2013-Issue 6—Institutional hurdles to effective transfer pricing planning, implementation and compliance

Transfer pricing is traditionally viewed through two lenses: planning and compliance. Planning (and subsequent implementation) focuses on establishing the optimal mix of functions, risks and assets across the enterprise, and allocating appropriate returns to them in order to maximize efficiency and after-tax cash flow. Compliance focuses on meeting statutory requirements in order to provide sufficient justification and documentation for transfer pricing positions taken during a specific period.

This article highlights some institutional and practical constraints that can have far-reaching implications for both transfer pricing planning and compliance. These constraints may be encountered during the design, implementation or documentation stages, as discussed below.

I. Design

Many elements are necessary for an effective transfer pricing design; however, none is more critical than the availability of sufficient and accurate financial data. Specific data requirements will be dictated by the facts and circumstances of the intercompany transaction(s) and planning goals; however, without an adequate level of granularity, effective transfer pricing planning is simply not feasible.

Examples of commonly encountered data shortcomings include the availability of (or rather lack of) product-specific or channel-specific profitability data and reliable projections. While most companies maintain some level of segmented financial data, they often lack the capability of calculating accurate product-specific or channel-specific profitability. This may be driven by back-office systems limitations such as the inability to fully allocate overhead expenses, or by business practices such as revenue recognition procedures (i.e., bundling of products or services by customer or segment). Similarly, while most companies produce basic business forecasts, these forecasts are rarely produced with transfer pricing planning in mind. As a result, they often lack key elements required for effective transfer pricing. For example, forecasts are often not prepared separately for different supply chains, or they often do not contain detailed data on projected operating costs and operating profits. Thus, effective transfer pricing planning is inherently bound by data constraints.

II. Implementation

Once a transfer pricing policy has been developed, it must be implemented. At this stage, the tax department must team with other departments in the organization, including legal, (various) operations, human resources and IT, in order to ensure proper application of the transfer pricing policy. A vast number of implementation issues may be encountered; a few examples of areas that can be problematic are discussed below.

Legal Contracts

Intercompany contracts that accurately reflect the functions to be performed, risks borne and financial terms among the parties must be executed. Furthermore, the parties must adhere to these contracts. A common problem arises over time when functions and risks evolve, or parties to transactions change, but legal agreements are not amended to reflect these changes.

Price Lists

Intercompany price lists that accurately reflect the stated policy on transfer pricing margins or prices must be developed and maintained. A multitude of issues surround the conversion of transfer pricing parameters to actual intercompany prices. For instance, when a selling entity in the group is compensated using (an overall) resale price margin on its business, that margin must be translated into specific prices for each product sold. There is no mandate that each product generate the same margin, and generally they will not. On an aggregate basis, however, the price list should result in the selling entity earning returns consistent with the transfer pricing policy. Furthermore, as products evolve or manufacturing costs and market prices change, price lists must be updated. Businesses in which a price list is a starting point for actual selling prices present an additional level of complexity.

Acquisitions and Integration

When acquisitions occur, or when additional products and services are introduced to a company's portfolio, they need to be integrated into the company's transfer pricing policies. Sometimes this is a straightforward exercise. But at other times this change requires a complete evaluation of the new products and the functions, risks and assets associated with them, as well as a reworking of the transfer pricing structure. Common pitfalls include inconsistencies in the margins earned on "old" and "new" products, with resulting unintended distortions in incentives for the business people.

Compliance With Local Country Tax Rules

In addition to complying with the global transfer pricing policy, it is important to abide by other local country rules (VAT, for example). This seemly administrative task may prove onerous and can have a severely consequential impact should the tax department fail to properly mesh the transfer pricing with other tax requirements.

Human Resources

Various human resources issues need to be considered when implementing a transfer pricing policy. For example, it is common for management compensation to be based at least in part on the performance of an individual's respective business unit or division. This alignment of compensation with divisional performance provides an incentive to maximize the results of the division, which may be in conflict with the success of the company as a whole and/or the company's transfer pricing policy. Furthermore, while a global transfer pricing policy may benefit a company as whole, it may shift profit between jurisdictions, and have a material impact on the compensation of management. Therefore, management incentive structures should be considered and potentially recalibrated so that implementation (or modification) of a transfer pricing policy does not produce unintended consequences.

In addition, some, if not most, transfer pricing structures depend critically on certain functions being performed in certain locations, or contracts being executed in certain locations. HR can assist in ensuring that employees are located only where they should be and carrying out only the functions they should.

IT

Several of the issues outlined above come back to one obstacle or hurdle: IT limitations. Deriving the financial information necessary for effective planning, implementing transfer pricing policies and developing the reports necessary for transfer pricing compliance all require a partnership between a company's IT and tax departments. In addition, the IT capabilities themselves must be robust enough to allow the tax department to access the necessary information. For many companies, this is the biggest hurdle of all to effective transfer pricing planning and implementation.

III. Compliance

The objective of transfer pricing documentation is to meet statutory requirements in order to provide sufficient justification for transfer pricing positions taken during a specific time period. To meet this objective, a tax department must ensure that necessary and accurate documentation is kept. Beyond the formal transfer pricing documentation report (whose contents and structure vary by jurisdiction), companies must keep legal agreements (as discussed above), supporting invoices and any other specific supporting documents related to their intercompany transactions. This seemingly straightforward task may prove to be a substantial burden for a tax department, as the required documents are likely located across the enterprise.

Alvarez & Marsal Taxand Says:

There is no doubt that effective transfer pricing planning, implementation and compliance are critical components of a company’s tax responsibility. Developing a transfer pricing policy that both meets the requirements of tax authorities around the world and helps achieve a company’s tax-planning goals is difficult enough. But companies must also meet the challenges of implementation and ongoing maintenance in a complex and ever-changing corporate environment. Far more than other aspects of tax planning and implementation, transfer pricing requires coordination among widespread groups outside the tax department at every step along the way. This poses unique challenges for the tax department and its transfer pricing team — challenges that may just be beginning as the ink dries on a transfer pricing report.

Author:

Laurie Dicker
Managing Director, Washington DC
+1 202 688 4215

Other Related Issues:

01/21/2013
Transfer Pricing Safe Harbors and Timing Issues

01/16/2013
Survey of Transfer Pricing Issues in U.S. Business Restructurings

11/01/2012
Transfer Pricing Changes in Foreign Jurisdictions

Disclaimer

As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors.

The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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