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Transfer pricing: what does the new guidance mean for you?

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Speed read

SPEED READ Rarely has so much new material on transfer pricing emerged so suddenly as in the last couple of years. It will change the way we all need to think about designing and supporting transfer pricing, in the face of increasing scrutiny by tax authorities. This article takes a high level look at recent and impending regulatory changes. It draws on the most important themes that will impact the way multinationals will need to flex their approach to transfer pricing in the future.

To tax and transfer pricing practitioners around the world, it often seems that the pace of regulatory change is slow.

A new version of the OECD Guidelines has historically appeared no more frequently than every 15 years; there have been only a few, albeit important, litigation cases; and the profusion of countries introducing requirements for contemporaneous transfer pricing documentation is noteworthy, but largely represents a geographic spread of similar themes.

However, the last couple of years have seen a number of key initiatives taking place, culminating in revisions to the OECD Guidelines in July, which have significantly changed, or will change, the transfer pricing arena.

Since early 2005, several important initiatives have come through from OECD.

These include, but are not limited to, exercises on the attribution of profits to Permanent establishments (2007–8); a review of both the hierarchy of transfer pricing methodologies and the use of benchmarking or ‘comparables’ (feeding in to revised Guidelines issued in July 2010); and a major piece of work on the transfer pricing aspects of Business Restructuring (resulting in a new chapter of the Guidelines in July 2010).

Each and all of these merits extensive review, beyond the purview of this short overview. But let’s look at what, in aggregate, they could mean for some multinationals.

Assessing the impact for multinationals

In the writer’s experience, most multinationals have historically viewed transfer pricing as a hugely important international tax issue, mainly from the perspective of compliance.

Ernst & Young’s biannual Global Transfer Pricing Survey has confirmed this for the past 15 years.

More recently, the drive in many multinationals towards global or regional centralisation of important functions has required some to work long and hard at aligning transfer pricing with changing business patterns.

Some have taken the opportunity to harness business change and add tax efficiency to it, for example by choosing a relatively low tax jurisdiction for those centralised functions.

It is worth reminding ourselves that the arm’s-length principle – the cornerstone of transfer pricing – requires that individual entities within a multinational enterprise should transact with one another on similar terms to those that would apply if they were completely independent. Thus, if they get it wrong, the same profits can be taxed twice.

Mechanisms exist to minimise the incidence of double taxation but most people would agree that avoiding it in the first place is preferable.

By the same token, if they align transfer correctly pricing with a tax-efficient business model, and get it right, there can be a significant contribution to shareholder value of an enterprise.

Compliance complexities

Compliance with the arm’s length standard can be hard work. The sheer number of countries requiring contemporaneous evidence of compliance means that companies have tried hard to keep things nice and simple.

Typically they seek to manage the increasingly onerous burden by: characterising their entities in a consistent and uniform way (eg, simple distributors/routine manufacturers/service centres); targeting an overall return for such entities (‘tested parties’), based on benchmarking the entity as a whole; and using high-level benchmarking approaches, often on a pan-regional basis.

For many multinationals, this approach has worked well.
For highly centralised ones, with common processes and routes to market, it may very well continue to do so.

But it won’t work for everyone.

Why not? Because the regulatory changes of the last few years are designed to test transfer pricing designs in greater detail than is implied by this approach.

Key themes

The key themes emerging from the initiatives above include the following:

  • Transfer pricing analysis should be two-sided (at least) and analyse both or all parties to the transaction in question. Thus, an entity characterised as a routine service provider to a related entity will need to show how it accounts to, and is overseen by the other party in the way that a third party service provider would be.
  • Profits follow bodies – that is, they are generated, in part, by the decisions of the people who control the risk-taking of an organisation. It will therefore become increasingly important to demonstrate that entities employing key decision makers are being adequately remunerated, and that highly remunerated entities can justify their rewards by showing the necessary substantive decision making.
  • It is no longer a safe assumption that the choice of transfer pricing method can itself determine the risk profile, and resulting reward, of an entity. Rather the tests will be more on what decisions that entity is making and how important they are in value creation. The idea that a guaranteed low stable return for an entity makes it low risk will be valid only if, by chance, its functional profile is that of a low risk taker.
  • Equally, risk (and commensurate reward) cannot be moved by contracts alone. Contracts will be the starting point of a transfer pricing analysis but will be respected only if they reflect the economic reality of the contributions of the respective parties.
  • We are no longer just talking about the price of a transaction, but also of all the attendant terms and conditions – including an increased need to show that it’s the type of thing that would have happened between independent parties, and resulted in a similar outcome, given their bargaining chips. This is a new field of analytical play that few tax professionals are used to.
  • The increased emphasis on detailed comparability analysis will challenge the high-level approaches taken by many. The elevation of ‘profit split’ from a method of last resort to one of equal status with other more frequently used methods will, at least, require more analysis of the full value chain, rather than one simple tested party.

Looking ahead

All in all, we can predict that these regulatory themes are trending towards the need for a different kind of analysis and compliance approach to that currently taken by many. It will entail a detailed understanding of the way that processes contribute to value creation and who controls those processes. It will also result in the use of things like ‘bargaining theory’ to assess the arm’s-length outcome of transactions. And it will require a broadening of the tax professional’s skill set.

Of course it won’t happen overnight, but the regulatory framework is falling into place, and the early signs of its use are coming through in some tax audits.

What does it all mean? Companies should perhaps use these new requirements as a stress test, to establish whether it is necessary to shift their approach to transfer pricing compliance.

If so, companies need to focus more resource and effort on those areas of the business that don’t merit the simple treatment. In the short term, however, and more importantly, don’t shoot the messenger!




John Hobster is the Head of Global Accounts for Ernst and Young’s Global Transfer Pricing and Tax Effective Supply Chain Management team. He has experience providing strategic TP advisory services including tansfer pricing design, with a heavy focus on controversy/dispute resolution and advance pricing agreements. Email:; tel: 020 7951 6438.