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Changing global transfer pricing rules have increased tax risks for international businesses.

International Business Complexity Rises as Transfer Pricing Rules ChangeARTICLE

By Bill Camarda

International businesses that maintain substantial operations in multiple countries must manage taxation in each of them. Today, changing global “transfer pricing” rules are making this even more complex.

International Business Transactions Risk ‘Disappearing Income’ and ‘Double Taxation’

To understand transfer pricing, imagine an international business transaction in which a manufacturer buys components for its products from a subsidiary in another country. The amount that the manufacturer pays its subsidiary affects its profitability – and its tax liabilities – in both nations.

Buyer and seller are supposed to price these transactions as if they were independent, following the “arm’s length” principle. As the Organization for Economic Co-operation and Development (OECD) defines this principle, “the value of participants’ contributions must be consistent with what independent enterprises would have agreed to contribute under comparable circumstances given… the total anticipated benefits they reasonably expect to derive.”1 But vague or obsolete rules have enabled some international businesses to move income to lower-taxed locations where they do little business, or to escape taxation on some income entirely – usually through perfectly legal means.2

The OECD says governments lose between $100 billion and $240 billion in global corporate income tax revenues annually due to these tax base erosion and profit shifting (BEPS) international business transactions.3 Taxing authorities want to change that.

Of course, the opposite situation occurs, too: rather than “disappearing,” income earned in one place may be taxed by two governments, a problem known as double taxation. For example, a luxury product manufacturer makes a sale through a local subsidiary, but parent and subsidiary country governments both attempt to tax the sale’s full profits.4

Both scenarios reflect different parties’ competing objectives: domestic and foreign tax authorities want more income, and the business wants to pay less.5 To resolve these conflicts, OECD has identified 15 “Actions” aimed at bringing greater coherence, transparency, and certainty to internal transfer pricing rules for international businesses.6 Among others, these include:

  • Stricter rules to “substantially lower the threshold under which a host nation can declare a corporate presence as a [taxable] permanent establishment (PE).”7 For example, BEPS changes the treatment of certain “commissionaire” and warehousing arrangements.8
  • Tighter alignment of transfer pricing outcomes and value creation, especially in “intangibles.” This may encompass how organizations contractually allocate risks and calculate interest or other payments made to funders within the enterprise. It can also encompass transactions which don’t appear to be “commercially rational.”9
  • More extensive documentation and reporting, especially for very large international businesses that may face comprehensive country-by-country reporting requirements10 (over 750 million euros, a threshold also used in other European financial standards; or US$850 million in the U.S., a value based on the rough equivalent dollar-to-euro exchange rate on January 1, 2015).11

Throughout 2016-2017, governments are embedding OECD’s Actions in their tax treaties and rules. However, as professional services firm EY recently wrote, they “are moving at different speeds… often with different legislative interpretations [and] enforcement postures.”12 This, of course, increases risk for international businesses – as does the fact that not all nations are members of OECD.

Not Just a Concern for Large Multinationals

Traditionally, transfer pricing has been viewed as an issue primarily for only the largest international businesses. And it is true that some nations have either created exemptions for small- and medium-sized enterprises (SMEs) or simplified SME paperwork requirements. For example, U.K. tax authorities exempt most international businesses with 250 or fewer staff, annual turnover of less than 50 million euros, or assets lower than 43 million euros.13 However, the U.K.’s rules don’t apply to transactions with subsidiaries in “tax haven” countries.14

According to Grant Thornton, a global audit, tax and advisory firm that serves many middle-market firms, “Mid-size companies [will] be swept up in the tide of the changes and face extra work in complying, even though they’re often not the ones using the avoidance schemes the Action Plan is seeking to eliminate.”15

Preparing for Tougher Rules and Enforcement for International Business Transactions

With global rules shifting and enforcement toughening, how can international businesses prepare? Tax and accounting specialists suggest considering these steps:

  • Centralise oversight and coordination of transfer prices, while eliminating informal processes based primarily on personal relationships.16
  • Ensure contractual language in intercompany agreements matches what actually happens in the real world.17
  • Reassess locations claimed as a “permanent establishment.”18 Some companies may relocate functions or staff, adjust travel and expatriation, or accept permanent establishment (PE) status and change other systems accordingly.19
  • Consider new technologies for streamlining transfer pricing workflows, capturing better information, and integrating transfer pricing with operations.20
  • Carefully document the risk assumed by each party. For example, PwC recommends, “if one party bears foreign exchange risk in a particular transaction, this risk should be documented in the agreement (e.g., by denominating the currency of an intercompany payment).21
  • Finally, where tax risks are highest, consider if it is worth the effort required to negotiate a multi-year advance pricing agreement (APA) with the taxing authority.22

The Takeaway

As taxing authorities look more closely at transfer pricing, and new OECD BEPS standards tighten the rules, international businesses face increasing tax risks – but, with care and foresight, these may be manageable.

Bill Camarda - The Author

The Author

Bill Camarda

Bill Camarda is a professional writer with more than 30 years’ experience focusing on business and technology. He is author or co-author of 19 books on information technology and has written for clients including American Express Private Bank, Ernst & Young, Financial Times Knowledge and IBM.

Sources

1. BEPS Action 8: Revisions To Chapter VIII of the Transfer Pricing Guidelines on Cost Contribution Arrangements (CCAs) 29 April 2015 - 29 May 2015, OECD; https://www.oecd.org/tax/transfer-pricing/discussion-draft-beps-action-8-cost-contribution-arrangements.pdf
2. "About BEPS and the inclusive framework", OECD; http://www.oecd.org/tax/beps/beps-about.htm
3. "Top 10 FAQs about BEPS", OECD; https://www.oecd.org/ctp/top-10-frequently-asked-questions-about-beps.pdf
4. United Nations Practical Manual on Transfer Pricing for Developing Countries (Chapter 1), United Nations; http://www.un.org/esa/ffd/documents/UN_Manual_TransferPricing.pdf
5. "Transfer pricing and its effect on financial reporting", Journal of Accountancy; http://www.journalofaccountancy.com/issues/2013/oct/20137721.html#sthash.6f8BT4TA.dpuf
6. "OECD/G20 Base Erosion and Profit Shifting Project: 2015 Final Reports, Information Brief", OECD; http://www.oecd.org/tax/action-plan-on-base-erosion-and-profit-shifting-9789264202719-en.htm
7. "How anti-BEPS policies are changing Transfer Pricing", EY; http://www.ey.com/gl/en/services/tax/ey-anti-beps-policies-are-changing-transfer-pricing
8. "BEPS Action 7: how the OECD's proposals to redefine a PE could affect multinationals", DLAPiper; https://www.dlapiper.com/en/belgium/insights/publications/2016/02/global-tax-news-feb-2016/beps-action-7/
9. Aligning Transfer Pricing Outcomes with Value Creation, OECD/G20 Base Erosion and Profit Shifting Project; http://www.oecd-ilibrary.org/docserver/download/2315351e.pdf
10. "BEPS Action 13: What U.S. Multinationals Need to Know", Thomson Reuters; https://tax.thomsonreuters.com/blog/beps-action-13-what-u-s-multinationals-need-to-know/
11. IRS issues final country-by-country reporting rules, addresses voluntary reporting for 'gap year,' along with a few points of clarification, PwC; https://www.pwc.com/gx/en/tax/newsletters/pricing-knowledge-network/assets/pwc-TP-US-final-CbC-rules.pdf
12. "BEPS project rewrites the book on transfer pricing", EY Tax Insights; http://taxinsights.ey.com/archive/archive-articles/beps-project-rewrites-the-book-on-transfer-pricing.aspx
13. "Transfer pricing: transactions between connected companies", HM Revenue and Customs; https://www.gov.uk/guidance/transfer-pricing-transactions-between-connected-companies
14. "Global Transfer Pricing eBook 2014", Grant Thornton; http://www.grantthornton.at/globalassets/1.-member-firms/austria/pdfs/broschuren-sonstige/transfer-pricing-ebook-2014-final.pdf
15. "Getting to Grips with the BEPS Action Plan", Grant Thornton; http://www.grantthornton.global/globalassets/1.-member-firms/global/insights/article-pdfs/2014/getting-to-grips-with-the-beps-action-plan_final.pdf
16. "End-to-end transfer pricing: Beyond the tax department", PwC; http://www.pwc.com/gx/en/services/tax/transfer-pricing/end-to-end-transfer-pricing.html
17. Final BEPS guidance places renewed emphasis on intercompany agreements: The new normal: full Transparency, PwC; http://www.pwc.com/gx/en/tax/publications/transfer-pricing/perspectives/assets/tp-16-beps-ic-agreements.pdf
18. "Infographic - 5 Tips to adapt to today’s post-BEPS world", EY; http://www.ey.com/gl/en/services/tax/ey-2016-transfer-pricing-survey-series
19. Permanent establishments: Recent trends and developments, EY; http://ey.mobi/Publication/vwLUAssets/ey-permanent-establishments/$FILE/ey-permanent-establishments.pdf
20. "Transfer pricing: using technology to avoid the pitfalls", World Finance; http://www.worldfinance.com/markets/transfer-pricing-using-technology-to-avoid-the-pitfalls
21. Final BEPS guidance places renewed emphasis on intercompany agreements: The new normal: full Transparency, PwC; http://www.pwc.com/gx/en/tax/publications/transfer-pricing/perspectives/assets/tp-16-beps-ic-agreements.pdf
22. "Infographic - 5 Tips to adapt to today’s post-BEPS world", EY; http://www.ey.com/gl/en/services/tax/ey-2016-transfer-pricing-survey-series

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