Multinationals are facing new tax risks due to a growing number of authorities adopting divergent transfer pricing (TP) requirements, according to a new Ernst & Young survey examining the approaches and attitudes of tax authorities in 49 countries.
The 2009 Global Transfer Pricing Survey comprises insights from Ernst & Young’s TP professionals around the world and interviews with tax authorities. It reveals a dramatic increase in the scope of TP documentation demanded by governments and their stated intent to seek penalties more frequently and at higher levels when multinationals get it wrong.
"As governments search for tax revenues to offset growing budget deficits and financing stimulus, multinationals will have to be prepared for self assessment and more TP investigations," says Luis Coronado, Transfer Pricing Leader for Ernst & Young in the Far East. Coronado adds that in order to mitigate being selected for audit, multinationals will need to adopt a hands-on management approach to TP design as well as making sure they follow best practices in documenting TP decisions.
Increased TP Investigations
Given the need for governments to raise revenues in the challenging economic climate and the changing regulatory environment, the study anticipates heightened litigation in the near future. This expectation is driven by the almost universal trend towards increased TP investigation resources within tax authorities.
Countries that are relative new comers to TP enforcements are tending to gear up capabilities quickly. “In China,” says Jessica Tien, Leader of Transfer Pricing, Central China for Ernst & Young, “the rules are now fully in place. We are now moving to enforcement and the authorities – from State Administration for Taxation to local municipalities – are committed to developing their capabilities and enforcing the rules. Taxpayers should understand that the authorities are now committed to compliance and enforcement.”
According to the survey, there is a growing divergence of views among tax authorities about what TP should encompass. Most countries follow the OECD guidelines, but local implementation can vary significantly. Sometimes these variations lead to situations in which the tax authorities of the two countries involved come to quite different conclusions about the correct pricing and bilateral approaches needed to resolve the matter.
Coronado explains that organisations operating internationally are discovering that their TP positions may face challenges from one authority, even when that position is well supported and accepted by other tax authorities operating under the umbrella of the OECD guidelines.
“We have similar situations domestically in China, especially in the Southern China region where tax holidays were historically given to attract foreign investment," elaborates Walter Tong, Ernst & Young Central China Tax Leader. "This situation currently causes tensions, but will likely disappear over time as we move towards uniform tax rates, national audits, industry expertise and standardised examination procedures.”
Industries in the Spotlight
In roughly half of the countries surveyed, certain industries are formally or informally being targeted, including automotive, consumer products, financial services, oil and gas, and pharmaceuticals.
The survey also revealed that a clear focus is emerging on transactions with perceived tax havens and ‘blacklisted’ countries. Authorities are also more likely to consider a broader range of company transactions that can result in more detailed investigations.
Scenarios that signal potential TP investigation include fluctuating profit levels or consecutive losses in a group company; corporate restructurings involving closures or reductions in operations; significant inter-company management fees or royalty payments; dealings with a group company in a tax haven; and being located in a low-cost country.
As a result of the global financial crisis, shifting economic conditions have made managing TP issues more difficult for tax directors of late, as many of the factors that influence the TP decision-making process are constantly in flux. These shifts in the economic environment are, in some cases, providing a trigger for a transfer pricing audit, adding another layer of complexity for the tax function.
“China’s Circular 363 is a concrete example of this issue. The circular clearly targets inappropriate profit shifting in the wake of the crisis," adds Tien. "From the tax authorities’ perspective, companies that are seen to be earning not enough profits in China now will be heavily scrutinized and need to thoroughly document the business rationale to substantiate their profit positions.”
Managing the Risks
Since every cross-border intra-company transaction potentially requires dealing with at least two different tax authorities, each of which may look at the same transaction twice, it is impossible to eliminate TP risk entirely. However, this can be mitigated by exercising good risk management principles. For instance, if an organisation has a good working relationship with its local tax inspector, documentation can provide a basis for reaching a mutually agreeable settlement of the issues.
The survey also indicated that globally an increase in the usage of Advance Pricing Agreements (APAs) is occurring, in an effort to give both the taxing authority and the multinational an increased level of certainty in an uncertain world. An APA is an agreement between a tax authority and a multinational company about the determination of the appropriate transfer pricing method to be used for pricing inter-company transactions. APAs may be unilateral, bilateral (two governments) or multilateral (three or more governments). “APAs are important to China,” says Tien. “We have already seen a surge of requests for bilateral and unilateral agreements. For MNCs with complex TP issues with Chinese operations at the centre, APAs are a key risk management tool.”
In addition, Tien also adds, “Following the footsteps of the Chinese tax authorities, the Hong Kong Inland Revenue Department (HKIRD) has also strengthened its transfer pricing effort recently. It has issued a Departmental Interpretation and Practice Note (DIPN) No. 45 explaining the Double Taxation Agreement process for Mutual Agreement Procedure to resolve international tax disputes, and it is in the process of drafting its first official circular regarding transfer pricing. The HKIRD’s examiners have been more active in transfer pricing review matters, and the recent anti-avoidance court cases concerning several Hong Kong taxpayers with operations in China also provide insights into the HKIRD’s focus on the subject matter.”
Planning for the Future
The continued and growing interest of tax authorities in TP and the proliferation of local rules have made the assessment and management of TP risk a key focus for CFOs and tax directors. Multinationals should have in place effective tools for identifying and measuring risk and a familiarity with both technical and procedural approaches for dealing with TP issues raised by tax authorities.
“Our survey demonstrates that there has been a wave of transfer pricing rules and regulations internationally over the last few years. In addition, there have been high-profile court cases and the deployment of a considerable amount of transfer pricing enforcement among local tax authorities. Not surprisingly, tax directors all over the world see transfer pricing as the most important tax issue facing their company today,” concludes Coronado.
Tong states that transfer pricing is most of the time so intertwined with the operation of the company that it cannot be addressed in isolation. "For Chinese MNCs expanding into other economies, a systematic, centrally managed and structured approach is key. Ultimately, TP needs to be an integral part of any multinational’s business model.”