Written By: Susan Smithfield – Corporate Finance
In today’s economy in which multinational enterprises (MNEs) play an increasingly prominent role, transfer pricing continues to be high on the agendas of tax administrations and taxpayers alike. Governments need to ensure that the taxable profits of MNEs are not artificially shifted out of their jurisdictions.
The Organisation for Economic Co-operation and Development (OECD) recently released the 2017 edition of its Transfer Pricing (TP) Guidelines: “The work of the G20 and the OECD to repair and improve the international tax system so everyone pays their fair share remains one of the most important responses to these challenges, as well as one which is having a concrete impact,” said Angel Gurria, the OECD’s secretary-general.
In the 2017 edition, the OECD particularly insists on the use of the “arm’s length principle” and also dedicates a large chapter to the transfer pricing of intangibles, which include patents, copyrights, and trademarks and trade secrets, which are not easily slotted into physical or financial categories but that nevertheless traverse corporate family-tree branches of multinational enterprises.
Inter-company pricing under arm’s length principles not always easy to prove.
Among the different methodologies listed by the OECD to be used by multinationals to price transactions between two of their related parties, the arm’s length methodology makes sense to tax authorities and governments in that the amount charged by one related party to another for a given product must reflect the market price that two independent parties would apply. Countries feel less harmed if tax authorities can check that the revenue received for exports represents the fair market values of the transactions. They generally want to ensure that the tax bases reported by multinational enterprises in their countries reflect the economic activities undertaken.
However, for some multinationals, and especially financial ones, the arm’s length methodology is not so easy to use. Indeed, in some cases, no market price is existing or easily available. Hence, the documentation to be gathered (such as markets analysis) and to be shown to the tax administration to prove the price set is not available.
For banks, for instance, it is common to charge subsidiaries for the information-technology (IT) development made by the mother company for all subsidiaries. If those IT developments are made in developed countries, the arm’s length principle will come to a far higher price than the subsidiary would have paid in its own country. The interest of the group is to harmonize the IT tools so that all of its subsidiaries are using the same software, and to ensure that development costs are incurred under the mother company’s control. But if the arm’s length price in the mother company’s country is not the same as the arm’s length price in the subsidiary company’s country, both tax administrations could have something to contest.
The OECD insists in its report on the use of the arm’s length method, even in cases in which the documentation is difficult to obtain, and stresses that tax authorities should not systematically suspect fraud when enterprises have difficulty collecting documentation. The OECD rejects the global formulary apportionment method, sometimes used to replace the arm’s length method.
On intangible assets, the OECD is also attempting to clarify what can be accepted.
Indeed, many multinational companies are charging to their subsidiaries their trademarks, copyrights or other patents. This is quite an easy way to charge their group costs to and shift profits from their subsidiaries. However, the amounts are often heavily challenged by tax authorities and lead to lawsuits between them and local tax administrations, which do not accept huge amounts that are sometimes difficult to analyse and justify.
In its 2017 edition, the OECD puts in light how the arm’s length conditions must be determined for the use or transfer of intangibles, one of the most controversial transfer-pricing topics: “In cases involving the use or transfer of intangibles, it is especially important to ground the functional analysis on an understanding of the enterprise’s global business and the manner in which intangibles are used by the Multinational Enterprise to add or create value across the entire supply chain”.
According to the guidelines, taxing authorities need to identify who controls the intangible and who benefits from it. In some multinationals, the intangible’s “legal owner” may not be the only one involved in, or benefiting from, or at least partially responsible for the intangible, the OECD explained. “For transfer pricing purposes, legal ownership of intangibles, by itself, does not confer any right ultimately to retain returns derived by the Multinational group from exploiting the intangible, even though such returns may initially accrue to the legal owner as a result of its legal or contractual right to exploit the intangible….The return ultimately retained by or attributed to the legal owner depends upon the functions it performs, the assets it uses, and the risks it assumes, and upon the considerations made by other Multinational group members through their functions performed, assets used, and risks assumed.”
For the mother company’s invoicing of part of its intangible assets to a subsidiary, contractual arrangements will not be sufficient to prove the reality of the costs incurred by the mother company. Real functions must be fulfilled and real risks must be assumed to justify any intangible assets invoiced by the mother company to its subsidiary.