The Usefulness of Transfer Pricing

I've been receiving a bit of criticism regarding my articles for always putting down Transfer Pricing, so I have decided to write this article in order to express the positives of Transfer Pricing compliance, as well as the added value it provides to a company.

1. Protection against Tax Authority Audits

The primary role of Transfer Pricing, similar to any kind of compliance is, of course, to protect the company from all the possible negative effects of an audit by local tax authorities, or at least to minimize their impact. A skilled professional will be able to understand the requirements (especially in jurisdictions where the legislation is either lacking or vaguely defined), keep up with the practical expectations of tax inspectors, explain the strategies used by the company in technical transfer pricing terms, and, of course, protect the company from any unjustified attacks or claims made by tax inspectors.

This prevents the company from getting fined or red-flagged by tax authorities for non-compliance, and can easily deter a tax inspector from finding a pretext to run a full audit by simply allowing them to browse transfer pricing documentation during an unrelated audit. Which brings us to our second point.

2. Risk Mitigation / Assessment / Planning

Transfer Pricing is, I'm sure we're all in agreement, a matter of risk. Since there is are no fixed international laws that guarantee transfer pricing compliance, the transactions a company undertakes with affiliated entities, and the way they are analysed within the transfer pricing file, will lead to a wide range of results depending on the aggressiveness of the tax authorities, the aggressiveness of the tax planning strategies the company has put in place, the market as a whole, the situation of the group, etc. Point is, there are varying levels of risk, and a transfer pricing approach can limit or help plan for that risk.

First of all, a transfer pricing file is in itself a risk mitigation tool. Simply having one prepared, regardless of its contents, can avoid a fine and earn goodwill from tax authorities. Having a decent one usually also discourages tax inspectors from coming back to do a full transfer pricing audit. Beyond that, of course, if a tax audit does take place, a transfer pricing file can present all the underlying facts of a transaction, together with their context, and link them to significant elements regarding the functional profile of the business, the economic situation of the market, the strategy of the company as well as the group, and so on. In a worst case scenario, a transfer pricing file can provide the main arguments to create the basis for a strong legal defense, as well as the transfer pricing methodology that tax authorities will have to dismantle in order to attack the transactions of the company. And, since we're talking about significant potential adjustments, this protection is important.

Second of all, a transfer pricing file is a risk assessment tool, as it will undoubtedly uncover most transfer pricing irregularities within a company. As such, a company undergoing this process can have a clear picture of what its weaknesses are, as well as how likely it is that they will lead to adjustments. Practically speaking, any transfer pricing specialist with experience will spot weak points and possible unfavourable interpretations and signal them, if the company is willing to entertain the idea. Such assessment can be very valuable, as a company can react in time in order to restructure its transactions based on transfer pricing principles, earn goodwill from tax authorities, as well as avoid future penalties.

Third of all, transfer pricing is a risk planning tool. Many companies view transfer pricing strictly as compliance, but, in theory, transfer pricing should be used primarily before entering into transactions with affiliated entities. As such, a transfer pricing expert will be able to advise the company as to the likeliness of transfer pricing risks, compatibility issues with foreign jurisdictions, potential solutions and workarounds that do not disrupt the company's natural supply chain, etc.

3. Change Management

We need to look no further than the BEPS initiative for proof that the world of transfer pricing is forever changing. Rules become clarified or completely replaced, loopholes are closed, safe harbors are created or eliminated, and the expectations of tax authorities are ever changing, evolving with their level of technical expertise, necessity for additional tax resources or existing jurisprudence.

Transfer Pricing allows companies to, through their experts, understand what is expected of them, and adapt quickly, ideally before they are informed of this by the tax authorities themselves.

Furthermore, change within the company itself often needs transfer pricing expertise, as many aspects of business restructuring are quite finely regulated by transfer pricing laws or literature.

4. Automated Systems

Our age is being defined by automation at every level. Of course, this has led to significant levels of automation in both tax compliance and tax audits, which I feel is partially a mistake, due to the inherent high complexity of assessing transfer pricing compliance, but is regardless a trend that we must adapt to. Primarily, tax compliance should be free of most automations, since its purpose is precisely to analyse, in great depth, the transactions and circumstances of the client, and find the best solution for them, while also respecting as much of the transfer pricing guidance as possible. However, it does make sense that tax auditing uses some automation, both in assessing potential tax evasion risk as well as in detecting potential tax schemes or tax avoidance structures.

Regardless, automation is already here, and from what I can tell it serves two purposes for the immediate future: automatic information exchange and automatic detection of tax avoidance. Transfer Pricing is essential when dealing with these systems, as their functioning will inevitably result in direct consequences for taxpayers that aren’t even aware they are being “audited”.

In the case of automated information exchange, transfer pricing can help by ensuring the local entity, as well as the group, are synchronised regarding both their transfer pricing policy and approach, as well as the timing for providing and implementing this approach to local entities before tax authorities receive it, allowing for rapid deployment of solutions as well as fully understanding the basic information on which tax authorities base a potential transfer pricing audit.

In the case of automated detection of tax avoidance, the problem will be significant for companies, as they will be judged based on undisclosed KPIs, and common schemes, legal or not, will become very obvious to tax authorities. For example, the OECD has already described that they will go after local entities in lower-tax countries with higher profits than group average, entities with profit margins lower by 4 to 8.5% than domestic-only operations, concentrated FDI, separation of taxable profits from value creating activities and debt being concentrated in higher statutory tax-rate countries. Beyond that, I’m quite certain there are a significant number of other hidden criteria, flagging, for example, companies which have group cost allocations or non-critical services in excess of their net profits excluding these expenses. As such, companies will have to build their own internal analytics and monitoring mechanisms, and perhaps in time even link them to decision-making processes in order to ensure quick response to any deviations.

5. Business Intelligence

Transfer Pricing is a surprisingly useful tool even outside the field of transfer pricing, as I’ve noticed in my own activity. While preparing transfer pricing documentation, and exploring the transactions the company is taking part in, its relationships with affiliates and its motivations, as well as the context for all that, certain insights appear that are not visible at other levels. For example, the per entity approach used in transfer pricing can give a completely different perspective regarding the health of an entity or potential issues than a per-BU or per division perspective.

As such, transfer pricing can generate meaningful action even in cases where the company is healthy and compliant, especially with the new post-BEPS focus on value creation. Identifying that value will in turn help the company in being lean and focusing its resources around what is proved to be significant in that creation of value.

Finally, transfer pricing compliance often results in financial and legal compliance, as issues in those fields are routinely detected by connected transfer pricing issues.

Conclusion

I hope I’ve covered at least some of the areas where Transfer Pricing brings real value to a company, beyond just reactive compliance, and why it is, of course, worth the costs.

While transfer pricing uncertainty remains a significant problem in this field, for all involved parties, I believe that it still makes a lot more sense to prepare even a barebones defense than to forego it, for the simple reasons outlined above.

As always, if you have any questions, or simply want to discuss Transfer Pricing, feel free to message me or comment below.