The new cost of global compliance
07 April 2014
Posted by: Author: Brian Tully
Author: Brian Tully ( Thomson Reuters)
Brian Tully discusses the new cost of global compliance in the transfer pricing landscape with emphasis on the importance of private company data for local comparables.
All of us in the tax world know that transfer pricing has been a hot topic this past year. Around the globe, tax authorities have become more aggressive, primarily in order to reduce government fiscal deficits. The transfer pricing practises of a number of companies have been challenged, as tax authorities look to corporate taxes to help buoy revenue above the red line. In the most widely known cases, the argument was layered with issues of ethics, responsibility and interpretation of laws that hadn’t caught up with the realities of business today. Now the conversation has taken a dive into each of these layers, with authorities taking a granular look at not only the tax policy of a business, but how that policy plays out in every transaction and line item.
According to the IBFD and World Bank, the number of countries that introduced specific transfer pricing regulations for direct taxation purposes skyrocketed between 2007 and 2011. These countries are focusing resources on building capacity within their tax administrations to handle the influx of audits and paperwork. At the same time, in a number of emerging markets, tax authorities are taking on transfer pricing for the first time.
The UN, OECD and the World Bank have all been vocal on the need for transparency and standardisation. In the next year or two, the OECD alone plans to rewrite up to 15 action items from its plan, while the UN recently released its updates, with promises for more coming. There’s clearly a need for it since, according to the 2013 EY Global Transfer Pricing Survey, the rate at which transfer pricing documentation was rejected as inadequate increased in 22 of 25 countries surveyed since 2010.
As tax authorities introduce new rules and require corporations to provide detailed documentation
to defend their policies, multinationals must be certain they meet the requirements of the arm’s length standard – and provide the documentation to prove it. Appropriate comparables are one of the biggest issues in this documentation process.
Tax authorities are no longer satisfied with weak documentation and increasingly prefer local comparables. The issue of finding local comparables data isn’t new; it’s the scrutiny that’s changed the game.
Not having local comparables can be costly – according to that same survey by EY, 70 percent of companies surveyed reported they had experienced double taxation as a result of an adjustment; 60 percent had been subject to an interest charge when they had an adjustment, and 24 percent had been subject to penalties. This trend demonstrates that governments are coming down on companies with regards to their transfer pricing. One of the issues is that using public company data from where it’s available and applying that to any region is no longer considered acceptable by many tax authorities.
Although public comparable information is easily verifiable, outside of countries where there is plenty of public company information to pull from, tax professionals must now find a new source of local comparables data on private companies because of more aggressive tax authorities.
"Multinationals worldwide need to make sure they document their position now so they can be ready
to review their position under the new guidelines as they are released”
Most of the public company data comes from the U.S., UK, Germany, Australia and handful of other regions. This leaves the rest of the world – including difficult tax regions such as BRICS, Italy and others – in a sort of dark spot when it comes to the availability of local data, if only public comparables data are being considered. Without a set of local or regional comparables to work from, multinationals run the risk of penalties, double taxation and other audit issues that could cost plenty of time and money. A good comparables set is critical to achieving the highest level of practical comparability – and therefore having a solid case in any litigation or audit.
Dr. James Herald McClure, senior manager of transfer pricing at Thomson Reuters, helps illustrate
this point further:
"As a simple example, suppose that the typical distribution affiliate has $200 million in sales per year and that the multinational grants these affiliates with profit margins equal to 2 per cent, or $4 million per year. If the foreign tax authority in any one nation expects that the profit margin should be 8 percent, there is the possibility of double taxation on the difference of $12 million in that nation alone.
Let’s also assume that the typical contract manufacturing affiliate incurs costs equal to $500 million per year and is afforded profits equal to a 5 percent mark-up over these costs or $25 million per year. If its local tax authority expects this mark-up to be 20 percent, there is the possibility of double taxation on the difference of $75 million.
The individuals in charge of navigating such disputes need access to similar financial information
for regional third-party private companies in order to craft an appropriate position that would hopefully create a mutual understanding between the IRS and the foreign tax authority in order to alleviate double taxation.”
Options for private data are fairly limited; the market for private data is small, but growing quickly, thanks to the push from tax authorities for local data. Purchasing access to private data is the only way to get information on these countries, which is sourced from local statutory filings. To get the most out of this expense, firms should opt for the flexibility of a web-based database with global data that supports regional audits. This allows widely dispersed teams the ability to share data. Larger databases with a
single interface allow those who are not transfer pricing experts to understand the data much easier. Teams would also benefit from accounting firm support and support from the data provider when navigating local audits, as the process and requirements are different everywhere.
Comparables are critical, but are just one piece of transfer pricing compliance. To fully prepare for the changes coming in the next couple of years, it’s best to benchmark your global practices now so there’s a baseline for any shifts later. This means closely looking at documentation, policies and whether the proper information is being disclosed in the financial footnotes for each local government. Companies who do not have a strong handle and system in place for these practices today will get left behind when
changes are introduced.
We can’t know what the future will bring or where the lines will be drawn by local governments or the OECD. But we do know that demands for documentation, transparency and consistency are only going to be stronger in the coming years. Multinationals worldwide need to make sure they document their position now so they can be ready to review their position under the new guidelines as they are released. In the end, having local private data and other audit defense plans in place should help reduce the cost and risk of double taxation and ultimately help multinationals comply with the increasing burden of transfer pricing compliance.
This article first appeared on the March/April edition of Tax Talk.