Article by Andrew Hickman, Senior Manager in KPMG's Global Transfer Pricing Services, published in April 2001 edition of "Tax Adviser". Transfer pricing: does size matter?
Transfer pricing and smaller multinationals
- Transfer pricing affects all multinationals, small and large.
- Documentation requirements and audit risk are not determined by size of the multinational.
- Limited scope exists for reducing disproportionate compliance burden for smaller multinationals.
- Some assistance provided by risk-assessed
documentation, arbitration, formal and informal rulings, and software solutions.
The abolition of the discretionary nature of the UK’s transfer pricing rules and the integration of transfer pricing within Corporation Tax Self Assessment (CTSA) have had, in one sense, an equitable impact. All affected taxpayers, great and small, have to comply with the transfer pricing rules and adjust intra-group pricing to comply with what would have been charged at arm’s length. But in another sense the impact is inequitable. Compliance costs tend to have a significant fixed element. The costs involved in putting in place adequate transfer pricing documentation do not vary in proportion to the size of the transaction but to the nature and complexity of
Transfer pricing issues cut across size
Smaller multinationals can have the same kind of transactions as larger multinationals, and transfer pricing issues can be common to both. Even one of the simplest commercial functions found in large and small multinationals, that of import/distribution, potentially gives rise to a full range of transfer pricing issues relating to products, intangibles, services, and funding. For each of these transaction categories there are likely to be a number of issues that need to be considered regardless of the size of the multinational, and the following outline is intended to be indicative rather than exhaustive:
- Products – what is the arm’s-length price of the product supplied intra-group? If products are also supplied by third-parties, are they sufficiently similar to group products to be used as a pricing comparable? Does the same effort go into selling them? Are the risks the same? If a resaleprice method is used to give the reseller a discount from the end-selling price, does that margin take into account the particular functions and risks of the group importer/distributor. Does it perform all functions of a typical importer/distributor, or more limited ones. Does it incur market, credit, inventory, currency, product risks?
- Intangibles – does the pricing of product recognise any embedded intangible value? Should there be a separate payment for the use of intellectual property, such as a brand or technical know-how, provided intra-group? Does the importer/distributor own any intangibles that contribute to value?
- Services – are there additional intra-group services received or provided? Does the importer/distributor benefit from centralised services in relation to, say, marketing, accounting, or administrative functions? Does the importer/distributor provide services to group members because, for example, it undertakes warranty repairs on behalf of the supplier or because it acts as a regional centre providing support functions to smaller group distributors?
- Funding – is the importer/distributor funded by debt from the group or from third parties under group guarantee? Is the interest rate arm’s-length? Is the amount of debt funding in excess of that which would have been achieved at arm’s length?
Risk of audit is not determined by overall size
It might be thought that smaller taxpayers are less liable to a transfer pricing audit from the Inland Revenue than larger, potentially more fruitful, targets. The Inspector’s Manual states at IM 4662:
‘A transfer pricing enquiry is frequently time consuming and resource intensive both to the Inland Revenue and to the taxpayer concerned. Proper selection of cases for enquiry is thus crucial and cases should be taken up for enquiry only where there is substantial tax at stake.’
This statement may give some grounds for asking the Revenue to drop trivial enquiries, but what is substantial is not made clear, and the amount is likely to vary in accordance with the type of tax office responsible. However, the statement is not an
amnesty for smaller multinationals. The overall size of the multinational does not necessarily determine the importance of transfer pricing. A major multinational may have relatively insignificant intra-group, cross-border transactions which consequently do not have a material impact on profitability, whereas a small subsidiary may have significant intra-group trading, the terms of which determine its profitability. For this reason a UK distributor selling £50m of goods, all purchased intra-group, may be regarded as a more suitable audit target than a £1bn-plus multinational.
The writer’s experience in reviewing transfer pricing enquiries made by the Revenue for CTSA periods indicates that taxpayers with small UK operations are very well represented. Apart from the amount of tax considered to be at stake, interest in smaller UK operations may also arise because, as a result of the simpler functions, it is easier for the examining Inspector to identify the transfer pricing issues. Certainly, a UK-based distributor of a foreign parent or a service provider are regular audit targets. In addition, changes to commercial or pricing structures, a common reason for taking up transfer pricing enquiries, are easier to recognise in an entity which has only one function. In other words, it is easier to spot a winner when the field is smaller.
Documentation is not affected by size
All taxpayers are covered by the same requirement to keep and preserve records in support of a tax return, including records supporting self assessment of transfer pricing. The Revenue states that it ‘does not want taxpayers to suffer disproportionate compliance costs, nor to be required to prepare and retain documentation which is out of keeping with the nature, size and complexity’ of the business or transaction (see the Revenue’s Tax Bulletin, issue 37, October 1998). However, the list of documentation then makes no distinction between documentation which may be sufficient in small cases and documentation which would be required for larger cases. In all cases documentation would include, among other items, identification of:
‘the method or methods by which the nature and terms of relevant transactions were arrived at, including any study of comparables and any functional analysis undertaken; how that method has resulted in arm’s length terms etc. or, where it has not, what computational adjustment is required and how it has been calculated. This will usually include an analysis of market data or other information on third party comparables.’
The discussion of penalties in Tax Bulletin, issue 38 reinforces the need for comparable studies, and it is perhaps unfortunate that the examples concentrate on a situation that is extremely common for smaller companies: the provision of services priced in accordance with the cost-plus method. Where the plus is determined to be deficient, the Revenue would seek a penalty unless the taxpayer can produce evidence that it had considered arm’s-length pricing in setting the plus. The examples that escape a penalty are those where there is evidence of a search of industry data for comparable mark-ups. Reliance on a group policy alone or assertion that the pricing is arm’s-length without evidence would attract a penalty.
No safe harbours
Safe harbours for smaller taxpayers, providing shelter from transfer pricing compliance, are unlikely to be adopted in the UK given the failure of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations to recommend their use. However, the Guidelines do state that flexible administrative practices towards smaller multinationals may achieve to a lesser extent the same objectives as safe harbours (4.123). Greater tolerance towards smaller transactions would be welcomed in setting documentation requirements and in identifying audit targets.
What can be done for smaller multinationals?
Given that there is no reduction in documentation requirements for smaller multinationals and at least equivalent audit risk for smaller multinationals as for larger taxpayers, assistance in relieving the disproportionate transfer pricing burden is limited.
However, there are some options that may help.
It is unrealistic to expect that every transaction potentially covered by the transfer pricing rules will be subject to the same level of attention. Indeed the Revenue’s reference to documentation in keeping with the size of the transaction acknowledges this and is endorsed by the references in the Guidelines to documentation in keeping with the complexity and importance of the matter. Some risk-assessment and
prioritising in preparing documentation are sensible measures since the charge for the provision of support services which have cost £20k would not seem to merit the same intensity of attention as the sale of goods for £2m or the licensing of valuable intellectual property. All transactions with affiliates need to be identified and documented, but then the extent of the econo s, and complexity of the pricing approach.
When considering how to benchmark the pricing against market pricing, it is important not to overlook the possibility of being able to use internal data that may remove the need for an intensive review of external comparables, such as the margins achieved by independent businesses. The multinational may not be conversant with transfer pricing jargon, but may nevertheless have a shrewd grasp of pricing in its business sector and its competitive position that can be documented to form a basis of support for its own pricing. Internal arm’s-length comparables may also exist that can be accurate indicators of the market price. For example, a group distributor might buy some of its product from an independent supplier; if it is making the same margin when selling this product as made on products supplied intra-group, then it should be considered whether this represents adequate support for the transfer price. The Revenue will generally ask about internal comparables and consider their relevance, even where modification is required to achieve proper comparability.
Sophisticated software solutions are available that have the capability to assist a multinational in producing the necessary documentation to support transfer pricing. Some of these enable a multinational to organise the collection and presentation of the required information, search for comparable data to benchmark the pricing of the transactions, and prepare a report. Such products can provide a cost-effective
solution for smaller multinationals, and the necessary training and support is sometimes available as part of the package.
Rulings and informal agreements
Rulings can reduce the burden and risks associated with transfer pricing compliance. The change from a discretionary to a mandatory transfer pricing regime within CTSA may have reduced the willingness of the Revenue to enter into informal agreements on transfer pricing. Pre-CTSA, informal agreements were fairly commonly reached in order to determine the profits of simple UK branch operations, subsidiaries providing routine services, and head office costs. Although the pricing may have been a fairly arbitrary cost – plus five – ten per cent, the benefit of certainty at low cost for a small but disproportionately tricky transfer pricing issue was valued. The Revenue has recognised the benefit and is prepared under CTSA to apply the existing framework of posttransaction, pre-filing rulings as outlined in Code of Practice 10 (COP 10) to transfer pricing issues in certain limited circumstances. (It may be that not all Inspectors regard CTSA as having reduced their authority to enter into informal agreements, and it may be worth enquiring whether a less formal approach than the post-transaction ruling would still be available from the company’s local Inspector.) COP10 itself makes no specific reference to transfer pricing rulings, but it is understood from comments made by the Revenue that guidance has been issued internally to Inspectors. The circumstances in which a ruling would be available for transfer pricing are understood to be:
- where the cost-plus pricing method is appropriate;
- where costs are small or relatively small;
- and where there is a rationale for the plus.
Costs under £10m are understood to be regarded as small, but the reference to relativity does extend the scope to, for example, head office costs that may run to considerably more than £10m, but are insignificant in the overall operations of the group. There is required to be some rationale for the plus, and it is understood that the local Inspector is authorised to deal with the request for a post-transaction ruling on these matters. The ruling would be valid for the particular tax return, but could be renewed annually, and is binding on the Revenue, subject to correct and complete information being provided and to any subsequent legislative changes. Rulings reduce the intensity of research necessary to document and support the pricing adopted, and would provide certainty that the tax return would not be challenged in this respect.
An Advance Pricing Agreement (APA) is a formal transfer pricing agreement for a future period of years. APAs can be reached with the Revenue and, when combined with an agreement between the Revenue and another tax administration under the terms of a tax treaty, APAs can determine the transfer pricing on both sides of the transaction. APAs are particularly useful where:
- transfer pricing is not straightforward,
- there is scope for diverging views being taken by tax administrations,
- the value of the transactions subject to the transfer pricing rules is relatively significant,
- there is a desire to avoid enquiries, adjustments, and potential double taxation and to obtain underpinning for the allocation of profits intra-group, and
- there is a desire to undertake a flexible, co-operative approach to problem-solving.
APAs also offer a means of dealing with an existing transfer pricing enquiry in the UK or overseas, by seeking to roll back the APA approach to the disputed earlier years. Indeed, the Revenue have been known to suggest this action.
Smaller multinationals are not excluded from APAs – the Revenue recognises that smaller businesses encounter complex transfer pricing issues and that APA applications will not be declined because the transactions are small (SP 3/99) – but the investment cost is likely to be a factor. Nevertheless, preparing adequate documentation and dealing with enquiries from tax administrations in the absence of an APA also tie up resources and incur costs, and the value of an APA spread over its term of, say, five years, may begin to look attractive. The ‘Expression of Interest’ stage of the APA application offers a useful means to discuss a potential application with the Revenue before the process is engaged. This can be done on an anonymous basis if required.
The European Arbitration Convention provides for tax administrations within the European Union to resolve a transfer pricing issue affecting their respective taxpayers, or have it resolved for them by independent arbitrators, and eliminate the double taxation within a fixed time-scale. This may well be a cost-effective means of resolving a transfer pricing enquiry, particularly if the Revenue is prepared to postpone collection of the additional tax. However, it is not advisable to ignore compliance responsibilities in favour of a sweeping-up by arbitration since access to arbitration is denied where a penalty attaches to the transfer pricing adjustment. Beyond the European Union, a company can invoke the Mutual Agreement Procedure of the applicable tax treaty and require the tax administration to endeavour to eliminate double taxation arising from transfer pricing adjustments, but, unlike the Arbitration Convention, there is no requirement to ensure that double taxation is in fact eliminated nor a fixed time-scale for doing so.
In practice the size of the multinational does not matter in transfer pricing. In the continued absence of special regimes for smaller transactions it is likely that the compliance burden will remain proportionately greater for smaller multinationals.
Nevertheless, there are some effective options available for managing the transfer pricing burden.
Smaller multinationals should consider:
- Sensible, risk-assessed documentation
- Internal data
- Software solutions
- Informal Rulings and APAs
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