any dispute. Conversely, if documentation is not contemporaneously prepared, then any audit will be harder to manage and there will be less evidence available to support your position.

MNCs should typically establish a more formal drafting a review process for their documentation cycle. This would start with a review of intra-group transactions to determine the nature of the transactions between other members of your group. Then, MNCs should determine if documentation is needed; for example, materiality/thresholds may be an issue, or exemptions may apply. Generally, if resources are finite, taxpayers concentrate their resources on a review of transactions that are higher in volume or complexity. In all cases, it is recommended to perform a transfer pricing analysis to determine whether the arm’s length standard is met. In this regard it is better to undertake transfer pricing planning in advance, to set a price, so that the documentation that tests the price can be put on surer footing. Finally, the analysis would be converted into full documentation at a group or entity level. It is worth considering the requisite extent of detail with a risk-based approach.

B. Ensure your Documentation is Complete as far as Possible and includes Supporting Information

Note also that documentation does not simply mean the transfer pricing analysis, but includes a whole range of supporting information such as legal agreements, invoices and any other background evidence or data that supports the arm’s length nature of the prices set. Most tax authorities require significant information to support the position taken by any given taxpayer in its transfer pricing documentation. It is important to note that the transfer pricing documentation only caps the supporting elements and tax authorities increasingly seek detailed evidence to back up the facts related in the documentation report.

For this reason it is important to conduct an ongoing risk, systems and controls review to ensure that documentation supports the structure and pricing of intercompany transactions. It is also vital that the requisite legal agreements are in place. Furthermore, documentation should be frequently revised every three years, or after major business changes.

C. Ensure your Documentation is Robust

It is important to ensure that the transfer pricing analysis and resulting documentation prepared and potentially submitted to the tax authorities is robust, and provides the authorities as little room as possible to challenge existing policies. The following questions are useful in assessing the robustness of existing documentation:

• Is the transfer pricing analysis and documentation consistent across the MNC group? For example, increased transparency may show large divergences in returns across similar entities performing similar functions, in different countries. Tax authorities that earn the lower profits will want to know why, and so documentation should either attempt to defend this or alternatively the return profiles may be made more consistent across the group. We see taxpayers taking both routes.
• Does the documentation focus sufficiently on local issues? For example, the functional analysis should be based on the activities of both counterparties to the transaction(s) and rely on local information, rather than generic information prepared centrally. Also, local TP requirements do differ and it is important to know how when preparing your documentation, to best defend your position.
• Have records to support the documentation been appropriately kept?
• Have audits happened in other locations where the MNC has substantial operations? If so, then in our experience it is more likely that they will happen elsewhere. This is particularly common for centralized operating models and IP-rich companies, where large elements of residual profits are centralized and earned outside of large market countries.
• Does the documentation accurately reflect the MNC’s circumstances, or have circumstances changed since the documentation was prepared? If regular reviews are not properly instated, then it is possible that the facts may change without the knowledge of the person preparing the documentation. This may lead to difficulties in resolving the audit.

D. Make Advance Preparations for CbCR

As indicated above, CbCR is intended to enable tax administrations to obtain a global picture of where MNC’s profits, economic activities and taxes are reported. A number of APAC countries have made clear either the effective dates of, or their intention to introduce, CbCR along with the associated master file and local file requirements. CbCR documentation must be prepared and submitted less than 12 months after the financial year end.

It is important that preparation for CbCR begins now. Adopt an integrated approach that considers the main technical and governance aspects of CbCR. This may include the following steps:

• Develop a sound understanding of the regulatory requirements. The OECD CbCR template generally requires the disclosure of the following information: revenues (both from related and unrelated party transactions); profits before tax; income tax paid on a cash basis; current year income tax accrual; stated capital; accumulated earnings; number of employees; and tangible assets (excluding cash and equivalents).
• Address existing systems issues and confirm reporting readiness: this entails undertaking a systems readiness assessment, and ensuring that all the relevant data is accessible. Where there are gaps in CbCR data, design an approach to help gather the additional information required. It may be worth employing technology such as workflow tracking and data automation software, depending on the size and scale of your company’s operations and reporting requirements. It is also worth considering how sensitive data will be stored and reported.
• Review the risks, gaps and strategy in relation to audits: this entails developing a detailed understanding of how tax authorities may perceive the information exchanged in the CbCR and where audit activity may arise. The objective of this would be to be able to establish as sound a defence strategy as possible, considering all available routes, and, if necessary, take remedial actions to address any material risks.

E. Pursue APAs where Feasible

An APA is a contract between a taxpayer and at least one tax authority specifying the pricing method that the taxpayer will apply to its intercompany transactions. APAs can last up to multiple years (both for future and past years), depending on the country granting the APA. By providing up-front certainty as to the transfer pricing method to adopt, APAs mitigate the possibility of disputes with tax authorities and reduce the incidence of double taxation.

We recommend that MNCs consider applying for an APA if they feel their risk of being audited is particularly high, or if there is a high chance that the tax authority may implement an adjustment in the event of an audit. However, it is worth bearing in mind that APAs require significant investments of time and effort, with no actual guarantee of success. There are options to look at bilateral/multilateral or unilateral APAs.

F. Consider all Available Dispute Resolution Mechanisms in Advance and Develop a Strategy Based on your Level of Risk

When a dispute arises, the most effective dispute resolution mechanism should be chosen based on local market characteristics and the issue at stake. In many countries, litigation is on the rise, as commonly MAP is seen as relatively ineffective given that mandatory binding arbitration and strict timelines to resolve disputes are not typically provided for in regional tax treaties.

VI. Conclusion

As the BEPS project has become a reality, the impact on transfer pricing controversies from the revised transfer pricing guidance is beginning to be felt. In an already complex and uncertain environment for transfer pricing compliance, the advent of CbCR, new documentation standards and clarifications what represents “arm’s length” behavior are creating significant further challenges to existing models. This underscores the need for a sound risk management and compliance strategy still further. Taking into account resource constraints (at both the taxpayer and tax authority level) and the divergence in interpretation in the tax authorities across Asia’s diverse (non-OECD) nations, it is imperative to consider both the local position as well as the regional position, and determine how best to manage disputes by harmonizing policies regionally/globally or by defending any local variations. Finally, undertaking a thorough review of your policies and developing more detailed documentation has been affected by the advent of increased transparency through CbCR, and planning to understand and address the issues is vital to creating a sustainable and stable tax position. A pro-active strategy to tackle enhanced scrutiny by tax authorities is the only way forward.