Transfer pricing continues to be challenging for taxpayers and tax administrations, especially during the COVID-19 crisis.
The Platform for Collaboration on Tax (PCT), a joint initiative of IMF, OECD, UN, and the World Bank, seeks to help developing nations successfully implement transfer pricing policies. Its latest initiative, a transfer pricing toolkit for developing countries on effective transfer pricing documentation requirements, was the subject of an expert panel at an 18 February PCT webinar.
The practical toolkit addresses the measures that tax administrations use to require taxpayers to document all stages of their transfer pricing analysis.
Concept of transfer pricing
Transfer pricing is a necessary and legitimate part of the global transactions of multinational enterprises (MNEs), involving the transfer of property or services along the MNEs value chain. However, MNEs may make errors in their analysis, or sometimes seek to exploit differences in tax systems between countries through manipulative transfer prices, shifting profits from high to low tax jurisdictions and denying countries essential tax revenues.
In most countries, when taxpayers conduct transactions with associated parties, domestic law and tax treaty obligations require the taxable profit from such transactions to be computed in accordance with the arm’s length principle.
Under this principle, the price and other conditions of the transactions need to be the same as those that would be expected had the transaction been between unrelated parties.
Normally, enterprises need to conduct a ‘transfer pricing analysis’ to analyze transactions between related parties. Taxpayers assess the functions performed, risks assumed, and assets used by those parties to determine and apply the most appropriate transfer pricing method.
In practice, there are some challenges that businesses face when determining the most appropriate transfer pricing method. Whilst It is necessary for businesses to use external and internal sources to identify comparable uncontrolled transactions, to determine the prices to be used or the profit to be reported by one or both respective parties, sometimes external data may not be available.
It is critical for taxpayers to document their transfer pricing policies and practices, given that tax administrations will examine a large amount of information to assess compliance with transfer pricing rules.
High-level overview of the contents of the transfer pricing toolkit
The transfer pricing toolkit covers the measures that tax administrators typically use to assess information and data received from taxpayers.
Internationally consistent transfer pricing rules can also encourage compliance by taxpayers. Clear rules on transfer pricing documentation can offer taxpayers certainty as they provide them with a means to justify their policies and demonstrate how to meet the requirements set out in the law.
Transfer pricing documentation may also provide protection against documentation penalties, reduce the risk of an audit, and may reduce penalties arising from an audit. However, it is recognized that the preparation of transfer pricing documents can be resource-intensive and costly for taxpayers.
The toolkit seeks to balance the information needs of tax authorities and minimize compliance costs for taxpayers. Therefore, it relies mainly on applying the transfer pricing requirements and guidance from the OECD’s transfer pricing guidance, the UN’s transfer pricing manual, and the World Bank’s transfer pricing handbook.
The main elements that the toolkit covers are the transfer pricing studies required to be documented by taxpayers, used in transfer pricing analyses, and submitted to tax authorities upon request, for instance, through the local file/master file from the OECD’s base erosion and profit shifting (BEPS) Action 13 minimum transfer pricing documentation standards.
The toolkit also provides guidance – generally in a standardized form – on tax authority information requests, for instance, the high-level information that can be requested from taxpayers.
It also covers the country-by-country report – as determined by the Inclusive Framework – and provides guidance for tax authorities to implement country-by-country reporting in an effective way.
The toolkit also contains standardized questionnaires that can be sent to taxpayers on an ad hoc basis that are generally intended to assist tax authorities conduct risk assessment or understand, for example, the behavior of a particular industry.
In less detail, the toolkit also touches upon information and documentation requests that can be made during an audit.
The toolkit also describes several common trends amongst jurisdictions. These include questions as to the design of the appropriate regulatory transfer pricing framework, the decision whether certain parts of the documentation requirements will be included in primary or secondary legislation as they can raise other issues, such as confidentiality and timing issues (e.g., when to submit the documentation), enforcement and compliance, as well as different mechanisms for penalties for late or non-submission of the documentation.
Lastly, the toolkit discusses ways tax authorities may access information held outside the local jurisdiction.
Considerations during the drafting of the toolkit and further work needed
The toolkit authors considered whether there is a need for international and regional alignment of developing country transfer pricing approaches with other documentation requirements. Clearly, such international consistency could be advantageous to both taxpayers and tax administrators as it is with, for example, BEPS Action 13 common template for master /local files/ country-by-country reporting.
One question that arises is whether the benefits from a common country template can be extended to other documentation, such as the transfer pricing return schedules that many countries require MNE taxpayers to file with or as part of their tax returns.
Private sector representatives raised the issue of the high cost of maintaining transfer pricing documentation. Some countries take different approaches, for example, exempting or simplifying for small taxpayers the requirement to file transfer pricing documentation. A question that arises is whether there should be international best practice, for example- the necessity to revisit transfer pricing documentation every year or, for example, to have a new comparable set every year where underlying transactions have changed very little.
The discussion also referenced an article (published after the toolkit was released) which opined that the quality of transfer pricing documentation was not always very good – specifically, documentation was sometimes treated as just a box-ticking exercise, or where the minimum analysis is done to avoid penalties or where the experience level of the staff that conducted the analysis could require a review.
While this does not mean that transfer pricing documentation is not valuable, the question is what can be done at a level of international guidance and best practice to enable taxpayers to produce more reliable transfer pricing documentation efficiently.
Access to transfer pricing documentation, namely, the master file/country-by-country reports, also assists tax authorities, especially developing countries, access reliable data and information. Small developing countries are having difficulty developing country-by-country report regulations as there are administrative requirements to be determined that provide the basis of preparation and lodgment. The question is whether there are any ways to improve the process and streamline the requirements for those developing countries.
Key questions and comments from the panel discussion
There was a panel discussion among experts, which included tax administration personnel from the US, Canada, Peru, Ghana, and India and representatives from accounting firms where a range of issues were raised.
One question that was addressed is whether a focus on documentation rules can divert both taxpayer and tax authorities’ attention away from an appropriate analysis of the arrangement’s economic substance to one merely focused on the form of the transaction (i.e., ignoring substance over form). For instance, the proposed simplification of the transaction net margin method envisioned in Amount B of Pillar One could be based only on the form of the arrangement rather than the activities’ economic contribution to profit creation, as per the recent reforms discussed by OECD.
To answer the above question, one needs to look at the usefulness of documentation in terms of improving the effectiveness of transfer pricing rules.
The US transfer pricing auditors seemed to believe that documentation is of limited use in enforcement, even when the documentation was organized. They said the information is too detailed and provided more information than could be used productively in actual life transfer pricing examinations.
The basic premise of comparable-based transfer pricing rules is that auditors must consider and apply the arm’s length principle using the available data to develop a more objective, reliable, and persuasive estimate of market-level arm’s length prices to underpin an audit adjustment. However, such an approach is predicated on the availability of reliable information and the capacity to apply it in a transfer pricing analysis.
During the panel discussion, it was noted that documentation rules have probably improved tax administration to some extent. However, the panel noted that there is also the concern that rules have promoted the illusion that comparable-based analysis can be produced more precisely and reliably than is the case in practice.
The goal of international tax policymaking is to reach a desirable balance between revenue collection on the one hand and the promotion of cross-border investments on the other. Reaching this balance requires a realistic understanding of how reliably and effectively existing monitoring and enforcement mechanisms work.
In this context, transfer pricing documentation rules may have led the international tax community to understate the inherent limitations of comparable-based transfer pricing rules and, therefore, may have incorrectly appeared to be appropriately balanced policymaking.
Currently, promising simplifications for transfer pricing rules are on the table, including, for example, the approach under consideration to determine a baseline return for distribution and marketing activities – Amount B under the OECD’s Pillar One proposal. If this proposal were to be extended to transfer pricing more generally, it might remove the need for some difficult detailed factual analysis. Simplifying transfer pricing rules should also provide more predictable results for taxpayers and tax administrators, and the administrative burden on all will be reduced. With simplification, balanced policymaking may become more feasible.
While it is appropriate to improve transfer pricing documentation rules and make them less burdensome for taxpayers, taxpayers also need to pay attention to developments around Pillar One (especially Amount B) and subsequent transfer pricing reforms designed especially for developing countries with limited tax compliance resources.
Taxpayers should not overlook the use of country-by-country report documentation as a developing country tool to monitor compliance and especially for risk assessment procedures.
The panel also responded to a question on whether the toolkit options improve the transfer pricing compliance landscape.
A Canadian Revenue Authority officer noted that transfer pricing documentation is critical because a robust transfer pricing analysis cannot be conducted merely by looking at the financial statements or numerical data about a transaction and public disclosures. Analysts need the additional data that can be found in the typical transfer pricing documentation, the officer said.
Transfer pricing inherently involves a two-sided transactional analysis, not just an analysis of the transaction made by the resident taxpayer in one jurisdiction. Data from the non-resident related-party taxpayer is also important. Information is critical, and compliance is improved where the transfer pricing documentation is robust and contains such a two-sided analysis.
There was support amongst the panel on the toolkit section that discusses confidentiality as this is very important. For MNE taxpayers to comply with information obligations, they must trust that the information provided will be kept confidential given the commercially sensitive and detailed nature of the information provided in a transfer pricing context. For example, in some instances, one of the most important inputs to the transfer pricing analysis may also be regarded as multinational group secrets, such as internal comparables. The terms and conditions, including prices paid by arms-length customers, may be the best evidence of arm’s- length pricing but may also be very commercially sensitive information. For taxpayers to share this type of information, there needs to trust that it will remain confidential.
The toolkit also includes suggestions for penalties for failure to provide certain information or reports. A robust penalty regime can be important to ensure that tax administrations have access to information required to understand the multinational transfer prices.
Given the importance of a two-sided analysis in transfer pricing, accessing documents held outside the jurisdiction is another important area that the toolkit discusses. On the flip side, the toolkit also cautions that only relevant and reasonable information should be requested. There is, therefore, a need to balance the taxpayer’s compliance costs in finding and analyzing offshore information with its persuasiveness in a robust transfer pricing analysis.
The tax authorities’ administrative options described in the toolkit also seek to improve the compliance landscape for low-risk small and medium enterprises. This could mean exempting some enterprises from documentation requirements. However, this does not mean that those same small and medium taxpayers are exempted from the transfer pricing rules, which otherwise apply to all taxpayers.
Another question to the panel concerned how standardization of documentation across jurisdictions could assist both MNEs and tax administrations. Standardization of documentation helps MNEs since a consistent framework fosters cost-effective compliance. Where transactions and taxpayer’s commercial operating context is similar, the same or a slightly adjusted transfer pricing documentation package could be provided to multiple jurisdictions. Standardization of transfer pricing documentation is also beneficial to tax administrations. It levels the playing field between taxpayers with respect to information received for risk assessment and the transfer pricing documentation used as a starting point for the transfer pricing audit.
During the panel discussion, it was noted that there are many challenges that tax administrations face in dealing with transfer pricing cases, but a particular reference was made to Ghana.
Although Ghana has recently introduced master and local file documentation requirements, the question arises whether they address Ghana’s information gaps bearing in mind the constraint on resources from the tax administration.
The Ghana tax officer noted that their main challenge is obtaining information from taxpayers, especially the supporting details concerning the related party dealings. Some taxpayers, it was noted, will only produce a transfer pricing analysis when they receive the audit notification from the tax authority.
Apart from the information challenge, the other issue is identifying reliable comparables from local markets or economies similar to the taxpayer. If they do exist, the data needed for a transfer pricing analysis may not be readily available.
The panel also considered a question as to whether country-by-country reporting has supported the Indian tax administration’s transfer pricing risk management processes. Amongst the panel, there was positive support for the usefulness of country-by-country reporting in terms of applying transfer pricing concepts for audit purposes.
India currently requires that Form 3CEB be submitted with the tax return, which requests the name and address of the associated enterprise, the amount of the international transaction, and the transfer pricing method used. However, Form 3CEB would only give information about the Indian entity; information on other non-resident related parties is also required. Thus, country-by-country reporting and its master file requirement is an improvement that addresses an information gap that Indian tax administrations used to face.
The panel also supported the notion that transfer pricing documentation can also help in dispute management, which is two-fold: preventing disputes and resolving disputes efficiently.
To some extent, mispricing transactions can be prevented as taxpayers will need to comply with the transfer pricing regulations on both sides of a transaction, likely to result in at least some allocation of taxable profits between the related parties and thus resulting in fewer disputes between tax authorities. In addition, a uniform approach can help reduce disputes as taxpayers and tax administrations will have a common starting point for discussion and negotiation.
Concluding remarks
The main practical challenge for MNE taxpayers with international supply chains that extend across many jurisdictions is the complexity of the regulations along the channel, and the constraint of resources in meeting their obligations, while keeping up to date with the new rules in many jurisdictions.
For MNE taxpayers, the development of a global transfer pricing policy and common template for the country-by-country report, master file and local file may be a cost-effective and useful control mechanism to ensure that future transfer pricing studies are consistent across the three files.
It remains to be seen if developing countries’ tax administrations will benefit from a simplified local transfer pricing approach, the more complex tax approach proposed under Pillar One, or more risk assessment and audit-driven transfer pricing compliance.
At the panel discussion, there was also strong support for simplification. It is essential to reduce the transfer pricing compliance burden and the possibility that a safe harbor derived from Amount B of Pillar One will eliminate the need for otherwise difficult comparability analyses.
