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Transfer Pricing

Transfer Pricing and Economic Substance

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There’s nothing static about business. So why should transfer pricing compliance be a static exercise?

It shouldn’t, and tax authorities have woken up to this fact. Many, facing acute revenue shortages, are placing far greater emphasis on the economic substance of transactions—including financial transactions and intangible assets. They have the wind at their back: recent OECD transfer pricing guidance suggests how transfer pricing documentation should be analyzed to determine whether (or not) the underlying arrangements are grounded in economic reality.

As goalposts move, transfer pricing risk increases. So, it’s time for tax directors to rethink the very meaning of transfer pricing compliance: to evaluate transactions based on their genuine commercial rationale; to stay on top of the regulatory trendlines; and to be proactive in engaging with tax authorities. It all adds up to a more sophisticated form of compliance. Here we break it all down across four key areas.

1) Documentation: A Moving Target

As is well known, the OECD’s BEPS Action 13 was introduced to address the transparency gaps and data inconsistencies that were hamstringing tax authorities in assessing the credibility of transfer pricing arrangements. It calls for three tiers of documentation for large multinational enterprises (MNEs): a master file; a local file; and a country-by-country report. The three layers serve different purposes, but taken together, they provide a far more complete picture than was possible before—making it easier for tax authorities to see where substance does (and doesn’t) exist:

  • The master file is a high-level, comprehensive overview of the global operations and transfer pricing policies and practices of the MNE, typically prepared by the parent entity. It includes aggregate data on the global allocation of income, profit, taxes paid, and economic activity among all the tax jurisdictions in which the company operates.
  • The local file focuses solely on a particular tax jurisdiction, zeroing in on the local taxpayer’s business activities, related-party transactions, transfer pricing methods—and the analysis supporting all of these transactions—to demonstrate compliance with the arm’s length principle.
  • Country-by-country reporting (CBCR) enables tax authorities to conduct high-level risk assessments of potential base erosion and profit shifting. It’s typically shared among countries to provide detailed data on the MNE’s operations, profits, taxes paid, and other economic indicators across all jurisdictions. The OECD has more recently introduced a standardized template for CBCR to further simplify country-by-country comparisons.

The problem is that the BEPS project is only a framework—guidelines and recommendations—and not all countries have explicitly adopted it. (The U.S., for example, does not strictly follow the OECD’s three-tiered approach, although they do require taxpayers to provide similarly detailed information.) Still, in practice, the principles behind Action 13 carry significant weight and influence across the globe: at least 52 countries have adopted master and local files and at least 84 have adopted CBCR. Every country has its own requirements—and those requirements are constantly changing, so that tax authorities can determine new ways to determine substance vs form.

One interesting case study is the UK. Even though HM Revenue and Customs have generally followed the OECD guidelines—historically, they’ve been among the most aggressive in transfer pricing enforcement—it wasn’t until 2023 that the UK government officially adopted BEPS Action 13 into their documentation requirements. And when they did, they added an additional layer of documentation on top of the other three: a summary audit trail to help HMRC assess the recency and process of the information-gathering.

Transfer pricing documentation requirements may on paper seem onerous for MNEs, but there’s plenty of advantages: Should tax authorities detect a lack of substance, that documentation is the best defense. More broadly, published requirements provide a measure of certainty for taxpayers, instead of the ambiguity that could work to the government’s advantage. And with controversies and disputes on the increase in many parts of the world, that clarity has significant value.

2) Intangible Assets: From Form to Substance

How much is something that you can’t touch—like a famous logo—worth? Where does a name brand’s value come from? In what country or countries was that value created?

Trademarks, brand names, logos, product formulas, and other forms of intellectual property are often a company’s most valuable assets. Not too long ago, many MNEs took to “parking” those crown jewels (and their associated profits) under entities resident in tax havens where their actual physical presence, local commercial activity—and tax liability—were minimal.

“Transfer pricing must align with economic substance and value creation.”

A combination of lenient rules, weak or absent cross-border regulatory coordination, and a focus on form over substance in documenting these kinds of intercompany transactions created a tax loophole that was conducive to base erosion and profit-shifting.

That all started to change a decade ago when the OECD added Actions 8-10 to its BEPS Action Plan, making explicit the principle that transfer pricing of assets (notably intangible assets) should align with economic substance and value creation.

Easier said than done for companies with all kinds of intangible assets and all kinds of subsidiaries. Which entity performs which functions, contributes which assets, creates which value, accumulates which costs, assumes which risks? How do you break it all down?

To help untangle these threads, the OECD introduced the gold standard of measuring intangibles: a five-part functional analysis called DEMPE (development, enhancement, maintenance, protection, and exploitation). Here’s how it works:

  • Development: It often takes more than a village to create, say, a valuable piece of software. So which entity or entities are conducting the R&D, and how much is each contributing? (Hint: It may not be the legal owner.) Who is testing it? Who’s in charge of strategic decision-making for the development?
  • Enhancement: IP needs to evolve to stay competitive. Which entities are involved with enhancing the value of the intangible? Who is ensuring licenses are up to date? Who’s making sure the brand is still a trusted name? Who is building customer relations and tracking performance issues?
  • Maintenance: Who’s improving the manufacturing processes, or updating the technology? Who owns the advertising and marketing? Who’s monitoring the competition?
  • Protection: Which entity protects the legal rights to the intangible? Who registers the brand’s trademark and keeps track of licensing agreements? Who patents the manufacturing? Who ensures customer privacy protections are up to date?
  • Exploitation: How is the intangible used to generate profits—and who is generating those profits? Who’s responsible for marketing, licensing, and distribution? Who owns the sales platform in which the intangible is sold?

The implementation of Actions 8-10 has freed tax authorities to be much more aggressive in scrutinizing transactions involving intangibles, and several name-brand companies—from tech behemoths to Big Pharma, to household-name consumer brands—have been hit with extremely heavy penalties for failing to value their economic substance satisfactorily in recent years. Coca-Cola, to cite one case, was penalized a jaw-dropping $3.3 billion in US Tax Court. The judge in the case, Albert Lauber, wrote: “Why are the supply points, engaged . . . in routine contract manufacturing, the most profitable food and beverage companies in the world?”

A pretty high price to pay for failing to evaluate those DEMPE functions—and a warning sign that the IRS has now a track record of prevailing in this kind of situation.

3) Financial Transactions: How Defensible Is This Deal?

Financial transactions have often been neglected in transfer pricing audits, but those tides are turning. Tax authorities are recognizing that financial transactions can and do have a significant impact on the profitability of related entities within an MNE group. The OECD’s Chapter X, added to its Transfer Pricing Guidelines in 2020, sheds light on how to evaluate intercompany financial transactions like loans, guarantees, and cash pools.

Instead of solely focusing on calculating arm’s length interest rates, Chapter X challenges companies (and tax authorities) to question the very nature of these transactions. Would a similar arrangement be made at all by unrelated parties? MNEs are compelled in effect to dissect these transactions—to consider the parties involved, the associated risks, the industries, and the comparability with third-party arrangements before making this determination.

For example: Should an intercompany loan really be regarded as a loan? What are the actual positions of the lender and borrower with respect to that transaction? Does the borrower have the capability to repay the principal amount and interest? Does the lender have control over the risk—and the financial capacity to assume that risk? What are the debt-service aspects? How do the terms of the transaction compare with other options that would be available to the taxpayer?

4) Extraordinary Circumstances Call for… Extraordinary Effort

Transfer pricing reflects economic reality, and economic reality is susceptible to all manner of external shocks. As recent history shows, those shocks tend to multiply and reinforce each other.

Over the last three years alone, we’ve lived through a global pandemic, a supply-chain crisis, profound economic and financial-market volatility, massive fiscal and monetary stimulus, near-record inflation, a dizzying chain of interest-rate hikes, a credit crunch, a “Great Resignation,” an overvalued dollar, a nascent banking crisis—and a hot war in Europe. We’ve also seen some whiplash changes in governments and fiscal policies, often with a goal of replenishing post-Covid, post-stimulus coffers.

So where does that leave transfer pricing?

Tax authorities understand these are extraordinary times and that businesses may face economic uncertainty, financial losses, and difficulties in maintaining their usual operations. (In fairness, governments have suffered their own losses and uncertainties.) So, they’ve made room for companies to adopt a more flexible approach to demonstrate arm’s length results.

But what exactly does “flexible” mean, when you’re facing situations no tax director has likely ever faced before?

It could mean casting a wider net to underscore your analysis—for example, extending the three-year range to show arm’s length ranges before an adverse economic event. Or adjusting your transfer-pricing methods, broadening your search to go beyond local or regional comparables. Or looking at limited-risk distribution models differently.

And then there’s the “but-for” factor. Every country suffered through the Covid crisis, and every country offered its own type and amount of assistance to hard-hit businesses. That, too, can lead to scrutiny in the case of intercompany transactions: you may need to demonstrate which transactions, at which price, would have (or not have) been done but for the circumstances brought on by the pandemic. You may also need to demonstrate how losses are caused by economic uncertainty, not transfer pricing.

One thing’s for sure: Extraordinary circumstances mean you will need to document more robustly, and more flexibly. While cost-cutting may be necessary in times of uncertainty, compliance becomes an even more important investment. Now could be the time for out-of-the-box thinking surrounding your analyses, but the goal of documentation and compliance will remain the same: to demonstrate arm’s length relationships and transfer prices based on current market value and economic reality—as opposed to convenient arrangements. In other words, substance over form.