The transfer pricing effect

If sales of headache pills have increased recently, the Inlandand the Inland Revenue itself – simply aren’t prepared for it, says Sarah Perrin. Revenue could be to blame. Corporate and professional tax specialists have been suffering mental anguish in the attempt to comply with the new transfer pricing rule. The worry is that some companies are lagging behind in their preparation. They can expect even bigger headaches when the Revenue’s penalty notices land in the in-tray.

Some companies are already adjusting to life under the new transfer pricing regime – which applies, like corporate self-assessment, to all chargeable periods ending on or after 1 July 1999.

Many more companies will soon be affected, but not all will be ready to cope with two key requirements of transfer pricing: to establish arm’s-length prices for intra-group transactions, and to maintain documentary evidence to support those prices.

Falling foul of the tax man

Although accountancy firms have experienced an upturn in enquiries about their transfer pricing services, it is not necessarily as much as might have been expected.

Allan Taylor, UK head of transfer pricing at KPMG, anticipated more demand.

‘I am suggesting that not all companies are addressing the issue,’ he says. One reason may be that tax departments aren’t getting the message across to budget holders, that money needs to be spent on getting the transfer pricing policy sorted out.

‘The person who is responsible for tax is pretty worried about this, but is not getting the commitment from the company, nor the budget needed, to make him or her happy,’ Taylor explains. Lack of support now could prove painful in the future, since the Revenue can apply a penalty of up to 100% of the tax lost.

Revenue managers deserve full support from their managerial colleagues, because the repercussions of the new regime extend beyond the tax department.

‘This matter has to be taken seriously in the boardroom,’ says John Hobster, Ernst & Young’s head of transfer pricing. ‘It can impact on performance, systems and IT, as well as buying and selling behaviour.’

Changes in the way companies communicate internally may also be required – for example, where operating units have traditionally made all the pricing decisions.

‘Now, they realise that it’s very important for the tax and finance people to be involved in those pricing decisions, or at least to be aware of the process,’ says Hobster. ‘They need to create an interface between the departments.’

How much work a company needs to do, to minimise its chances of falling foul of the Revenue, depends on the historic development of its transfer pricing and its exposure to other tough regimes, such as that of the USA.

John Liddiard, group tax manager at industrial gases giant BOC (see box), says: ‘We have had extensive transactions with our US group, so we have had to put in extensive documentation, and have broken the back of it.

‘Our transfer pricing policy was completely reviewed and redocumented. It took about 18 months to do it properly.’

The document, prepared to back up the rationale for the policy, came to over 100 pages.

‘We did it properly because we knew we were going to be audited in the US,’ Liddiard explains. ‘We decided we may as well get it right at the beginning, rather than scrabble to get it right at the end.’

The complexity of the process to establish an arm’s-length price depends on the particular circumstances of groups and the product it is trading internally.

Bob White – head of transfer pricing at Deloitte & Touche in the UK – explains that, while the methods approved by the OECD for establishing an arms-length price do make ‘fantastic theory’, they are also very difficult to apply in practice. ‘You can’t find a transaction between third parties that’s exactly the same as yours,’ he says. Nor are competitors likely to share data on their own transactions. So, what can companies do?

Deloitte & Touche is trying to get round the problem by accessing databases containing corporate data to find suitable comparative businesses. ‘You can find a range of comparables for a particular market,’ White says.

One result of this approach is that approximately one third of the Touche transfer pricing team are economists rather than tax experts. Companies that call in the big accountancy firms for help with transfer pricing projects will find they adopt a broadly similar approach.

KPMG first looks at the current method used by a client – the ‘where we are now’ position. It then considers where the company would like to be, including the regulatory requirements it must meet and the commercial outcomes it would like to achieve through its transfer pricing policy.

‘Transfer pricing is not just a tax issue,’ says Taylor. ‘It drives how people behave and how companies operate. There are a number of ways that getting the transfer price wrong can drive individual companies to behave in a non-group way.’

For example, charging a group company too much for a product would encourage it to look for an external and cheaper supplier. This would improve that individual company’s profit performance, but deny the group the chance to make profit on manufacturing that item.

Once businesses have clarified the result they seek from their transfer pricing, the price itself can be set, bearing in mind regulatory requirements.

There is still a fair bit of leeway when establishing a price that is not only sensible commercially but also acceptable by the Revenue as arm’s length. There is also some scope to influence what can be considered arm’s length by changing the risk associated with the transaction.

For example, a company selling a product to a group distributor, with a guarantee that every item produced will be purchased immediately, is taking a lot less risk than if it held the stock until the group distributor placed an order. The lower the risk for the producer, the lower the margin it should expect to make, and the lower the transfer price.

So, small is better

Although transfer pricing is a serious issue for major multinationals with extensive internal transactions, not every affected company needs to pay out for expensive pricing reviews.

Small and medium-sized enterprises, without significant transactions with group companies abroad, shouldn’t become overly alarmed. ‘They have got to keep records, but they shouldn’t panic,’ says Roy Stevenson, national managing partner of Cooper Lancaster Brewers. A company with just #100,000 of transactions with connected parties will not be badly hurt, even if the transfer pricing is found to be miscalculated by as much as 20%.

‘SMEs shouldn’t get into thousands of pounds of consulting,’ says Stevenson.

‘We have had discussions with multinational clients, with only a modest amount of trading between the group companies. When we started to analyse the amount that was at risk, it was fairly small in proportion to the size of the business.’

That said, companies that perform a risk analysis, and find they could be facing significant penalties, are advised to sort out their transfer pricing policies sooner rather than later. ‘The longer they leave it, the more difficult it is to correct,’ says White.

For example, a UK company selling goods on to a US group company, at a price that passes too much profit to the US, could get into trouble if it doesn’t spot the problem before the financial year-end. The UK figures would need adjusting for the UK tax return to produce an arm’s-length result. In other words, increasing UK profits and the tax bill. But then the US side of the equation has to be adjusted, which is no easy task.

‘So, if a transfer pricing study shows that prices are not arm’s length, you could end up paying tax on some of your profits twice,’ says White.

Don’t put it off

As with many aspects of life, short-term pain could reduce long-term suffering. Establishing sound transfer pricing policies now should make dealing with the Revenue easier in future.

Bob White draws a parallel between delaying transfer pricing reviews and avoiding a visit to the dentist. As he says: ‘It’s possible to put off the purchase, but eventually, your teeth fall out.’


BOC experienced one of the key difficulties with the new transfer pricing regime, when trying to establish an arm’s-length price for transactions with its French distribution company.

‘There is no-one else like us in France, so there is no comparative price,’ explains group tax manager, John Liddiard. ‘There is no real data out there on what competitors do.’ BOC sought information from corporate databases run by Price Waterhouse, as it then was, and Dun & Bradstreet. ‘The information we got back was fairly useless, but we filed that with the policies for when the Revenue comes round and asks for the evidence,’ says Liddiard.

In the end, BOC estimated what a third-party price would be, by starting from first principles. ‘We asked ourselves, if we were a third-party distributor, how much would we want to make,’ explains Liddiard. The question was complicated by the fact that BOC’s products are protected by patent – no-one else makes the same items. Also, when looking at the transactions of competitors, it is often unclear who bears the cost of servicing guarantees – the parent or the distributor? The answer has a significant impact on the transfer price.

‘You have to do a lot of rational thinking in the absence of third-party data,’ says Liddiard. ‘If you devote significant resources, you can do something sensible, but if you don’t, you have no defence against the Revenue coming along and saying, “You have charged #50 a tonne. It should be #60.”‘

Related reading