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. Of course, rules at a company’s headquarters location don’t necessarily free it from divergent rules that may exist in other locations where they maintain permanent establishments.
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.”13 Meanwhile, transfer pricing specialists WTP Advisors recently reported that the IRS is more assertively questioning transfer pricing at “U.S.-based companies that fall within $10 million to $250 million in assets and foreign parent companies operating limited-risk distributors in the United States.”14
Preparing for Tougher Rules and Enforcement
With global rules shifting and enforcement toughening, how can international businesses prepare? Tax and accounting specialists suggest considering these steps:
- Centralize oversight and coordination of transfer prices, while eliminating informal processes based primarily on personal relationships.15
- Ensure contractual language in intercompany agreements matches what actually happens in the real world.16
- Reassess locations claimed as a “permanent establishment.”17 Some companies may relocate functions or staff, adjust travel and expatriation, or accept permanent establishment (PE) status and change other systems accordingly.18
- Consider new technologies for streamlining transfer pricing workflows, capturing better information, and integrating transfer pricing with operations.19
- 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).20
- 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.21
