Last week’s webinar Why Transfer Pricing Matters: Avoiding Common Pitfalls encouraged a lot of discussion. There were several interesting questions from attendees for HSP's transfer pricing expert Justin Smith and DLA Piper's Ray Brown; here are some of the highlights, and answers:
- My company develops and licenses a medical software product, and we have subsidiaries in multiple jurisdictions that simply license the software from the U.S. parent and then sub-license to third party customers. Even though the license rate we use with our related parties is identical to what we use with our third parties, a couple of our subs have lost money in recent years. We’ve been challenged about the losses under local tax audit and are having trouble defending them. Are losses by a subsidiary that is simply buying and reselling defensible.
Most jurisdictions will have prescribed methodologies that determine whether or not intercompany pricing is arm’s length. Generally speaking, those methodologies will include a profits based test as well as a direct pricing comparison test. When using a transactional test on the price itself, you will need to be careful that you’ve made appropriate adjustments for volume, geography, and other factors that can affect price. You will also want to make sure you are selling into the same level of market between unrelated and related party transactions. Even in cases where you’ve prepared a thorough analysis of related party and third party prices, often it will be difficult for a tax authority to accept related party resellers incurring losses, at least for any noticeable period of time. There is an unwritten rule that related party distributors should normally earn profits, at least in the mid to long term.
- My company has numerous small service provider subsidiaries throughout Europe and Asia. It seems quite onerous to have to prepare a separate transfer pricing study for each country, and we have not done this to date. How do I decide where to prepare formal documentation, and what are my alternatives?
The decision about the level and type of transfer pricing documentation to be prepared is similar to the cost benefit trade off you face for many of your global tax requirements. You must determine the requirement in each country, the potential exposure from a transfer pricing adjustment, and match that with the resources you devote to preparing transfer pricing documentation. It’s common to prepare regional documentation that may cover multiple countries. This can be effective where you have multiple entities performing similar functions and receiving a similar markup. You can test the markup on an aggregate approach rather than country by country.
- Can you give some additional examples of recessionary adjustments when using the CPM?
Common recessionary adjustments tend to focus on the costs associated with the up and down nature of a recessionary environment. Costs associated with the layoff of employees might be adjusted for when doing a CPM analysis. Any extraordinary items or other operating expenses that are borne by the related party but not by the comparables should be scrutinized and potentially adjusted for.
- Is there a limitation on the number of years an audit can go back?
Statutes of limitation rules are established on a country-by-country basis through local tax law and regulation. Generally speaking, the statute of limitation will range from roughly 3 to 5 years.
- It seems that the discussion has been largely centered on cross-border transactions. What about transfer pricing issues between separate companies within a country such as within Belgium (or alternatively, within the European Union)?
Transfer pricing rules can be established between many different types of governmental entities, including states and municipalities. Requirements will tend to vary on a country by country basis. In the United States, each of the states has their own transfer pricing rules and requirements, often referencing the Federal Internal Revenue Code and Regulations. In the U.K., for instance, there are rules that lay out transfer pricing rules and require documentation between all domestic related parties. Note that the EU is a union made up of independent countries, each of which has their own tax rules and regulations. Each will have their own set of transfer pricing rules, and those rules would apply to intercompany transfers between EU member countries.
- Can you talk about cost sharing arrangements between parent and sub across countries?
A cost sharing arrangement is one in which related parties agree to share the costs of developing an intangible such that each of the participants can share in the exploitation of that intangible in a given jurisdiction. Rules regarding qualified cost sharing arrangements vary by jurisdiction, but generally speaking the goal is to ensure that the relative costs being borne by the cost sharing participants is commensurate with the relative benefits being enjoyed from the exploitation of the intangibles. It’s particularly important to ensure that parties bringing pre-existing intangibles to the cost sharing arrangement are adequately compensated.
- Where do Mexico and Brazil rank on enforcement?
Mexico and Brazil each have thorough enforcement of their transfer pricing rules. Mexico’s rules tend to have attributes more common to the OECD Guidelines and other developed countries. Mexico has built certain documentation requirements into certain filing processes that make transfer pricing documentation “the norm” for taxpayers with related party transactions. For instance, participation in the Maquiladora unilateral APA program and having audited financial statements both require the presence of an annual transfer pricing study. Brazil’s transfer pricing rules tend to be more formulaic and don’t mesh well with those of much of the developed world. They are well enforced, but often at the transactional level. For instance, funding of a cost plus service provider requires the presence of an intercompany services agreements, which will be checked by the banking entity receiving the funding.
- What are methods you use to adjust for the risk assumed by comparables? For example, my client is a low risk distributor but there are very few comparable companies available.
There are a number of adjustments that are common, and specifics will vary by jurisdiction. Working capital adjustments (adjustments for levels of accounts receivable, accounts payable, and inventory) are the most common for putting low risk distributors on par with other distributors. A PP&E adjustment might also make sense, depending on the level of capital employed by the comparables.
- Do any or many countries have a minimum transfer price mark up? As in the case of emerging industry products that are being sold to the customer at very low margin or at a loss.
Most countries set standards for transfer pricing based on an arm’s length principle. A few countries, such as Brazil, have statutory safe harbor rates for certain goods and services. This is the exception, however, and not the norm. In the case of an emerging industry product, where there is an investment in the market, the decision needs to be made regarding which entity should bear the risk of that development. It’s possible the risk bearer might earn no profits or possibly even losses during early stages of market development, while another related party simply distributing the product makes money. The expectation is that the risk bearer is building a market intangible and would be compensated for that intangible when the product becomes profitable in the future.
- For service type arrangements, is the mark up on costs typically limited to salaries and occupancy costs of the provider or is it also on invoices from third party service provider where the parent is the beneficiary?
Rules for cost inclusion vary by jurisdiction, but generally speaking cost pools should contain something close to a fully loaded cost. This is generally meant to include all operating costs associated with providing the service. From a US GAAP perspective, this would mean everything that sits above the operating profit line and not inclusive of interest, taxes, and other extraordinary items.
Interested in more information? Check out the OECD's risk indicators for transfer pricing.