Duff & Phelps: TP: is there a requirement for a two-sided analysis - Shiv Mahalingham
Some years ago, one of Duff & Phelps's clients referred to transfer pricing (TP) as "deciding which fiscal administration you want to upset the least". Recent OECD guidance and front-line audit experience has confirmed the importance of designing a TP policy that ticks as many boxes as possible in as many locations as possible despite the fact that the underlying economic analysis may point to a different result. Considering TP from the position of both (or all) parties to the transaction is recommended.
Statutory requirements: inconsistent with the OECD
Certain locations have a statutory calculation that must be applied to intra-group transactions. Recent experience with Brazil has demonstrated that a royalty rate paid above 1% of sales is likely to be met with a disallowance. Depending on the nature of the transaction, the intellectual property owner may require an arm's-length royalty (expressed as a percentage of sales) in the following range from operating companies using the intellectual property in question: 1% lower quartile, 3% median and 5% is upper quartile.
There are a few of methods that could be deployed to redress this balance:
- select a 1% rate for Brazil on the basis that this is still within the arm's-length range
- select a 3% rate and make an adjustment in the local country accounts
- rebalance the economic substance between the UK and Brazil to ensure that 1% is more appropriate (with Brazil more involved in certain strategic functions where possible)
- implement a system of credit notes between the UK and Brazil that is equivalent to the amount of 'double taxation' suffered.
Inconsistent local inspector preferences/practice
Recent experience in Germany has shown that local TP inspectors do not like to see a set of comparable companies that include loss-making entities (whereas OECD guidance advocates the inclusion of such entities when isolating the core factors of comparability). Therefore, Duff & Phelps runs the quartile ranges of possible outcomes with loss makers included and without, and then picks a position in the overlap.
Local country margins
Consider the above examples but in the context of global TP - it has become essential to consider the perspective of both tax authorities, even when one-sided methods are applied. In many situations, the company has implemented a 'hurdle' or 'blocker' to ensure that local country margins do not fall below a certain target level - this has become increasingly important in the context of country-by-country reporting. This may be challenged in the entrepreneurial/principal jurisdiction if such adjustments would erode the arm's-length reward to the jurisdiction below a certain level, and quarterly calculations and monitoring of such a TP policy will be important. Duff & Phelps has had some success agreeing this framework under advance pricing agreements (and so there appears to be support for this from fiscal administrations).
Recommendations from the experts
The above examples demonstrate the importance of looking at TP from the perspective of both parties in the transaction. Germany and Brazil are but two examples of local practice and/or local regulation being inconsistent with OECD principles, and it is important for businesses to ensure that a measured approach is adopted without succumbing to pressure to commission separate local TP studies in each operating location.
In addition, in recommending a two-sided consideration, preparing two sets of analysis and two sets of documentation (as many providers have been pushing in the market place) is not advocated; this concept is about balance and minimising the risk of a TP adjustment within a global TP structure. Overall TP risk is the product of detection risk and adjustment risk, and, by adopting a measured TP policy, it may be possible to mitigate negative cash-flow impact.