Written By: Darren Morris – Corporate Finance
Transfer pricing represents a tax risk that is not totally under the control of banks, but can they really manage this risk? It has now been around five years since international transfer-pricing rules were set by the OECD (Organisation for Economic Co-operation and Development) to oblige multinationals to expose in a transparent way their methods of calculation of intergroup invoicing. Whether the operations between international subsidiaries of a group are goods, services or financial operations, multinationals now have to report to each tax jurisdiction of the countries in which they are operating the nature and amount of their cross-border transactions.
In the 2016 Ernst & Young (EY) transfer-pricing series “On the spotlight, a new era of transparency and risk”, it was acknowledged that management of tax risk, and in particular management of transfer-pricing risk, constitutes one of the top priorities of multinational companies. Banks have increased their level of aversion to transfer-pricing risk, also linked to dangerous reputation risk. 75 percent of the surveyed companies confirmed tax-risk management as their top priority for banking and capital markets; and for the wealth and asset-management sectors the percentage reached 88 percent. This Ernst & Young 2016 survey covered 623 transfer-pricing executives in 36 jurisdictions across 17 industries.
Management of transfer-pricing risk means avoiding audits if possible but prevailing when they happen; avoiding double taxation; and above all, protecting the reputation of the company.
And to be ready in case of a tax audit, multinational companies face tremendous work, which they admit is not yet completed.
The OECD obliges companies to report transactions in a country-by-country report (CbC), meaning companies have to identify all intragroup transactions, their volumes and rates, and document the methodology used to set their intergroup prices. But taking into account the diversity and volume a multinational group can have, the surveyed companies declared to Ernst and Young that:
- only 21 percent are fully compliant in all jurisdictions in terms of the BEPS (base erosion and profit shifting)-mandated documentation;
- 44 percent say that they are fully compliant only in situations in which transfer pricing is viewed as high-risk;
- 22 percent say their approach is to adapt their existing master files or local reports as necessary or on demand. One out of 10 companies say they create documentation only in response to a specific audit (with 3 percent citing “other” but still non-compliant practices).
There can be several reasons for 79 percent of the surveyed respondents declaring they are not totally compliant:
- Multinational companies face huge projects and have to direct more resources towards compliance.
- They have implemented real systems to gather and present the information required under national CbC rules, and ensure that this data is filed on a timely basis in the right jurisdictions.
- Processes are heavy and still very manual.
But even if companies are concerned about the topic, some countries’ attitudes raise criticism.
Each and every national tax authority has its own pace and sensibility to adopt, adapt and apply the transfer-pricing rules of the OECD. The result is quite hazardous when speaking of tax audits, penalties and litigations. Only national jurisdictions can arbitrate in each country.
The tax treatment (audit, interpretation of rules and litigations) are totally different from one country to another:
- The top three most frequently cited nations in the Ernst and Young study, in which transfer-pricing policies have faced tax audits, are: 29 percent Germany, 25 percent United States and 25 percent India.
- The top five countries in which penalties have been imposed are: Germany, the United Kingdom, Switzerland, Japan and the United States. In 16 percent of cases, penalties were imposed; in 16 percent, the result is still unknown; but luckily in 62 percent of cases, no penalties were imposed.
But again, discrepancies are significant between, for instance, India and the US or Germany:
- Only 21 percent of Indian examinations resulted in no adjustment. Moreover, 38 percent of respondents said that their Indian cases remain unresolved, indicating that the procedures continue to be lengthy propositions.
- By comparison, just 19 percent and 14 percent of respondents said that their German and US cases were unresolved.
In some countries, such as Russia, methodology such as direct-cost invoicing (+ mark-up) is preferred by tax authorities, which complicates a lot of the work of documentation for banks. This may also happen in European countries such as Croatia. Companies subject to CbC reporting rules worry about the security of sensitive commercial information passed between national tax authorities, and the consequences if such data falls into the wrong hands.
In a recent Bloomberg article titled “Focus OECD Work on Practical Results, Not Participation: Stack”, Robert Stack, a former US deputy assistant Treasury secretary for international tax policy, stated that the success of the OECD project will be based not on how many countries are around the table to create the framework, but “whether it can produce work products fit to purpose and that address needs of companies and the international tax community”. And he stated that political pressure and the European Union along with other countries have spurred the attempts “to use transfer pricing as effectively like anti-abuse rules”, pushing aside the arm’s-length standard that has underpinned OECD transfer pricing for decades.