TRANSFER PRICING: A Truly Global Concern.
Numerous tax authorities have followed the lead of the Internal Revenue Service (IRS), enforcing the "arm's length standard" for transfer pricing by means of documentation requirements with penalties for noncompliance.
This heightened scrutiny has caused multinational corporations to face increased risk of transfer pricing audits and income adjustments, particularly in the U.S., Canada, the United Kingdom, Germany, France and Japan. The introduction of the euro has further increased exposure, due to the greater pricing transparency caused by a single European currency.
Global transfer pricing documentation has become increasingly important as multinational corporations need to document that their multiple transfer prices are consistent with the arm's length standard. Taxpayers perform detailed documentation studies in order to show compliance with rules and to avoid penalties in numerous jurisdictions. As the arm's length principle underlies the transfer pricing regulations of most tax jurisdictions, global documentation provides a consistent and effective solution that can be efficiently prepared.
Taxpayers now have the option of using state-of-the-art software programs as a management tool to manage transfer pricing systems and possibly reduce their company's effective tax rate. Software can be used to analyze complex transfer prices quickly and generate country specific or global documentation.
U.S. and OECD Requirements
The U.S. government was the first to enforce the arm's length standard as the overarching principle in setting transfer prices when, in 1994, the IRS issued final regulations accompanying section 482 of the Internal Revenue Code requiring that related party transactions meet the standard. A transaction meets the standard if its results are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in a comparable transaction under comparable circumstances.
The final penalty regulations accompanying section 6662 became effective in 1995 and provide that valuation misstatement penalties can be imposed for failure to comply with the section 482 regulations. The IRS has authority, in certain circumstances, to reallocate income among related parties if it determines that such reallocation is necessary to clearly reflect income. Such penalties may be up to 40 percent of the additional taxes that result from income adjustments. Taxpayers can avoid penalties for transfer pricing adjustments by complying with the standard, reporting arm's length results on their income tax returns, contemporaneously documenting their transfer pricing using methods described in the section 482 regulations and providing that documentation to the IRS upon request.
Similar to the section 482 regulations, the Organization for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrators ("OECD guidelines") endorse the arm's length principle as the international standard for the evaluation of intra-group pricing.
A transaction is considered to be compliant with the arm's length principle when conditions imposed and prices paid in related-party transactions are comparable to those imposed and paid by independent enterprises in comparable circumstances. Most transfer pricing regimes outside of the U.S. have adopted the OECD guidelines, thus subscribing to the arm's length principle.
In recent years, some of the leading industrialized countries have enacted new regulations that enforce strict transfer pricing requirements. A summary of current practices follows:
United Kingdom: The U.K. recently revised its rules, including them within its self-assessment regime, the Corporation Tax Self Assessment (CTSA). Under the new rules, which fully adopt the OECD guidelines and apply to accounting periods ending on or after July 1, 1999, taxpayers are required to apply the arm's length principle in computing profits for tax purposes. Taxpayers must also prepare and maintain sufficient transfer pricing documentation as part of routine tax preparation to have a complete return.
Also, the Inland Revenue may impose penalties if it determines that the tax return was not prepared in compliance with the arm's length principle or that the return was submitted fraudulently or negligently. In such cases, penalties of up to 100 percent of any additional tax can be imposed, and penalties of up to [pound]3,000 can be charged for failure to keep proper records documenting transfer prices.
Canada: Major legislative changes, made in 1997, have resulted in more stringent requirements that broadly follow the OECD guidelines. Taxpayers are required to disclose all nonarm's length transactions with foreign affiliates and to confirm that they have "prepared or obtained" all the relevant documentation to support their transfer prices. Penalties will be charged if an adjustment is made and the tax authorities conclude that the taxpayer did not make "reasonable efforts" to prepare the appropriate supporting documentation by the tax return due date. These penalties equal 10 percent of the full amount of the adjustments made in a tax year beginning after 1998, but only when the adjustments exceed the lesser of 10 percent of the taxpayer's gross revenue for the year and Cdn $5 million.
Germany: The proposed regulations -- in draft form since August 2000 -- require that transfer pricing documentation following the OECD guidelines be provided at the request of the tax authorities at the time of audit. Although no specific penalties exist under the current legislation, severe penalties, including imprisonment, can be applied in case of fraud.
It is expected that the regulations will remain in draft form for some time, as the highest tax court has ruled that no legal basis exists in Germany for field tax auditors to demand special transfer pricing documentation. However, the German Ministry of Finance plans to create a legal basis for the documentation requirement.
France: The importance of transfer pricing documentation has increased due to recent legislative changes. As French tax authorities have heightened their interest, taxpayers are advised to prepare documentation showing that transfer prices are in line with the regulations, which closely follow the OECD guidelines. Penalties of 40 to 80 percent of additional tax may be imposed if a taxpayer is considered to have acted fraudulently or negligently. In addition, the taxpayer may be disqualified from seeking relief from double taxation that occurs as a result of the adjustment. Fixed fines of Pr 50,000 may also be charged for not complying with the tax regulations.
Japan: The National Tax Administration (NTA) has adhered generally to the spirit of the OECD guidelines in creating its regulations. Although Japanese taxpayers are not required to maintain documentation, a penalty of 10 percent of the additional tax due may be imposed if an adjustment is made, and the penalty is increased to 15 percent if the additional tax due is more than 500,000 yen or more than the amount of tax paid on the original return -- whichever is greater. Also, in cases of fraud, a 35 percent penalty may be charged separately. It's expected that the regulations will become stricter in the next few years as the government reviews current regulations to possibly make Japanese transfer pricing taxation more compatible with other countries' systems.
The Euro and Globalization
Taxpayers with European operations should reconsider the transfer pricing systems currently in place in light of the transition to a single European currency. The euro affects inter-company pricing structures in three ways.
* More competitive pricing. Customers will be better able to make price comparisons without having to consider exchange rates. This will give the euro the effect of pushing prices for the same goods -- that may differ by country -- toward a common value. This more competitive pricing will mean that suppliers will need to readjust pricing and margins at all levels, thus placing strains on existing inter-company pricing structures and profits.
* Price and market changes affect the benchmarks that companies may have used for setting or validating inter-company transactions in Europe. Changes in prices and profits driven by the common currency will mean that arm's length royalty rates, comparable uncontrolled prices, resale margins and operating profit standards (e.g., returns on operating assets) may differ greatly pre- and post-euro.
* The clarity that a single currency brings to transfer pricing will enable tax authorities to more easily challenge intra-group pricing assumptions. Pre-euro, a multiple- country transfer pricing study might have involved a complex, exchange rate-driven justification of profit and loss allocations. The euro changes currency risk profiles and brings a transparency that necessitates revisiting intra-group pricing to ensure an accurate reflection of risks beyond exchange rate exposure.
To avoid the challenges listed above, taxpayers can update their policies to reflect current conditions and ensure that the new policies are well documented. While European tax authorities may not yet approach transfer pricing consistently, multinationals do, and with the euro in view, the timing is good time for an inter-company policy and documentation review.
Global Documentation And Planning
Fortunately, from the standpoint of efficiency in generating transfer pricing documentation, the arm's length standard is the firmly established principle underlying inter-company pricing rules. Combining this common principle with the increasing desire by tax authorities to see contemporaneous evidence of compliance, it's clear that transfer pricing documentation is most efficiently done once for global use and distributed as needed.
A point of debate is whether in the course of a single project, the taxpayer produces a single document or multiple documents that are somewhat customized, either for better application in multiple taxing jurisdictions or for additional detail regarding some local complexity that may be irrelevant to other taxing jurisdictions. Indeed, global transfer pricing documentation projects may provide substantial advantages to a multinational, including:
* Centralized control of worldwide transfer pricing and documentation at group headquarters.
* Current compendium of informtion by legal entity readily available to headquarters personnel.
* Appreciation by affiliates of actions that affect group tax rates, through participation in an organized fact gathering process designed to understand functions and arm's length benchmarks.
* Significant leveraging of project information and cost-effective preparation of documentation.
* Consistent presentation of the multinational's transfer pricing posture across jurisdictions.
* Greater consideration of the global business environment faced by the multinational than individual country studies.
Technology and Transfer Pricing As global planning and documentation becomes increasingly important, tax directors now have the option of using software programs to manage and document their processes. Powerful software programs enable using a single application for analysis of multi-country related-party flows of tangibles, intangibles, services and loans.
With software programs, tax professionals can use the financial information of publicly traded companies provided by outside databases to determine whether their transfer prices meet the arm's length standard. Software programs also allow tax professionals to collect and organize information and to generate documentation studies to help meet tax authority requirements.
The software will become considerably more powerful when it becomes available in a Web-enabled version, allowing a multinational's tax professionals in all locations to maintain transfer pricing-related information on one single platform. The software can also be used as a management tool, to possibly reduce a company's effective tax rate by testing different scenarios of a company's functions and risks in various locations.
One such product, KPMG's Interpreter[TM] software, is currently being upgraded to a fully functional Web-enabled version that can be made available on a company's server or through access to KPMG's server. The software offers transfer pricing guidance in over 30 countries and can be used to document inter-company transactions for each of these and other countries that generally follow the OECD guidelines.
As globalization continues, transfer pricing is becoming one of the most challenging issues multinationals face. As scrutiny becomes more prevalent, and a single European currency makes transfer pricing more transparent, multinationals are well-advised to prepare global transfer pricing documentation. A global approach helps to protect taxpayers from potential penalties and can support coordinating, planning and documenting transfer prices worldwide.
Steven D. Felgran, Ph.D., is KPMG LLP's National Partner in Charge -- Transfer Pricing, based in New York City, and Mito Yamada is a Senior Consultant with KPMG Fidal, based in Paris. The authors state that this information is of a general nature and is not intended to address the circumstances of any individual or entity. They suggest seeking professional advice before taking action.
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|Title Annotation:||multinational corporations|
|Date:||Nov 1, 2001|
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