The Transfer Pricing Story
There are four elements to an MNE’s transfer pricing story:
- The CbC report
- The master file
- The local file
How tax authorities detect risk in CbC reports and how MNEs can prepare
Now that Country-by-Country (CbC) reporting is an integral part of the compliance process for taxing authorities and multinational enterprises (MNEs) around the world, both are looking for ways to do their jobs more effectively and efficiently.
For taxing authorities, this means identifying intelligent means of using CbC reports to detect potential deviations from arm’s-length pricing. For MNEs, this means finding better ways of mitigating potential exposure. For both, the solution is technology that offers opportunities to consolidate, automate, and mitigate.
As taxpayers, MNEs must stay one step ahead of inquiries from taxing authorities. Here, we take a look at how governments are increasingly using technology to detect potential deviations from arm’s-length pricing and how MNEs can use this insight to understand and address potential anomalies in their CbC reports.
MYTH: Our company’s CbC report will be one of many that tax authorities will analyze, so we don’t need to be overly concerned with its contents.
REALITY: Tax authorities are using advanced technology to automate the way they analyze CbC reports in order to allocate resources efficiently in their determination of your potential transfer pricing exposure.
Tax authorities are automating the analysis of CbC reports
The latest advancements in data analytics are giving taxing authorities the upper hand when it comes to analyzing CbC reports. We all know that analyzing and comparing ratios, such as return on sales or assets, can help organizations gain critical insights on performance. But they can also aid tax authorities in determining potential tax avoidance. With data analytics capabilities, tax authorities can compare ratios to other companies in your industry or region — and identify potential anomalies.
This technology enables tax authorities to quickly compare financial ratios within a group or an industry, as well as scan the CbC report for similar “profiles” or “typologies” by identifying certain arrangements that pose a BEPS risk. Taxpayers exhibiting those profiles will inevitably be selected for further scrutiny.
Martin Sullivan’s June 14, 2010, Tax Notes discussion of corporate inversions noted the transfer pricing of oil service companies that led to low effective tax rates: “By inverting, a multinational is no longer subject to U.S. tax from its foreign operations. In addition, the transactions often are accompanied by planning techniques that strip income out of the United States.”
The oil-drilling-rig multinationals Sullivan mentioned often had effective tax rates in excess of 25% before these “planning techniques” were implemented, but lower than 15% after the new transfer pricing structure. This structure often involved either centralized leasing, where the oil rigs are formally owned by affiliates in tax havens or intercompany financing. These techniques shift income from the U.S. operating affiliates and operating affiliates in nations such as Australia, Brazil, Norway, and the UK. In the post-BEPS era, tax authorities will be able to identify characteristics of this transfer pricing structure in the CbC report and flag MNEs exhibiting this profile for further investigation.
How MNEs can proactively identify anomalies in CbC reports
The OECD recently released the Handbook on Effective Tax Risk Assessment as a resource for tax authorities who have implemented legislation in accordance with BEPS Action Item 13. This document explores how tax authorities can use CbC reports to detect and identify transfer pricing risk and other BEPS-related risk factors.
While the Handbook was created for tax authorities, MNEs can glean important insights from the Handbook’s tax risk indicators and use them to strategically mitigate potential risks in their CbC report. This mitigation is increasingly important as more and more taxing authorities are taking advantage of technological trends to automate the way they analyze CbC reports to better pinpoint risk and allocate resources efficiently.
What Tax Authorities are Monitoring for Signs of Transfer Pricing Abuse
Some of the potential risk indicators tax authorities can monitor in CbC reports include:1
- High relative profits in a low tax jurisdiction or low relative profits in a high tax jurisdiction
- Results that do not reflect market trends in a jurisdiction
- Jurisdictions with significant profits but little activity
- Jurisdictions with significant activity but low profits (or losses)
- A group has procurement entities located in jurisdictions outside its key manufacturing locations
It’s important to note that while CbC reports can provide indications of potential BEPS risk, the Handbook emphasizes that it does not provide evidence in and of itself. That said, the Handbook provides 19 specific tax risk indicators and what they could mean in terms of risk, as well as other possible explanations for their existence.
This document offers an enormous opportunity for MNEs to proactively mitigate risk within their CbC report ahead of possible inquiries from tax authorities.
Is your CbC report putting your transfer pricing documentation at risk?
The OECD listed 19 “risk” factors. The key considerations are:
- The types of activities conducted by each of your affiliates
- The scale of activities conducted by each of your affiliates, as well as the level of related party revenues
- The profits received by each affiliate relative to the scale of activities and/or the reported level of assets
If relative profits are low in a high tax jurisdiction, the tax authority for that jurisdiction may deem this to be indicative of transfer pricing abuse. High relative profits in a low tax jurisdiction will also be seen as an indication of transfer pricing abuse. In general, a low effective tax rate will require some explanation by the multinational as to why its overall transfer pricing should be seen as consistent with arm’s-length pricing.
Action Item 13’s documentation requirements include a master file as well as local files. A properly prepared master file tells the multinational’s overall transfer pricing story, including the functions, assets, and risks for each affiliate, the ownership of intangible assets, and the nature of intercompany financing. Transfer pricing practitioners often prepare reports that lay out the multinational’s overall story as the foundation for the overall documentation of a multinational’s transfer pricing policies as being arm’s length. Local files would follow by providing the actual economic analysis appropriate for each jurisdiction.
Particularly difficult issues may arise when a multinational undergoes a restructuring of its activities, as well as transfers of key assets that materially impact the allocation of profits. Tax authorities may also take notice when the location of intangible assets is separated from the performance of intangible development, marketing activity is separate from key markets, or procurement entities are located in jurisdictions outside the key manufacturing locations.
How MNEs can tell a consistent transfer pricing story
In the post-BEPS era, there are four elements to an MNE’s transfer pricing story:
- The CbC report
- The master file
- The local file
- Intercompany agreements
Technology adoption is becoming more common for MNEs in telling a consistent transfer pricing story.
Technology addresses transfer pricing challenges by:
- Providing a cost-effective, web-based solution for easy, step-by-step analysis of the arm’s-length nature of tangible, intangible, service, and loan transactions
- Offering a comparable database platform to search multiple global private and public company databases at once
The latest technology solutions enable MNEs to centralize transfer pricing data and documentation, collaborate with multiple users across geographical and departmental barriers, visualize global transfer pricing exposure, and execute global documentation filings.
To illustrate how technology can assist in the example above, an oil rigging MNE may proactively monitor the presentation of the CbC report, choose to upload a CbC report into a technology application on a quarterly basis, and utilize custom analytics to monitor certain key ratios. A low profit before tax to tangible assets ratio may suggest that the rig owners are charging leasing payments in excess of the arm’s-length price, effectively shifting profits from the jurisdictions of the lessees to the jurisdiction(s) of the lessor(s). The proactive monitoring
of this ratio has now afforded the MNE the ability to apply adjustments and remedy the economic distortion prior to filing the CbC report.
Bottom line: The OECD’s release of the Handbook on Effective Tax Risk Assessment further illustrates that technology is critical in the post-BEPS environment. Tax authorities are adapting and, if MNEs want to comply with confidence, it is essential that they do so as well.