Why it is important to be proactive when it comes to the complicated issue of transfer pricing.
Transfer pricing occurs whenever two companies that are owned by another company, with each of them located in different countries, trade with each other.
It might be the case, for example, that a French company owns one subsidiary company in Romania and another in Italy. The Romanian firm might make a product that the Italian firm wants to sell. If the companies were wholly unrelated to each other - if they were not owned by the same company - then the two would negotiate in order to reach a fair price from which both would benefit. That would be the 'arm's length price'. This is the price that the market has set by negotiation, which is believed to be fair and correct for taxation purposes.
This is the yardstick which transfer pricing is trying to emulate. What actually happens is that because both companies have the same parent company, the parent company may decide to set a different price to the market price. It might set a price that gives it the lowest overall tax rate. The parent company will then declare the resulting profit in the country which has the lowest tax rate. This tends to lead the tax authorities in the country where profit is not declared to protest, as they feel they are unfairly missing out on tax revenue.
Multinationals need to tread carefully. Most states have tax laws which are designed to prevent them from reducing taxes inappropriately by entering into transactions among related parties on terms that would not occur in a comparable 'arm's length' situation.
Some companies have already fallen foul of the regulations. In September 2006, pharmaceuticals firm GlaxoSmithKline agreed to pay the US Internal Revenue Service (IRS) $3.4bn to settle a transfer-pricing dispute that stretched back to the 1980s. The IRS said the agreement was the largest tax settlement payment in the history of the agency. The dispute concerned the amount of taxes owed under the transfer pricing method by Glaxo Wellcome, which merged with SmithKline Beecham in 2000, from 1989 to 2000, and taxes of the merged company up to 2005.
BE PROACTIVE
Patrick Cauwenbergh, the partner in charge of Deloitte's Brussels transfer pricing practice, says that disputes with the tax authorities can be avoided if companies are proactive. 'In a lot of countries, the best way to be proactive is to prepare your documentation,' he says. 'This shifts the burden of proof onto the tax authorities. They are likely to be much more lenient towards you if you have done your homework in advance - if you don't, they will simply do it themselves, using their own rules.'
This advice echoes the recommendations in the OECD's transfer pricing guidelines. These state that as long as the taxpayer has prepared information about transfer pricing, the tax authorities have to use this as their starting point when they assess the company. In principle, they have to accept it unless they can prove that it is wrong. That is a completely different situation from the tax auditors carrying out their analysis from scratch because the taxpayer has taken no action at all. The approach can be taken a step further if the company discusses its transfer pricing arrangements in advance with the tax authorities.
This can be particularly useful for complex situations like intangible transactions, and it can lead to Advance Pricing Agreements (APAs), where the company reaches an agreement with the tax authorities about what constitutes an appropriate transfer price for a particular transaction. 'This is becoming more and more common, especially for more complex transactions', says Cauwenbergh. 'It means that you avoid an audit and you avoid double taxation, which a lot of multinationals find to be the worst possible situation.'
Obviously, it is a good idea for companies to keep a close eye on tax legislation in the countries in which they operate. In many countries, there are regular administrative circulars in which the tax administration outlines what it considers to be 'red flags' for an audit.
These could be ongoing losses for a distributor, restructured operations or transactions with tax holidays. 'If you know this, and you know that you are going to attract the auditors' attention, it's important to be proactive and at least document it,' says Cauwenbergh. 'If you feel comfortable about the transfer pricing, then go for a ruling. Otherwise, you can be almost certain that it will be audited. The tax authorities can then attack you and impose penalties.'
Prolonged disagreements over double taxation can lead to mandatory arbitration at the EU Arbitration Convention. According to Martin Schmitt of PricewaterhouseCoopers in Germany, this is something most companies prefer to avoid. 'Normally clients are quite reluctant to go through a complex procedure which takes a long time and where a large amount of documentation has to be prepared,' he says. 'No one wants to agree to it because there is so much administration and so many consultancy fees. This means it is not really worthwhile and only used if something goes seriously wrong.'
One final point to note is that transfer pricing is about more than just direct taxes. It is also about customs. Customs authorities often use different methods to transfer pricing authorities, which can cause problems.
'It's very important if you are looking proactively at transfer pricing that you reconcile both, and if you go for a ruling in those countries where you can combine customs and transfer pricing, go for a combined ruling,' says Cauwenbergh.
