Tax Strategies for the Global Market

A global dream brings with it global realities- such as being subjected to tax in numerous new markets. The creation of foreign subsidiaries and bases of operation for cross-border flow of products, services, trademarks, funding, and technology will also inevitably raise the issue of transfer pricing.

Transfer pricing is the process by which a company doing business with foreign affiliates sets the prices for goods and services between and among the worldwide group. For example, a US company that manufactures bar code scanners establishes affiliates in Canada, Germany, Mexico, Singapore, China and Korea to distribute the scanners locally. The parent may provide the product at cost and allow the affiliates to earn all of the profit on the sale, or mark up the transfer price so that the affiliates must sell to their customers at cost, in effect leaving all the profit in the U.S. Either approach has tax consequences so governments are interested in making sure that the prices set in these inter-enterprise transactions are compatible with those found in the open market. The global standard for tax purposes is the “arm’s length standard;” i.e. the rate at which unrelated parties would agree to enter the same transaction.

Setting transfer prices is a strategic undertaking. Yet a poorly conceived strategy can result in an excess global tax rate and the risk of substantial penalties imposed by multiple tax authorities. This raises a number of important challenges: How do you implement cross-border expansion without risk of future tax problems or controversies? What method or means do you use to arrive at this “arm’s length” price? And once you’ve set this price, how can you assure that it will be accepted by all relevant tax authorities?

The Penalties for Improper Pricing

The consequences of poor pricing decisions are onerous, for most of the world’s major trading partners have strict rules requiring businesses to establish their arm’s length prices according to an acceptable method. Many also require companies to document that process. A transfer pricing error usually results in an adjustment of tax and, in many countries, a penalty. If the IRS, for example, reviews a company’s transfer prices and decides that they are not correct, it will make an adjustment and can impose a penalty equal to 20-40 percent of the tax from that adjustment. The company can avoid the penalty, however, if it can provide documentation to the IRS showing the method it used to arrive at its prices, and explaining why that was the best available method.

The IRS is not alone in its enforcement efforts. Increasingly, tax authorities throughout the world are stepping up their review of multinational companies’ transfer pricing policies. Tax authorities are more likely to focus on growth companies because sales in fast growing markets tend to increase quicker than profits. To withstand such scrutiny, solid documentation of the company’s transfer pricing strategy is the key to success.

Such success can be challenging, however, because the arm’s length standard, although universally accepted, is not consistently applied around the world. Rather, each country has developed its own view of which of the generally accepted transfer pricing valuation methods it considers to be most reliable. In the US, for example, the IRS seems to favor the comparable profits method, which determines a transfer price by comparing the profitability of unrelated companies that engage in similar activities to the profitability of the parties engaged in the controlled transaction.

Global Approaches to Transfer Pricing

Many other trading partners, however, that are a member of the Organization for Economic Cooperation and Development (OECD), favor the so-called transactional methods such as comparable uncontrolled price or resale price. The transactional methods look for transactions involving substantially the same property and contractual terms, and compare those prices with the controlled transactions to determine if the arm’s length standard is met. A particular country can also take a unique approach, such as Japan’s version of the profit split or Brazil’s statutory margin methods.

The many inconsistencies mean that creating documentation that can justify a transfer price in all the relevant countries is not a one-size-fits-all process. Whereas, in the example above, the IRS might favor seeing prices established and documentation showing that the profit earned by the distribution affiliates on the sale was within an arm’s length of the profit earned by similar companies selling similar products, the German tax authority might favor seeing that the price was within the range of prices paid by comparable German companies for the same or a closely similar product. For that matter, the Mexican tax authority might favor seeing that the affiliate’s gross margin was within the range of gross margins received by comparable Mexican companies for the same or similar product.

In addition to these substantive differences, countries disagree on the particular documents that must be maintained, and the time periods for capturing the information relied on for establishing the price. There are timing differences regarding document preparation, as well, with some countries requiring documentation to be prepared by the filing date of the company’s tax return and others having no specific deadline.

Setting a Safe and Advantageous Transfer Price

What can a CFO or tax director do to satisfy all of these seemingly conflicting rules? The first step for achieving transfer pricing success is locating third-party transaction or financial information on companies whose activities are comparable to its own. This information is then analyzed to identify the transactions in which the circumstances are the most comparable to the company’s transactions. Sophisticated computer software programs have been developed to assist companies with this analysis. Armed with this information, the company can develop a comprehensive transfer pricing strategy taking into account the peculiar circumstances of its markets, products, and business strategies.

The final step in the process is to prepare written documentation. The documentation should explain the company’s business, its transfer pricing strategy, and why that strategy is consistent with that country’s interpretation of the arm’s length standard. In some cases, separate analyses and reports will have to be prepared to take into account each country’s interpretations of the arm’s length standard.

Done right, a company’s documentation can be its first line of defense in a tax audit. An effective global transfer pricing strategy can also reduce management’s time directed to tax controversies, avert the imposition of onerous penalties, and reduce a company’s global tax rate.

The information above was provided by Deloitte & Touche LLP. Companies wishing to discuss global pricing strategies can contact Mark Nehoray at 213-688-4104.