In Alvarez & Marsal Taxand's recent survey of 302 CFOs, 30 percent said transfer pricing was the area that created the greatest risk for their company. This concern is understandable, as the regulatory landscape governing intercompany transactions is swiftly changing. These changes are partly a result of recent public scrutiny of companies' international structures. For instance, on September 20, 2012, the Permanent Subcommittee on Investigations of the U.S. Senate Homeland Security and Government Affairs Committee conducted hearings recommending reform for transfer pricing and other provisions that are seen to encourage the "offshoring" of profits. The hearings focused on how companies have used aggressive transfer pricing transactions to shift their intellectual property to lower tax jurisdictions, in part to avoid or reduce U.S. taxes to the tune of billions of dollars.
Even where companies may have already structured their intercompany transactions to comply with increasingly complex transfer pricing rules in the United States, they may not be paying enough attention to the multitude of transfer pricing changes in various foreign jurisdictions. Accordingly, this article presents a sampling of the most recent foreign legislative changes that may call for a new or updated global transfer pricing study.
General Principles of Transfer Pricing
Transfer pricing is, in short, the methodology of determining the appropriate price of a transaction between related parties, typically under an arm's-length standard. Under these principles, transactions that are not supported by the appropriate standard (and properly documented) may be reallocated by the relevant taxing authority to better reflect the income of the parties and prevent the evasion of tax. These reallocations are often accompanied by severe penalties.
U.S. transfer pricing rules are generally set forth in IRC Section 482 and the regulations promulgated thereunder. Such rules, covering goods, services, intangible property and other intercompany transactions, incorporate, broadly speaking, five specific transfer pricing methods, with the additional freedom to use an "unspecified method," as long as it satisfies special requirements. The five specified methods are the comparable uncontrolled price (or transaction or service), resale price, cost plus, profit split and comparable profits methods. All of these methods exhibit variations depending on whether the property being transferred is a tangible good, an intangible property or a service. Again, the ultimate underlying principle with any of these methods is that a related-party transaction should objectively demonstrate it was consummated under the arm's-length standard.
Because of concerns raised by many governments and international organizations (like the Organisation for Economic Co-operation and Development) that such practices are subject to substantial abuse, virtually every multinational corporation with related-party transactions is subject to scrutiny. Increasingly, in foreign jurisdictions, companies are finding themselves subjected to local regulations modeled after either the U.S. regulations or the OECD guidelines on transfer pricing. Furthermore, as of late, several favored low-tax jurisdictions have begun joining the initiative to require accountability for intercompany transactions and modeling their legislation to supplement, if not mirror, the OECD regulatory framework.
Accordingly, while active transfer pricing regimes and controversies exist in jurisdictions throughout the world, from across the border in Canada, through Europe, Asia and beyond, this article is not meant to provide an in-depth analysis of international transfer pricing rules. Rather, it highlights a sampling of recent international reforms and variances to consider.
Panama: Panama recently introduced legislation expanding the number of taxpayers subject to its transfer pricing rules, which were initially drafted to govern parties residing in jurisdictions with which Panama had an income tax treaty in force. As the United States and Panama do not have an income tax treaty, these rules were previously inapplicable to transactions between residents of Panama and the United States. However, starting in 2012, Panama's transfer pricing rules apply to all transactions involving residents of Panama and foreign related parties, including those located in the United States. The rules generally follow the OECD guidelines.
Malaysia: On May 11, 2012, Malaysia published 14 updated transfer pricing rules, effective from January 1, 2009, setting forth five transfer pricing methods. Such rules follow the OECD's guidelines and expressly acknowledge the arm's-length principle as the governing standard for transfer pricing in Malaysia.
India: India continues to propose and/or enact bills to modify its transfer pricing rules. On May 28, 2012, Indian authorities enacted The Finance Act, 2012, with effect from July 1, 2012. Under the Act, the Indian authorities introduced the ability to use advanced pricing agreements, giving taxpayers and authorities the opportunity to come to agreement in advance of controlled transactions on the appropriate set of criteria for calculating such transactions over a fixed period of time. On August 30, 2012, the authorities followed up with a notification introducing the rules for implementing such agreements. The Act also extended India's transfer pricing rules applicable to international transactions to certain "specific domestic transactions," including various transactions made between domestic related parties.
Australia: On August 20, 2012, the Australian Senate approved a bill (already passed by the House) that will incorporate into national legislation transfer pricing regulations that were previously only relevant to companies operating under an Australian tax treaty. Such rules will reference the OECD guidelines with respect to interpreting the arm's-length principle. The rules will apply to related-party transactions occurring as far back as July 1, 2004.
South Africa: South Africa recently amended its transfer pricing rules by increasing both the scope and the discretion of authority given the South African Revenue Service to adjust transactions. Under the regulations, which entered into force on April 1, 2012, a related-party transaction is governed by the South African Revenue Service if the taxpayer enjoys a "tax benefit" because the transaction fails to satisfy the arm's-length principle. Transfer pricing adjustments imposed by the revenue service according to the arm's-length principle are deemed to be loans between the related parties involved that carry an arm's-length interest rate. While the taxpayer is required to demonstrate both which transactions are at arm's-length and what an arm's-length interest rate is, previous regulations provided a safe harbor for companies that accepted an interest rate within 2 percent of the appropriate interbank rate. However, this provision was removed from the updated regulations, adding additional exposure risk to multinationals operating in South Africa.
Chile: In Chile, Congress recently approved a bill, effective January 1, 2013, that will not only increase the corporate tax rate and expand the definition of Chilean-source income, but also provide a set of transfer pricing rules that generally follows the OECD guidelines. The previous Chilean transfer pricing rules were drafted in 1997, and while they already incorporate concepts like the arm's-length principle embodied by the OECD guidelines, the guidelines failed to establish which calculation methods were acceptable for use by the taxpayer. Such rules merely referenced the traditional transaction methods as the means by which the Chilean government could adjust related-party transactions. The current bill both provides specific guidance on the use of the traditional transaction methods and stipulates that taxpayers must follow the "best method rule" in the OECD guidelines. The new rules also address advance pricing agreements, which were entirely absent from the previous regulations, as well as the definition of a related party and certain reporting obligations. The new rules provide that a transfer pricing study qualifies as evidence of compliance with the new regulations.
Brazil: Brazil recently introduced changes to its transfer pricing regulations that become effective January 1, 2013. In addition to introducing two new methodologies for calculating the price of commodities (the listed price on imports and listed price on exports methods) and adjusting the applicable rates for related-party loans, the regulations change existing methodologies of determining an applicable transaction price. Specifically, the regulations modify the "PIC" method (equivalent to the comparable uncontrolled price method) to include transactions by comparable third parties in its analysis, which expands the methodology beyond merely including comparable transactions by the taxpayer with an unrelated party and completely revamps the calculations and resale profit margins under the PRL method (similar to the resale price method).
Peru: Peru recently modified its transfer pricing regulations, with varying interpretations. The new regulations, which take effect January 1, 2013, may be interpreted to provide for an adjustment to related-party transactions as long as the government and tax auditors determine that a taxpayer has received a tax benefit from such transactions. Or, the regulations may be interpreted to allow only the government to conduct transfer pricing studies and therefore allow the government to develop its own criteria for determining the appropriate tax liability. These new regulations also cast doubt on their scope by not specifying whether they apply to international transactions or only transactions involving related parties domiciled in Peru.
Russia: Russia's transfer pricing guidelines, which took effect on January 1, 2012, provide that fewer transactions will now be subject to control, while also providing greater detail on which transfer pricing methods are acceptable. The regulations reduce scrutiny over many domestic, barter and even some intergroup cross-border transactions, even though many other transactions between unrelated parties can still be controlled. The regulations also provide for certain revenue caps on transactions, meaning that the aggregate of eligible transactions must reach a certain dollar value of revenue before becoming controlled. While generally conforming to the OECD regulations by outlining the traditional pricing and transactional pricing methods, Russia's guidelines leave a significant gap in providing guidance on more sophisticated transactions by not directly addressing intellectual property and interest-bearing loans. However, the Russian guidelines do indicate a preference for the traditional pricing methods over the transactional pricing methods.
Additional Issues ---- Intra-jurisdictional Transfer Pricing
The enactment of domestic transfer pricing rules (as noted with India above) and the existence of intra-jurisdictional tax arbitrage have also increased the need to review and document intercompany transactions on an intra-country level, based on transfer pricing principles. For instance, in jurisdictions such as Singapore, Luxembourg, Ireland and others, varying tax rates among domestic entities and/or activities create intra-country transfer pricing issues to consider.
To illustrate, take Singapore for example, where an entity may apply for one of various tax incentives, lowering its tax rate. Incentives, among others, include reduced tax rates for qualifying as a regional or international headquarters, a trading company or a promoter of Singapore's industry. However, what becomes tricky is that these incentives are offered on an entity-by-entity basis, with varying tax rates. Accordingly, it is possible for a common parent to have multiple entities domiciled in Singapore that are all taxed at different rates and are, therefore, not allowed to consolidate under their group relief system. As a result, the concern in Singapore is the migration of transactional activity not just to low-tax jurisdictions but also to local entities qualifying for reduced tax rates. Accordingly, Singapore's transfer pricing guidelines state that the arm's-length and documentation guidelines are applicable to all related-party transactions of goods, services and intangible properties, while providing that guidance on mutual agreement procedures and advance pricing agreements are applicable to related-party transactions involving at least one resident of Singapore or a resident of a country with which Singapore has an income tax treaty.
Therefore, as alluded to above, as companies expand their global reach, and as international jurisdictions continue to reform their transfer pricing policies, intra-country related-party transactions may also prove to require further transfer pricing analysis and documentation.
Cost of Noncompliance
Significant penalties may be levied against companies for failing to comply with transfer pricing principles and documentation requirements under both the current and reformed rules and across jurisdictions. For instance, the United States provides that a substantial understatement or gross understatement of tax liability subjects the taxpayer to a penalty of 20 to 40 percent of the understatement, respectively. Panama assesses a penalty calculated as 1 percent of the gross amount of the transaction not reported on an informational return. India assesses a penalty of 2 percent of the value of an improperly documented transaction and 100 to 300 percent of the additional tax payable. In Malaysia, the tax authorities may impose a penalty of 45 percent if the company does not maintain contemporaneous transfer pricing documentation for transfer pricing adjustments made in a transfer pricing audit. The Chilean regulations assess a flat 35 percent tax in addition to a 5 percent penalty on the amount of an adjustment. The list goes on.
Alvarez & Marsal Taxand Says:
This article presents only a sampling of the jurisdictions that have recently updated or instituted a national transfer pricing regulation scheme. The majority of governments instituting transfer pricing reforms are following the OECD guidelines for defining an arm's-length transaction. Countries that previously had limited or nonexistent transfer pricing schemes are instituting regulations that adopt the traditional transaction and even the transactional profit methods, while others like Brazil are instituting regulations that deserve more than a standard OECD transfer pricing study.
For multinational corporations, this means a comprehensive review of your transfer pricing strategy from a U.S. and local country perspective is necessary in order to reduce your risk of foreign tax exposures, as well as to potentially maximize opportunities. Accordingly, we highly recommend you conduct a transfer pricing study for any jurisdictions in which you operate and update your studies for any jurisdictions with recent regulatory changes. In addition, looking at inter-jurisdictional transactions may not enough: taking advantage of local country tax incentives may also mean conducting an intra-country transfer pricing study.
Transfer pricing is an area that requires constant vigilance, with an eye toward continuous compliance, as well as the possibility of adapting your international structuring to weather waves of new legislation as they become effective.
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.