Now is the Time to Plan for Your 2015 and 2016 Transfer Pricing Positions

For many companies, the 2014 tax filing season has either come to an end or will shortly.

For those with global operations, now is an opportune time to revisit operational flows reflected in tax return(s) and consider whether any actions can and should be taken now to improve future tax results. For example, what is the company’s effective tax rate (ETR) and how does it compare to its peer group? To the extent ETR may be perceived as high relative to peers, it may be worthwhile to assess whether your existing transfer pricing policy and structure can be modified to produce more tax effective and efficient operational flows.  

Does your transfer pricing policy efficiently and effectively cover current operational flows?

From a compliance standpoint, several basic questions should be addressed including:

  • Are there any de facto related-party transactions of material size not covered in either your existing transfer pricing policy or your contemporaneous transfer pricing documentation?
  • Are there intercompany licenses in place that grant certain rights from your parent company (IP owner) to downstream operating affiliates and have the license fees been benchmarked for consistency with the arm’s length standard?
  • For related-party service transactions, were the cost bases accurately disclosed with reference to work papers? For example, were costs excluded for: (a) activities that did not provide a direct benefit? (b) activities of a stewardship nature? (c) pass-through expenses?
  • Were appropriate mark-ups applied based on reference to comparable third-party benchmarks?
  • Was a transfer pricing report prepared in certain jurisdictions that require formal contemporaneous documentation? In Canada, for example, taxpayers must disclose in their tax return whether they prepared contemporaneous transfer pricing documentation. In China, taxpayers must complete nine related-party transaction forms and, if certain volume thresholds are met, must also submit a formal transfer pricing report. Many other countries have similar requirements in place.

How will your transfer pricing position impact your tax provision?

Pursuant to ASC 740, publicly traded companies are required to identify and quantify their uncertain tax positions. Accordingly, because transfer pricing positions routinely end up being challenged in tax audits, taxpayers need to assess their processes for identifying, quantifying, and documenting not just the transfer pricing positions themselves, but also the tax provisions taken in regard to the transfer pricing positions. Any errors and/or lack of documented support could lead to a significant audit deficiency. Furthermore, such events will call into question a taxpayer's ability to satisfy its professional financial responsibilities through adequate internal control measures.

Can current operational flows be revisited in order to generate efficiencies?

In many cases, a company’s operational flows evolve over time in response to changes in, among other things, market opportunities, locations of newly acquired companies, key customers, key suppliers, specific functional departments and/or executives. The key question that should be asked regularly is: does the company’s current operational flows contain inefficiencies that should be streamlined. In addressing this question, a few basic areas should be considered, including:

  • Ownership of intangible assets: In determining how operating profits should be allocated among entities within a controlled group, whether U.S. or foreign, place significant weight on which party(ies) own intangibles, particularly those connected to intellectual property (IP). In practice, examiners tend to connect IP ownership with the rights to accumulate residual profits after all other routine functions are compensated. Thus, the location of IP rights can have a significant impact on a company’s ETR. It is important therefore to evaluate carefully the operational requirements of IP ownership and, where feasible, transfer IP rights to jurisdictions that offer both operational and tax efficiencies.  
  • Product flows: Taxpayers often assume that because the results of their related-party product transactions are consistent with those of unrelated third parties, such related-party transactions would also be considered at arm’s length. However, that is not necessarily true because in many cases, the related-party transactions differ significantly from the unrelated third party transactions. For example, related party product transactions often operate according to a two-tiered structure in which a parent company sells product not just to related parties in foreign markets but also to a related party that acts as a regional super-distributor. In such case the regional super-distributor sells to unrelated third parties but also provides related parties in other jurisdictions with regional support and oversight. If structured properly, the super distributor may be entitled to accumulate residual profits while capping the profits in the sub-licensing territories to a lower, routine level. Thus, while it may turn out that the super-distributor earns profits consistent with what unrelated parties earn, the super-distributor may in fact be entitled to higher profits because its functions are likely broader than those performed by the unrelated parties. Bottom line: transactions that appear to be arm’s length may not be and further, there may be opportunities to improve tax efficiencies that aren’t being pursued.
  • Service flows: Many companies routinely streamline their support functions into shared services organizations, locating them according to where resource pools and/or lower wage levels reside. It is a best practice to locate service functions to jurisdictions offering a balanced mix of the desired resource pool, lower wages and favorable tax rates. Note that when high-value services are performed, it is important to ensure they receive arm’s length compensation. Otherwise, tax authorities may assert that the local service affiliate has in fact created value intangibles/IP, which entitles it to accumulate (undesired) residual profits.  

Plan now to get ahead

Before fiscal year 2015 winds down, taxpayers should evaluate the transfer pricing position implied by their operational flows and consider whether any steps should be taken to avoid unpleasant surprises. Whether that means accounting for transfer pricing adjustments to avoid an ASC 740 reserve, preparing (or updating) contemporaneous documentation or evaluating whether operational flows should be restructured, taxpayers would be well-served to apply a measure of prudence now while there is still time to properly align their fact profiles, transfer pricing policy and tax accounting.