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The Wall Street Journal's Tax Blog gives “tips and advice for filers,” and Paul Caron’s legendary TaxProf Blog is an excellent clearinghouse for academic and policy-oriented news. Yet, tax practitioners still lack a dedicated resource to call their own. For those intrepid souls, we offer TaxBlawg, a forum of tax talk for tax pros.
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TaxBlawg’s Guest Commentator, David L. Bernard, is the former Vice President of Taxes for Kimberly-Clark Corporation, a past president of the Tax Executives Institute, and a periodic contributor to TaxBlawg.
Transfer pricing among affiliated companies is the classic “double-edged sword”. When carefully designed, transfer pricing practices can cut a company’s effective tax rate (“ETR”) with little risk of interference from tax authorities. When done poorly, transfer pricing can devolve into a mess of ETR-killing practices. As quickly as one edge can save a company money, the other edge can cut short a tax professional’s career.
This post is not aimed at the largest multinationals. Most such companies have elaborate principal company structures based in low-tax jurisdictions, with limited-margin service providers providing the distribution and manufacturing in high-tax countries. Instead, this post is aimed at companies that do not have sophisticated supply-chain structures and supporting systems in place.
These mid-sized companies just beginning to approach transfer pricing systematically should see opportunity. With corporate tax rates around the globe ranging from zero in certain tax holiday situations to approximately 40% here in the U.S., transfer pricing is a simple way to take advantage of tax-rate arbitrage opportunities to lower a company’s ETR. Similarly, setting advantageous transfer prices can help use up net operating losses. There is even a repatriation benefit: if an affiliate is generating cash in a country with a high statutory tax rate, transfer pricing may be an effective way to return cash, depending on the affiliate’s earnings and profits, tax credit pools, and position in the global organization structure.
As attractive as these opportunities may be, every Chief Tax Officer (“CTO”) has to worry about possibly violating transfer pricing rules, whether it is the U.S. Section 482 rules or the myriad of rules of our trading partners. As more and more countries adopt comprehensive transfer pricing rules and aggressively seek tax revenue, guarding against assessments of tax, interest and penalties becomes more difficult. Using transfer pricing to lower a company’s ETR or as part of a repatriation strategy can indeed backfire, with the downside far greater than the upside originally sought.
So what can the CTO do to better manage transfer pricing risk? The answer is threefold: consistency in approach, appropriate documentation, and a good governance process.
Perhaps foremost, the CTO should push for a standardized policy covering all cross-border movements of goods and services. Ad-hoc pricing that results from negotiations among business leaders in different countries will only lead to a disaster. Consistency in approach and application is a must as because it is the best defense when the tax authorities come knocking.
Exactly what the standard policy should be depends on each company’s facts. Where are the intangibles owned? What are the licensing relationships? Where does the risk of loss reside in the supply chain? The easiest way to establish a consistent policy may be to first decide where the risk of loss should be borne. Should it be in the manufacturing entity, the distribution company or an intermediary in the supply chain?
For example, a company’s circumstances may dictate that a handful of manufacturing affiliates either own or license the group’s intellectual property. In such cases the preferred approach may be to treat the manufacturing entities as the risk takers and entrepreneurs. In these cases, the distributor affiliates would be limited-risk service providers (the “tested parties”) and would earn a fixed margin based on a “resale-minus” methodology.
Alternatively, perhaps some affiliates manufacture products for resale under a license of intellectual property but also import substantial amounts from affiliated entities for resale in their local markets. Rather than splitting the entities’ roles into part risk taker and part service provider, it may be appropriate to treat such affiliates as entrepreneurs bearing the risk of loss for both locally manufactured goods and those imported from affiliated manufacturers. This would mean that the exporting affiliates are service providers or “tested parties”, and a cost-plus methodology would be appropriate to determine the manufacturing companies’ margins.
At a minimum, documentation should include an analysis of the functions performed by each party to the transaction and outside studies supporting the methodology used and the margins earned. CTOs must guard against allowing the outside studies to become stale. Margins earned by service providers, both manufacturers and distributors, will vary as economies dip into and rebound from recessions. Don’t get caught in the middle of a recession with a 5-year old study performed during a booming economy.
There will no doubt be situations where an exception to the standard policy is warranted or necessary, but such exceptions must be very limited. This is where the governance process comes into play. A transfer pricing council should be established to consider requests for specific exceptions to the standard policy. The council’s mission should be to limit exceptions as much as possible, as exceptions will only make the discussions with the tax authorities more difficult. The council must be a credible group comprising both respected business people and finance staff both in the U.S. and abroad.
Regardless of the care taken in trying to minimize risk, there invariably will be cases where a tax authority takes exception to what a company is doing. In such cases, tax departments should take maximum advantage of mutual agreement procedures available (“competent authority”), assuming there is a treaty between the relevant countries. Competent Authority can be a lengthy process – CA’s only meet twice a year and deal with many cases -- but it does not have to be an expensive one because, once the initial request for relief from double taxation is made, the burden falls on the pertinent taxing authority to resolve the double taxation problem that may result from a transfer pricing adjustment. Remember it is the job of each country’s competent authority to resolve a transfer pricing dispute without double taxation.
CTOs should also consider the possibility of Advance Pricing Agreements (“APAs”). APAs remain a very effective way to remove control of a transfer pricing issue from the control of an aggressive examination team, both for previously filed years and future years. Yes, obtaining an APA can be a lengthy process and can be expensive depending on the level of documentation and analysis requested by the taxing authorities. However, with the possibility of “roll-backs” to cover previously filed years and the normal five-year forward looking agreements, APAs can pay for themselves many times over.
Ultimately, the lesson is caution. Although use of transfer pricing techniques in ETR and repatriation planning can be quite attractive, CTOs must be aware of the potential downside. Tax planning “at the margins” of a standard policy can generally be successfully defended. Overly aggressive use of transfer pricing as a planning tool can lead to disastrous results.