ONGOING ECONOMIC globalisation has led to the increasing importance of the tax implications of intercompany cross-border transactions of multinationals.
Governments become particularly concerned when these transactions are entered into between related companies that are resident in different countries, because they impact the profit allocation between these companies and the countries involved and therefore may be used to effectively lower the overall tax exposure.
In these circumstances, the arm’s length principle is commonly resorted to for tax purposes, which requires transactions between related parties to operate as they would between independent parties. This principle is embodied in Paragraph (1) of Article (9) of the OECD Model (see box).
ARM’S LENGTH PRINCIPLE
The international standard that OECD member countries have agreed should be used for determining transfer prices for tax purposes. It is set forth in Article (9) of the OECD Model Tax Convention as follows: where “conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly”. [OECD Glossary]
The OECD Transfer Pricing Guidelines provide support to the application of the arm’s length principle by identifying five methods for determining the arm’s length range of prices. The preferred method (CUP) consists of a comparison of the price of the inter-company cross-border transaction with prices of a similar transaction between unrelated parties. Where this method lacks applicability, which frequently happens, then other methods that are based on the comparison of gross margins or of operating margins may be considered. The adopted transfer pricing policy must be disclosed and supported by proper documentation.
By following the lead of the US tax authority (the Inland Rrevenue Service), other tax authorities have become increasingly aware of the key role played by transfer pricing in determining the taxable income of multinationals. Consequently, more audits are being done in this regard.
It can be expected that transfer pricing will become a focal point for tax litigation in the forthcoming years. The US GlaxoSmithKline case ($3.4bn (£2.1bn) settlement), and the US AstraZeneca case ($1.1bn settlement), are clear examples of the risk exposure that transfer pricing poses for multinationals.
Current issues in transfer pricing include:
Business restructuring – A new chapter in the OECD guidelines regulates the application of the arm’s length principle to business restructuring (e.g. reorganisation of the supply chain and rebranding) that is particularly complex.
Matrix type organisation – Most multinationals have adopted fully integrated business models based on matrix-type organisational structures. This structure often gives rise to several permanent establishments with the related problem of income attribution. Additionally, this structure could lead to the joint development of intangible assets, which creates questions over who owns the asset and how its use is regulated among the related companies.
Marketing intangibles – The issue of economic versus legal ownership of marketing intangibles has arisen in certain landmark cases in international law (for instance the GlaxoSmithKline case). Some tax authorities have already addressed the topic by issuing specific guidelines, for example in China.
Intercompany transactions are not only an issue about tax, but also for corporate governance and accounting purposes. Recent corporate scandals (such as Enron and Parmalat), have highlighted the necessity of closely monitoring intercompany transactions to protect minority shareholders from abuses by managers and majority shareholders.
Consequently, company boards must manage and monitor group transfer pricing policy more diligently.
There are two main tools for managing the tax risk related to transfer pricing: documentation and Advance Pricing Arrangements (“APAs”) (see second box).
Advance pricing arrangement
An arrangement that determines, in advance of controlled transactions, an appropriate set of criteria to determine the transfer pricing for those transactions over a fixed period of time. The arrangement may be unilateral, involving one tax administration and a taxpayer, or multilateral, involving the agreement of two or more tax administrations. [OECD Glossary]
Setting up and updating a proper set of documentation to support the transfer pricing policy will check on the consistency of the policy with the arm’s length principle and reduce the risk of tax disputes. In addition, in some jurisdictions it also reduces potential penalties in case of tax assessments.
In many cases, APAs are the best way to manage transfer pricing risk, because they grant certainty on the consistency with the arm’s length principle regarding the transfer pricing policies adopted in related party dealings. This was, implicitly, confirmed by the increasing attention given by the relevant market authorities to transfer pricing issues.
For example, there is a positive impact on the valuation of the listing prospectus, where transfer prices have been agreed with tax authorities by means of APA. The same AstraZeneca case was settled by means of a bilateral APA (between US and UK tax authorities).
The increasing attention of accounting standards, corporate governance regulations and tax law to intercompany transactions shows the necessity for coordinated management and careful, transparent planning by multinationals.
Stefano Simontacchi is partner, and Francesco Saverio Scandone is associate, in the tax department of international law firm Bonelli Erede Pappalardo
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