Transfer pricing getting more scrutiny: a survey by Ernst & Young finds that government authorities are putting more attention and more resources to examining--and even auditing--transfer-pricing transactions.

As multinational companies globalize their operations and international trade continues to increase in importance, tax issues associated with varying jurisdictions take on new importance--increasing government attention and focus on transfer pricing. Transfer-pricing audits are becoming more and more common, and multinational companies are being forced to pay closer attention to their transfer-pricing policies and procedures, according to the Ernst & Young Transfer Pricing 2003 Global Survey.

The results of the most recent E & Y survey show that transfer pricing is the most important international tax issue multinational companies (MNCs) now face. This high level of company concern is driven by the fact that 86 percent of MNC parent company respondents and 93 percent of subsidiary respondents indicated that audits by tax authorities are becoming a rule rather than an exception. This audit increase is, in turn, driving a new focus on compliance. Of parent company respondents that have experienced an audit, half have reviewed their transfer-pricing documentation practices as a result. These findings summarize a spectrum of transfer-pricing management issues from planning to documentation and controversy.

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Staying Current By Planning

It is increasingly important for MNCs to design their transfer pricing by taking into account both tax and commercial considerations. This view of planning is not the nefarious view that governments have, which holds that companies artificially manipulate intercompany pricing to achieve undue tax advantages. Rather, this is the view of planning in which operational and regulatory changes are taken into account in keeping transfer-pricing policies current.

Globalization implies supply chain changes. As companies increase their volume of related-party transactions, change the types of these transactions or switch their, the policies and pricing of the transactions should change, too. Unfortunately, only a minority of survey respondents seems to recognize the connection: 32 percent of parent respondents said that business unit leaders were involved in transfer-pricing design.

Survey responses show transfer-pricing responsibility rests with either the CFO or the tax department. These results suggest a less balanced allocation or sharing of responsibilities than one might expect, given the importance of business strategy in the design of transfer-pricing policies as well as the "business approach" taken by many transactions-based tax regimes.

At the same time, proactively taking into account aggressive new legislative, regulatory and enforcement efforts aimed specifically at transfer pricing is another aspect of planning. Seventy-two percent of parent company respondents and 75 percent of subsidiary respondents said they reviewed their current transfer-pricing documentation in light of current revenue authority pronouncements and trends.

For example, 80 percent of Germany's parent-company respondents indicate they are currently reviewing their transfer-pricing documentation in relation to newly introduced documentation requirements. In the U.S., the government has proposed services regulations aimed at recognizing the reality of an increasingly important global service economy. Keeping up with the changes and understanding the often-subtle differences in local approaches to the application of the arm's-length principle constitutes sound transfer pricing-based tax planning.

Documentation and Compliance

Even if MNCs don't take an integrated tax and business approach to transfer-pricing design, it's still a compliance activity. Indeed, most survey respondents (52 percent of parent companies) said that transfer pricing is only a compliance activity. Documentation strategies should be driven by an assessment of the significance of current transactions and which jurisdictions pose the highest risk for examination.

While MNCs are expanding into new tax jurisdictions, they must also expand their transfer-pricing compliance process to encompass each jurisdiction's requirements. When companies enter a new jurisdiction, they find that the arm's-length standard is a somewhat fluid transfer-pricing concept, capable of interpretation and implementation in a variety of ways. Seven more countries introduced transfer-pricing documentation rules in 2003, bringing to 27 the number of countries with effective documentation rules.

The divergence in approach among tax administrations is a growing concern to MNCs, resulting in more focus on documentation strategies. Nearly two-thirds of parent company respondents, and 56 percent of subsidiary respondents, see documentation as more important than they did two years ago. Only 1 percent saw it as less important.

In an attempt to provide some cross-jurisdictional consistency, the Pacific Association of Tax Administrators (PATA) published a single documentation package in 2003 intended to meet the requirements of the member jurisdictions (Australia, Canada, Japan and the U.S.). However, without a convergence in policy and practices at the national level, the PATA initiative hasn't made much of an impression on the survey respondents: Only around half of parent respondents and one-third of subsidiaries based in the PATA countries said they were familiar with the package.

Consistent with the lack of interest in this PATA initiative, most survey respondents said they don't take a global approach to documentation. Less than one-third of MNCs prepare coordinated multi-country documentation. The country with the highest proportion of respondents that did so was Switzerland (60 percent of Swiss-headquartered respondents). Interestingly, Switzerland also reported one of the highest percentage of headquarters companies that have been audited somewhere in the world since 2000. It is not surprising, then, that most Swiss respondents (72 percent) believed the importance of transfer-pricing documentation has increased since 2001.

Audits and Controversy

The importance of maintaining documentation is also directly linked to the incidence of audit. It is logical that Swiss-headquartered companies were also most likely to have been subject to a transfer-pricing audit, since 80 percent of Swiss respondents experienced a transfer-pricing examination somewhere in their global operations in the past three years. Overall, since 1999, nearly half (49 percent) of parent company respondents said they were subject to a transfer-pricing audit somewhere in their organization. A similarly high number of respondents expect this audit attention to continue. In 2003, 76 percent of parent respondents and 77 percent of subsidiary respondents believed that a transfer-pricing examination will likely occur within their group during the next two years.

Survey respondents also believe transfer-pricing audits are increasing because revenue authorities are more sophisticated about transfer-pricing issues. Tax authorities confirm that perception, reporting that they are adding to their transfer-pricing examining staffs and the amount of training they receive.

The focus of the authorities is still large companies and tangible property transactions. However, as the volume of services transactions increases, the examination of these transactions is also increasing. In the 2003 Survey, 29 percent of audits involved services transactions--an increase of 12 percent over the 2001 results. With the introduction of the recently released U.S. proposed regulations on services, attention on these transactions will likely grow and lead to more audits.

The problem for multinational companies is not only the increased likelihood of audit, but the increasing difficulty of the examinations as authorities' understanding of the issues gets more sophisticated. One-third of audits concluded since 1999 led to an adjustment.

Parent-company respondents noted that 40 percent of adjustments resulted in double taxation. Even worse, one in three of the adjustments also included a threat of penalty, and half of those threatened had some form of penalty actually imposed. To resolve transfer-pricing disputes with the tax authorities, companies have to engage in a time- and resource-consuming process.

The Importance of Globally Consistent Documentation

Given this information about the actual audit experience, it comes as no surprise that strengthening and improving documentation is a priority among survey respondents who have had recent audit experiences. This, coupled with the stated intent of many tax authorities around the world to continue their focus on transfer pricing, should serve as a "heads up" to other MNCs to tighten up their approach.

Globally consistent transfer-pricing documentation should be a key component of a multinational company's controversy and risk management strategy. Most respondents that have experienced an audit and subsequently reviewed their documentation report improving their documentation practices as a result. Further, a significant portion (half or more) of both parent and subsidiary companies have documentation maintenance protocols to review intercompany pricing policies in light of business change.

As companies expand their operations around the world, it is becoming increasingly important for them to pay attention to all aspects of transfer pricing: from an operations and tax planning perspective, to controversy management and compliance strategies.

RELATED ARTICLE: M & A Implications Of Transfer Pricing

The Ernst & Young Transfer Pricing 2003 Global Survey reveals that many multinationals fail to re-examine their transfer-pricing policies in the wake of mergers or acquisitions. Strategic business actions are an appropriate justification for reevaluation of both entities' current intercompany pricing systems. However, the survey shows that such reviews are the exception rather than the rule.

While nearly half (46 percent) of the survey's parent respondents had been through a merger or acquisition in the last two years, only 18 percent either recognized the need or used the opportunity to reexamine their overall transfer-pricing policies. Sadly, the practice has not really changed since the last E & Y transfer pricing survey in 2001, when 50 percent of those respondents that had been through a merger or acquisition reported applying the dominant company's transfer-pricing policy.

In the most recent survey, almost half of the respondents who went through a business combination again simply used the dominant player's transfer-pricing policies. Further, another 27 percent of that group simply let multiple systems continue without a clear proactive review. Indeed, less than one in five in this group reexamined the entire transfer-pricing policy in light of the business change.

These responses demonstrate a disconnect between management and fiscal transfer pricing. Only 40 percent of parent company respondents and 36 percent of subsidiaries believe that transfer pricing is more than just compliance. This often means that as businesses restructure, the pattern of transactions and the allocation of functions, assets and risks between entities change, but transfer pricing policies don't keep up.

With the increasing scrutiny of transfer-pricing policies, it is essential for a multinational company (MNC) to review the impact of any business change on its transfer-pricing risk profile. In many cases, this will highlight the company's need to redesign its basic transfer-pricing policies. Failure to adjust these policies following major business changes may leave an MNC exposed when the years in question come up for review. Furthermore, alignment of transfer prices with management views of the business as it changes can enhance the defensibility of the transfer prices, ease administrative burden and add to the effectiveness of a transfer-pricing program.

MNCs aiming to maximize shareholder value must integrate tax into the supply chain planning process to ensure the operational savings and cost reductions from a merger or acquisition are not eroded or unexpectedly offset by higher taxes. The combination of constant business change in an increasingly challenging transfer-pricing environment presents new opportunities for multinationals to reap the benefits of aligning their tax strategy with their global business strategy.

Mergers/Acquisitions and Transfer-Pricing Policies

                                                  Parent   Subsidiary

No recent merger or acquisition                   54%      69%
Yes, recent merger or acquisition                 46%      32%
  Dominant company policies unilaterally imposed  49%      43%
  No integration/Multiple policies                27%      30%
  Reexamine entire TP policy                      18%      17%

Source: Ernst & Young Transfer Pricing 2003 Survey Numbers rounded.

Bob Turner, (416.943.3513), [e-mail], is Global CEO, Ernst & Young Transfer Pricing Services. Bob Ackerman, (202.327.5944), [e-mail], is Director, Ernst & Young Transfer Pricing Services, Americas. Karen Kirwan, (202.327.8731), [e-mail], is a principal in Ernst & Young's International Tax and Transfer Pricing Services practice.