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Transfer Pricing

By Editorial
December 20, 2011

Facing record deficits and unsustainable levels of debt, governments have spotted an opportunity to raise some easy cash from multinational companies through more frequent scrutiny of transfer pricing practices, and this has become the top tax issue facing business groups trading across national borders.

While transfer pricing rules have evolved considerably around the world in recent years, and more countries now tend to follow guidance set down by the Organization for Economic Cooperation and Development (OECD), there is still no uniform standard or practice that tax authorities follow when conducting transfer pricing audits, and in the increasingly globalized world of trade and international finance, this is leaving many companies vulnerable to attack.

Tax rules in this area, which have been established for about 50 years, seek to determine whether goods and services traded between two companies which are part of the same group or otherwise 'connected' have been conducted at 'arm's length' - essentially, the same price that would have been charged in the market place between two unrelated companies - in an attempt to prevent the generation of artificial tax benefits. This a much simplified explanation of a very complex area of international tax law however, and in reality, that patchwork of different transfer pricing methodologies and documentation requirements employed by national tax administrations is a real headache for companies with a global presence.

Therefore, while some companies may prefer to operate riskier transfer pricing policies than others, even the most tax-compliant company may find it virtually impossible these days to negotiate the maze of transfer pricing rules without slipping up somewhere along the way and attracting the attention of tax investigators. What's more, the situation isn't being helped by the frequency with which new transfer pricing laws are being passed or proposed by governments and parliaments, with a slew of new rules being announced this year.

In April, the Chinese State Administration of Taxation (SAT) further strengthened its audit of transfer pricing methods, after a rise in revenues generated from such action over the past two years. It was reported that SAT generated additional revenues of over RMB2.5bn (USD382m) from 178 transfer pricing cases in 2010, up almost a quarter over the level seen in the previous year and more than twice the 2008 figure. It is now expected that, given SAT's already stated aim of targeting domestic companies operating abroad (particularly those going into low tax jurisdictions), the tax authority will also examine conversions from manufacturing to service-based companies, intellectual property transactions and issues surrounding the interplay of transfer pricing, thin capitalization, controlled foreign corporations and cost sharing.

In May it emerged that the Indian authorities were examining various transfer pricing models with a view to forming new rules and formats aligned with best international practices so that they can be put in place when the Direct Taxes Code is implemented from the next financial year. This is likely to include arrangements for Advanced Pricing Agreements (APAs), which seek to limit the potential for conflict between companies and the tax authority. It is said that nearly 70% of global transfer pricing litigation emanates from India.

Also in May, Russia published its long-awaited transfer pricing law, designed to both improve the efficiency of tax administration and reduce opportunities for tax avoidance. The law attempts to define more clearly the nature of arm's length related party transactions and increases penalties for failure to adopt this approach. It also outlines procedures for APAs.

In July, the tax authorities of several African countries discussed how to collaborate in exchanging information on the transfer pricing practices of multinational companies operating in countries within the Africa Tax Administration Forum (ATAF). Following the meeting, Logan Wort, ATAF's executive secretary, reported that the countries had agreed to start talks on a regional tax information exchange agreement, which would allow them to share their data on all types of transfer pricing, including not only the pricing of goods and services, but also the treatment of such payments as royalties, and management and procurement fees.

Later that month, the United States Internal Revenue Service announced that it was taking additional steps in the continuing efforts to improve the agency's international operations, particularly with regard to transfer pricing, by reorganizing the way in which such issues are examined. Under the changes, the IRS Advance Pricing Agreement programme shifts to an office under the Transfer Pricing Director in the Large Business & International Division's international operation. In addition, the IRS Mutual Agreement Program (MAP), concerned primarily with the bilateral resolution of transfer pricing disputes with US treaty partners, moves to the same office. "Improving how we manage transfer pricing compliance and continuing to develop our capacity to coordinate effectively with our treaty partners is ever more critical to our job," said IRS Commissioner Doug Shulman.

On November 1, 2011 the Australian Assistant Treasurer Bill Shorten announced that the government intends to reform the transfer pricing rules in the income tax law and Australia's future tax treaties to bring them into line with international best practice. The new rules will be more closely aligned to OECD Transfer Pricing Guidelines. Shorten indicated that the government will also address a related area of potential uncertainty: whether tax treaties provide a power to make transfer pricing adjustments independently of transfer pricing measures taken under national tax legislation. Shorten said that the government is taking this action "to ensure multinationals pay the correct amount of tax in Australia on their income and to provide certainty on our transfer pricing laws".

While changes to national transfer pricing rules are increasing in frequency, according to the OECD, they are at least getting simpler, with over 80% of respondents to its national transfer pricing survey saying that simplification procedures have been put in place. Nevertheless, the 2010 Global Transfer Pricing Survey of tax directors and international tax practitioners, produced by Ernst and Young, concluded that transfer pricing legislation is increasing, and enforcement actions are placing greater emphasis on intercompany financing transactions and service transactions. E&Y points out that transfer pricing audits are "increasing in significance, intrusiveness and scope" and recommends that multinationals "tailor their global transfer pricing platform to local requirements in higher-risk, more complex countries". Multinationals, E&Y says, "should consider a more proactive approach to controversy management, including appropriately targeted advance pricing agreements".

If transfer pricing disputes do end up in court, they can be protracted and costly affairs for companies, especially if judges come down on the side of the tax man, as recent cases have illustrated. Take AstraZeneca for example, which said in March that it expected to pay USD1.1bn to resolve all United States transfer pricing and related valuation matters for all periods from 2000 to the end of 2010. And in the following month, IBM lost a AUD55m (USD60m) court case resulting from a lawsuit that IBM Corporation and IBM Australia filed against the Australian Tax Commissioner in 2009, disputing that tax was owed on earnings from the Australian subsidiary based on a software licensing deal dating back to 1987.

It is vital then, say tax experts, that multinationals ensure that they put in place effective transfer pricing policies in order to mitigate the risks of audits by national tax authorities and the potential for litigation, which not only affects a firm's bottom line, but also its reputation with investors.

"Today, a properly coordinated defence strategy is a basic necessity rather than an expensive luxury," writes Nick Raby of PwC US in the firm's 2011 International Transfer Pricing report. "It's vital for every company to have a coherent and defensible transfer pricing policy that is up to date and current. A sound transfer pricing policy must be developed within a reasonable timescale and be invested in by both company management and professional advisers."

With the economic environment expected to worsen, and with many governments in full-scale retrenchment mode, this situation is unlikely to change any time soon. So for multinational enterprises, transfer pricing will remain a priority for company tax executives for many years to come.



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