I have just finished teaching this year’s MA course on International Tax Law Level 3 to students at a faculty within the University of London. The first question I always ask them is “What are the fundamental requirements of an international tax consultant?” Enthusiastic as they are, I receive many responses, some printable and some not, but the one I am looking for often eludes them – commercial intelligence – a sense of business. International tax is not the province of the intellectual theorists but that of the practical consultant who can learn the joint skills of academic knowledge and practical awareness of how to implement such knowledge.
I can’t think of a better example to illustrate this than in the field of transfer pricing, this month’s article. One can study as many papers as are produced by the OECD on transfer pricing mechanics, review the formal legislation of many of the world’s developed economies, and compile a 100 page transfer pricing report with comparative prices, percentages etc to support the mostly anodyne conclusions. However, the study may not go to the heart of the issues relating to a particular client. And these reports are generally reactive following transfer pricing enquiries made by Revenue authorities. In my opinion, it is far preferable to proactively review accounting information supplied to Revenue authorities prior to submission, in order to assess the likelihood of a transfer pricing enquiry being raised.
There are of course some obvious issues that could lead to a transfer pricing enquiry, such as lower net profits on increased turnover, or the omission of specific assets such as patent rights where expenditure on research and development has been deducted in profit and loss accounts. This month’s article reviews the practical recommendation of how to prepare a transfer pricing report for all intra-group transactions, so that the methodology of inter-company charging can be clearly thought out before accounts are submitted to Revenue authorities.
I hope that I have always tried to bring this practical approach to all IFS clients, and I am now basing our annual conferences on the same approach, dealing with one or two topics in a technically comprehensive manner but with practical case studies on a multi-jurisdictional level. Last year was the first annual IFS conference (using the title of my book International Tax Systems and Planning Techniques to create the ITSAPT Conference) and I am happy to say that, due to its considerable success, we at IFS have decided to present the ITSAPT conference on an annual basis for the foreseeable future. I am encouraged that my friend Roy Rohatgi has held annual conferences in Mumbai for the past 17 years, and it would be nice to think that I could emulate this over the next 17 years, but closer to home.
So again, the second annual ITSAPT conference will be held at the Landmark Hotel on 3 November 2011, and as for last year, we have the same respected speakers from the US, Canada, Singapore, Israel, Switzerland and many EU countries, with Philip Baker QC in the Chair. As I mentioned in my last newsletter, the topic this year will be personal and corporate migration, and each of the speakers will be looking at these two issues from the point of view of their jurisdiction, with Philip and I giving an overview on the OECD, EU and other international views on corporate and personal migration.
As for last year, we will hold a cocktail party in the Gazebo at the Landmark Hotel after the conference so that delegates and speakers can discuss matters of mutual interest. The draft programme and booking form can be found by clicking on the ‘ITSAPT’ link.Readers of our newsletter will be entitled to a further discount of 10% on the booking fee, which is relevant for both the ‘early bird’ discount for bookings before 31 July 2011 as well as the full payment for bookings after that date. I look forward to seeing you on 3 November if not before.
Transfer Pricing
Transfer pricing refers to the valuation process for transactions between related parties. In broad terms, it is the price charged by one part of an enterprise for a product or services that it supplies to another part of the same entity. Tax authorities may adjust the transfer price and impose additional tax liability should that price differ from what unrelated parties acting at arm’s length would have charged each other. The recently updated OECD Transfer Pricing Guidelines provide guidance on the application of the “arm’s length principle”. It is primarily based on the functional analysis that looks into the relationship between the connected parties and allocates compensation due to an entity based on the functions performed, taking into account tangible and intangible assets used and risks assumed.
The 300-page light blue tome of the Guidelines is a familiar occupant of many international tax advisors’ desks. Indeed, the Guidelines offer ample tax planning opportunities for affiliates and branches, provided their principles are understood and practically applied. Prevention is better than cure, and a new corporate structure can be set up with regard to the Guidelines, moving high-risk and high-value activities and assets to low or high-tax jurisdictions, depending on the desired outcome. Many a businessman, however, although well-versed in international business parlance, will avoid like the plague dipping their toes into the muddled waters of CUPs, CPPs and TNMMs.
The thread of Ariadne for the uninitiated is to prepare comprehensive transfer pricing documentation showing that their controlled transaction satisfies the arm’s length principle and having it available to substantiate their tax returns. Seeing that usually the burden of proof in transfer pricing matters lies with tax authorities, the documentation provides solid indication of the taxpayer’s good faith. According to the Guidelines, the taxpayer is not expected to incur disproportionately high costs in preparing the report or engage in an exhaustive search for comparables if they believe that no comparables exist. At the same time, the taxpayer, in determining the transfer price and preparing the supporting documentation, should exercise the “same prudent business management principles that would govern the process of evaluating a business decision of a similar level of complexity”. In other words, the taxpayer should be reasonable and realistic in their analysis, for example, looking at potential competitors for a comparable price or clearly explaining why there are none.
Our esteemed Italian colleague Matteo Rapinesi prepared practical recommendations for maintaining a Transfer Pricing Document (the Master file) to rebut tax assessments based on adjustments of inter-company charges, and particularly the extent of relevant penalties demanded. I would suggest that all clients would benefit from adopting such a Master file if relevant to their business.
Over the past decade, there has been an increase in the number of controversies relating to transfer pricing rules. The theories supported by the Italian judges that have dealt with transfer pricing disputes rely on the conviction that the fair market value should be determined according to the OECD Guidelines and international directives. Particularly important is the decision rendered by the Italian Supreme Court (decisions no.11226, March 27, 2007, and no.22023, June 22, 2006) stating that, in a transfer pricing case, the burden of proof rests with the tax authorities who have to prove (through an analytical reconstruction of the average consideration charged by independent parties) that there actually is a difference between intra-group prices and the fair market value of the goods supplied or services rendered.
One of the most interesting innovations was introduced by Law Decree no. 78 of May 31, 2010. Accordingly, in the event of an adjustment of the “normal value” (i.e. fair market value) of intra-group transactions by the tax authorities, which results in a higher tax liability or lower tax credit, the penalties for untrue income tax return (typically between 100 per cent to 200 per cent of the difference in income tax as assessed) do not apply if the taxpayer submits proper documentation proving the compliance of intra-group transactions with the normal value. To avoid these penalties, the existence of transfer pricing documentation must be notified to the tax authorities in advance.
In particular, the “proper” transfer pricing documentation should include a Master file containing information on the multinational group as a whole and country-specific documentation with information on the Italian-resident enterprise.
Master file
1. General description of the Multinational Group: history, recent developments, market sectors in which it operates and overview of the relevant markets of reference;
2. Group structure:
2.1. Organisational structure: organisation chart, list of group members, their legal nature and their respective shareholding percentages;
2.2. Operational structure: brief description of the role that each of the associated enterprises carries out in the framework of group activities;
3. General strategies pursued by the Group, including any changes in strategy compared to the previous tax year, with specific reference to group development and consolidation strategies;
4. Transaction flows: overview of transaction flows, invoicing methods and amounts of transaction flows, with a description of the underlying economic and legal reasons and a flowchart of transactions (including extraordinary transactions);
5. Intra-group transactions:
5.1. Transfers of tangible or intangible property, provision of services and provision of financial services; this section should be subdivided into as many sub-sections as the types of transactions, describing the nature of each transaction and the group members involved in such transactions.
5.2. Functional services to the performance of intra-group activities: this section, too, should be subdivided into as many sub-sections as the types of functional services to the performance of intra-group activities provided by one or several group companies to the benefit of another or several other group companies, with indication (for each type of service) of the enterprises involved therein;
5.3. Cost contribution arrangements: for each arrangement, it is necessary to indicate the scope, duration, group members involved, areas of activity and projects covered;
6. Functions performed, assets used and risks assumed: separate indication for each of the group enterprises involved and indication of any changes compared to the previous tax year (with specific reference to changes caused by business restructurings);
7. Intangible assets: list of intangible assets with separate indication of any royalties paid for the use of such assets, per recipient or payer respectively;
8. Group transfer pricing policy: a description of the group transfer pricing policy explaining the arm’s length nature of the group transfer pricing policy, including a brief reference to the contractual arrangements underlying such policy and a summary of the contents thereof;
9. Advanced Price Arrangements (APA) and transfer prices ruling: brief description of relationships, if any, with the tax authorities of each of the countries where the group operates, structured by Country.
Country-Specific Documentation
1. General description of the company: history, recent developments and overview of the relevant markets of reference;
2. Sectors in which the company operates:
3. Operational structure of the company: general overview of the role that each of the enterprise’s divisions and business units carries out;
4. General business strategies pursued by the enterprise, including any changes in strategy compared to the previous tax year: description of market- or sector-specific business strategies;
5. Intra-group transactions (transfer of tangible and intangible property, provision of services and provision of financial services): this section should include an introduction with a summary of intercompany transactions, amounts of each transaction as well as the underlying economic and legal reasons; where necessary, this section should also include as many sub-sections as the types of transactions, including for each transaction a description of its nature and the group members involved therein.
5.1. Type 1 transactions:
5.1.1. Description of the transactions: in this section, taxpayers should indicate both of the group members involved in each transaction, as well as similar or analogous transactions with independent parties, if any;
5.1.2. Comparability analysis:
a) Characteristics of property or services;
b) Analysis of functions performed, risks assumed and assets used, with specific indication of any changes compared to the previous tax year, especially changes caused by business restructurings;
c) Contractual terms: key features of written agreements and an indication as to the general validity of such agreements;
d) Economic circumstances: general description of the markets of reference (supply, transit or distribution markets);
e) Business strategies;
5.1.3. Selection of the transfer pricing method:
a) Transfer pricing method chosen and reasons why it is consistent with the arm’s length principle: outcome of the comparability analysis and reasons underlying the choice of the aforesaid method. Moreover, should a transactional profit method (as referred to in Chapter II, Part III, of the OECD Guidelines) be selected where a traditional transaction method (as referred to in Chapter II, Part II, of the OECD Guidelines) could be used instead, it will be necessary to explain the reasons for such choice. The same applies if the method chosen is not the CUP method (comparable price method), when both can be applied;
b) Application criteria of the selected transfer pricing method: accurate description of the procedure for the selection of comparable transactions and explanation of the underlying reasons for identifying a specific arms’ length range;
c) Results deriving from the application of the selected transfer pricing method;
6. Intra-group transactions (Cost Contribution Agreements to which the enterprise is a party):
6.1. Participants, scope and term of each CCA;
6.2. Framework of activities and projects covered;
6.3. Method used to determine the expected benefits for each of the associated enterprises taking part in a CCA, including expected results, partial outcomes and any divergences;
6.4. Form and amount of each participant’s contribution to an arrangement, including criteria used to determine each contribution;
6.5. Formalities, procedures and consequences arising from the participation in or withdrawal from the aforementioned CCA’s and termination thereof;
6.6. Contractual arrangements concerning any balancing payments or amendments to a CCA due to a change in circumstances;
6.7. Changes occurred during the validity period of a CCA.
In addition to the Master file and Country-specific documentation, two Annexes must be included in the “proper documentation”:
* Annex 1: flowchart of transactions (including extraordinary transactions); and
* Annex 2: copy of the written contracts governing the transactions.
The Master file can be adapted to virtually any transaction, where transfer pricing issues may arise. Even a small or medium enterprise may save significantly on legal and compliance costs by following the proposed structure. DIY transfer pricing compliance may be even more relevant when the transaction involves intangibles or highly unusual products or service, for which no comparables exist, and where professional advisers may be unable to assist the client other than providing costly analyses of the transactional profit methods recommended by OECD Guidelines. Indeed, the client may find search engines helpful in ascertaining whatever comparables exist and adapting these to the transactions entered into by intra-group companies. What is important, even more than finding the exact comparables, is the maintenance of a Transfer Pricing Memorandum in the form recommended above, so that on first request by tax administrations for information as to related party transactions, this Memorandum may be produced to reveal the client’s integrity in appreciating the requirements of a transfer pricing policy.