Matthew DeMello: As far as survival techniques for MNEs in the midst of pandemic, tax scrutiny, of course, is a major risk for MNE’s going forward. Mimi, how are you seeing clients or anyone on your radar responding to that tax scrutiny?
Mimi Song: So I think historically we’ve been talking to a lot of multinationals who perhaps had tabled transfer pricing had tabled international tax scrutiny in terms of their top priorities.
But all of a sudden that’s starting to bubble up, back up to the top now that they’ve been able to deal with some of the more urgent fires, like keeping on the lights and making some more strategic business descriptions.
Everything else has to fall into place. And so multinationals are now alert to the fact that many of them, their fiscal years just ended. They had to deal with year–end provisioning and things of that nature. And now they have to worry about the compliance aspects of it. And they’re thinking, “Oh no, okay. Here’s, here’s another fire I have to deal with now because most multinationals do understand that tax scrutiny increases.”
And I think we’ll get into that over our discussion today, just about who’s looking at what and how do we know that.
Matthew DeMello: Of course. And I think a great place to start specifically with who’s looking at what is Denmark. I’ll leave it to you for at least the description for why they make the list, but this has traditionally been a tough jurisdiction for MNEs.
Mimi Song: Oh, absolutely. I mean, they have one of the highest tax rates in the world, right? And individual tax rate can be half of your income. I mean, they have a lot of social taxes that are being applied. They have twenty-five percent VAT on purchases, 150 percent tax on cars.
And we’ve always known that the Danish tax story, which we will refer to as SKAT, they’ve always been aggressive. They were the first jurisdiction that I know of that applied a just for not having documentation in place. Their tax authority has become much more sophisticated when it comes to transfer pricing. They’ve increased the number of examiners. I think over a hundred new examiners have been added over the past 10 years. And the Danish tax authority actually was able to collect over 80 billion Danish Krone from multinationals over that time. And this is pretty significant uptick.
They even have proposals to incorporate what they call a Tax Evasion Alarm Center which is like a whistleblower channel. It’s “Hey, report, suspicious tax behavior here!”
Who knows that they’ll be able to provide a little benefit or a little prize for those reporting! But I wouldn’t be surprised if that would be the case. And they have a lot of analytical tools that are at their disposal. They do think that transfer pricing related issues are significant that it’s an area of focus and they are going to be proposing over 1,000 new employees over the next four years. It’s a lot of investment of time and effort there.
Matthew DeMello: As far as the Tax Evasion Alarm Center that might even say something to our listeners just about the culture you already need the culture in place of a, ‘see something, say something’ for that to work. I don’t know if you could [laughs with Mimi] do that as easily in America and expect the same results.
But what does all of this mean bottom line for MNEs? What are the changes in mentality that they need to make to address these challenges?
Mimi Song: I think it means you, first of all, you can’t avoid the documentation requirements, right? Like as stated. Denmark has a penalty, if they don’t have documentation prepared. So clearly the burden of proof is on the taxpayer. And basically if the documentation isn’t prepared, the SKAT can make discretionary assessments. That’s not unusual, but we know that it’s, it’s very specific to Danish standards. And so that’s really the challenge.
They have very specific prescribed standards that they’re looking for at the end of last year, the Danish parliament actually passed a bill that requires taxpayers to submit the master file. Local file effective for tax years, beginning on January 1st, 2021. And that deadline is within 60 days after the tax return is filed. So they give you a little bit of cushion in terms of your documentation. Doesn’t have to be contemporaneous with the tax return, but it has to be filed and prepared 60 days after you submit your tax return. And that’s a change. That’s a big change, all of a sudden: it’s not a nice to have, it’s “You have to submit it.”
The actual content requirements they do generally follow the OECD recommendations. So in terms of the content requirements for documentation, it hasn’t dramatically shifted for what Denmark wanted to see pre 2021. But once again, I think the focus here is on the fact that you no longer just need to prepare the information and get penalized when you get audited, you actually have to submit it. You are required now to submit it 60 days after your tax return on an annual basis. Now let’s remind our listeners that the penalty could be upwards of 30,000 euros per year. It’s actually 250,000 Danish Krone, but depending on interest rate fluctuations, we can do the conversions. And then there’s even additional penalties that are applied in case there are adjustments right up to 10 percent of the adjustment amount could be penalized. And then on top of that, if you don’t have your documentation, it’s not only do you start off with a baseline penalty of 250,000 Danish Krone, but then you get penalized every day until you submit it. It’s not fun.
Matthew DeMello: Well, in speaking of this submission, how does that change the mindset for taxpayers in terms of preparing versus submitting?
Mimi Song: So historically Denmark’s one of those countries where the documentation is a must have, where it should have been prepared contemporaneously. So perhaps the mindset from a taxpayer who has operations in Denmark, it goes from ‘should have’ to ‘must have.’
And I’ve always categorized it as a ‘must have’ anyway, but because you’re physically having to submit that documentation, it raises the level of awareness and it raises the requirement standards.
I mean, think about your homework. If your teacher said, “Hey, Matthew, you have to do your homework by the end of this week.” Okay. But I’m going to collect that homework next Tuesday, or she may or may not collect it. There’s still this question where I go. She just said it had to be done by Friday, but she may or may not collect it. That’s going to change your mindset about whether or not you have to have it done by Friday.
Matthew DeMello: Of course. And once again, that the classroom trickles in and our anecdotes about transfer pricing, just to sum up here, at least some bottom line mentalities that MNEs can adopt, at least when it comes to their Danish transfer, pricing, documentation, more documentation requirements in Denmark now, more penalties…
I feel a little bit like that. MSNBC pundit who always like quotes rappers. Because now I sound a little bit like the Notorious B.I.G., “More documentation requirements, more penalties, more problems…”
It’s just it at the end of the day. More resources, more resources employees at the Danish tax authority. Now more analytical tools for evaluating documentation and suspicious tax behavior. We know transfer pricing is a priority for what has already been a very aggressive tax authority. Mimi, what are some strategies MNEs can employ to address these challenges?
Mimi Song: Well, I think first and foremost, ensuring that you have documentation and then not only do you have it, but doesn’t meet those Danish requirements. Is it robust enough to meet those localized standards? Or did you take a sort of haphazard approach to just meeting the contemporaneous requirements? Because now you have to be mindful of the fact that SKAT is going to be looking at this and then not only that, but with their additional analytical tools, could they be reading these documents using AI or machine language? I mean, that’s not out of the question, right? And so given that, are there certain ways you want to put this together? So that it makes sense. So that it’s not triggering any red flags. Do you have a robust functional analysis that really tells the story of where value is being created? Have you selected the most appropriate method, given your facts and circumstances?
So these are all the things that you’re going to have to reevaluate to make sure that your documentation aligns with the SKAT’s requirements so that when you do submit it, it’s not going to trigger an audit.
One thing I do want to focus on is clearly the functional analysis. It needs to be prepared to make sure not only is it telling the story about your business, but that it is telling it in a way that the reader can really understand what is driving value within the organization. So the functional analysis in and of itself, maybe the old way that a multinational had put it together was focused on one entity versus the actual transaction. But remember the functional novices is going to dictate the type of method to be applied. And so it has to focus on the transaction. It has to make sure to delineate the different activities, being performed by the two different parties, as it pertains to that particular transaction, it has to stand up and be clearly understood and therefore help dictate the type of method to be applied.
And so if you have a good functional analysis and then it helps determine and assess the applicability of each of the methods, then you can highlight which method should be applied, given those facts and circumstances. And so you need to be very mindful of that. If you’re doing your documentation for Denmark, it goes above and beyond just what you might have had historically, because someone’s going to be reading it. And if someone’s going to be looking at it that closely and trying to determine whether or not it is, it is sufficient enough to avoid potential adjustments. So that’s what you need to be mindful of as multinational operating in Denmark.
Matthew DeMello: Of course, of course. A jurisdiction we’re going to be keeping our eyes on throughout the year, for sure.
So to just give a brief synopsis here. The reason they make our list is they’re combining transfer pricing with corporate audits. More companies are getting audited effective for fiscal years, beginning on or after April 1st, 2020 new regulations provide guidance on intangibles in align with OECD guidance on intangibles, including valuation.
The discounted cash flow method is an acceptable method seen as reliable by tax authorities, transfer pricing directive state that when the discounted cash flow method is one of multiple appropriate methods, the other method should be selected. So it’s a possible revenue grab.
The statute of limitation for transfer pricing is extended from six years to seven years. The net now has an additional year to review in propose adjustments expect to be scrutinized by tax authorities.
Turning to our next jurisdiction on the list. That would be Japan. What puts Japan on the list?
Mimi Song: So in 2016, Japan’s NTA, they actually announced the International Taxation Total plan. And according to the plan, the tax authorities highlighted that they’ll be conducting vigorous tax audits on CrossBorder transactions of multinationals, as well as high net worth individuals.
And when we talked about Japan historically in one of our previous episodes, I was explaining to you that the Japanese, culturally, they are good corporate tax paying citizens, but that doesn’t necessarily mean that all companies are Japanese parent companies. They’re all MNEs operating in Japan fall within that bucket, perhaps. But beyond that, the NTA is also focused on increasing its tax base as well as tax revenue, you know, because Japan’s economy has its own challenges. I mean, it’s suffering from a deflationary environment for the past 20 years.
So when we think about Japan over the past – what, five years or so, I think 2016, for over four years – the amount of the adjustments that they were able to identify for cross border transactions had increased from $2.2 billion in 2016 to over $3 billion in 2017, and then even further to $6 billion in 2018.
So if you see put yourself in the NTA shoes, if you see that upward trend, right of adjustments coming from cross border transactions, clearly you’re going to throw more resources at this. Cause maybe there’s even more that you’re missing, or maybe there’s some additional activity that you’re not able to scrutinize because you can’t audit every single company.
So the NTA basically said that the key issues that they’re going to be focused on would be transfer pricing, donations to overseas enterprises payments that are basically characterized as gratuitous payments or gifts, and shouldn’t be deducted; and then controlled company rules. So those are the areas of focus in 2016. Now Japan also, they were one of the countries that put audits on hold because of the pandemic, but then they resumed those audits in the middle of all this. So sometime around October, and that was before it came to a close and it were still ongoing, but they were very open about focusing on multinationals cross border activities.
And they want to be able to make sure they’re applying their resources strategically. Because as I said, you could see that increasing trend of revenue being identified as a result of these audits. And so they’re already highlighting to operations locally, “Hey, if you don’t want to get audited, start paying attention to your intercompany transactions, because we’re going to come, we’re going to find the issues and we’re going to challenge them.” And now transfer pricing audits are just par for the course with corporate tax audits.
So essentially if you’re on the list to get audited through one of those natural corporate tax audit cycles, many Japanese companies are. They expected audit every two years or so. You can expect to be audited for your transfer pricing.
Matthew DeMello: And that’s just part of the regular functions. Is that something that you can just expect as a Japanese taxpayer in that case, the further corporate audit?
Mimi Song: Absolutely. Do we remember tax authorities, when they audit companies, they’re trying to go through a cycle and audit every single company eventually, right? They’re trying to cycle through all of them, but now transfer pricing audits are going to be par for the course. With these corporate tax audits, more and more taxpayers are going to be subject to transfer pricing audits, which in turn could result in additional adjustments and increased tax revenues for Japan. One of the things I also wanted to highlight, Matt, the NTA, effective for fiscal years beginning after April 1, 2020, because there are actually a lot of companies like MUFG Union Bank that had a fiscal year end of March 31. It’s not sanctuary, but it is elective. But we do tend to see that for Japanese multinationals., the new guidelines, the new regulations, actually provide additional guidance on intangibles.
And they start to align more with the OCD guidelines on intangibles, including valuations, right? And so one of the methods that companies can use to value intangibles is actually called the discounted cashflow method. And this had historically been seen as unreliable by tax authorities, so the DCF method. But the TB directives by the NTA actually state that now they would deem the DCF method as one of multiple appropriate methods.
And so you have to question the reliability here or exactly what the direction that the NTA is heading if out of one side of their mouth, they’re saying the DCF is unreliable and now on the other side, as a directive, they’re saying, “Oh, it’s a reliable method.” What is going to happen? Why are they talking out of both sides of their mouth? Are they setting taxpayers up for challenge or are there other underlying motivations happening? That’s the piece where they have to be mindful of.
And don’t forget, they’ve also changed the statute of limitations for transfer pricing from six years to seven years, that’s in line with a lot of other jurisdictions. So not a problem, but ultimately it’s an additional year that they can audit now. So an additional year for them to go and audit, propose adjustments. So Japan is definitely on the list.
Matthew DeMello: And Mimi, what are some of the strategies MNEs can employ to address these challenges?
Mimi Song: Once again, I think we know transfer pricing audits are going to be inevitable. And so, because of that, the level of documentation, the level of transfer pricing requirements, it should be prioritized higher than anything else. It shouldn’t be a ‘nice to have’ or ‘should have’. It really does become a ‘must have’ because documentation requirements in Japan, they are contemporaneous requirements. And you inevitably, if you’re going to get audited, you’re going to be scrutinized for your transfer pricing.
And we know the NTA is focused on this vigorously, right? I mean, that’s their choice of words. So making sure that you have the documentation to support your positions, but especially when you think about the intangibles, how have you, as an organization valued your IP. Did you use the discount cashflow method? If so, is it, is it going to be scrutinized by the NTA? Have you selected the appropriate discount rate to be applied in the DCF model? Is that supportable?
A lot of times it’s the inputs that are challenged as opposed to just the output. So the various inputs, like the discount rate being applied, it’s going to have an impact to the value of the IP in terms of how you’re applying that model.
Being focused on that is really important, being able to have a supportable position and … just the knowledge of understanding that the NTA is aggressively seeing transfer pricing revenue as a way to increase their tax revenue should already put you on the edge of your seat to make sure that you are in a position so that your multinational, you should expect that the NTA is going to be looking at your transfer pricing policies and your frameworks, and have all the evidence and the support in accordance with their local rules and guidelines.
Matthew DeMello: And like your homework, you want to hand that in on time. Just bottom line.
Mimi Song: [Laughs.] That’s exactly right.
Matthew DeMello: As we all learned in school.
Which brings us to our next jurisdiction, which is the United Kingdom. I would say many recent events and the institutions being founded at least to increase tax scrutiny that lead to this. But tell us Mimi, why did the UK make the XBS list?
Mimi Song: There’s been a lot happening in the UK. They had their whole diverted profit tax introduced in 2015. They were also at one point going to implement additional mandatory disclosure requirements. Now that’s recently changed. They’ve basically taken the OECD framework and applied their own nuances to it. But they’ve always been concerned about which multinationals are not paying their fair share of taxes.
And so, this has not been a surprise to see that the UK has been focused on transfer pricing. But we also know that they’re even taking it a step further. We understand that HMRC has relaunched a campaign on multinationals that they suspect are unfairly and wrongly reducing the UK tax bills and shifting profit outside of the UK.
And they’re taking a more criminal [law-based] approach to it. It’s going beyond just, hey, taking advantage of tax arbitrage opportunities. But to say that they’re doing it egregiously and they’re doing it against their laws, right? And that they’re doing it in such a manipulative manner as to avoid the payment of taxes.
So the HMRC themselves, they’ve estimated that 2,000 largest businesses with operations in the UK could owe an additional – get this number – 34.8 billion British pounds in tax related to just two years. That’s significant, right? I mean, over $30 billion of potential tax losses. So why wouldn’t they put more resources toward this effort, if that’s what they’re estimating it at? That’s their market size.
What we’re seeing is, HMRC said that of that $34 billion of unpaid taxes, over $10 billion was specifically related to transfer pricing. That’s an area for them to focus on. So HMRC has basically come out of the gate and said, “Multinationals, you need to be on alert. I’m putting you on notice that we are going to be auditing your operations. We’re going to be auditing your cross border transactions, your transfer pricing, your transfer pricing policies. We’re going to be reviewing all of your transfer pricing arrangements.”
They had suspended audits during COVID as many countries and jurisdictions did, but then they relaunched them back in September. And then they’ve asked multinationals, basically, I don’t know if asked is the right word. Maybe, they’ve demanded [laughs] that multinationals review all of their transfer pricing arrangements and asked them to send them a letter to tell them, “Hey, our transfer pricing was appropriate.”
So it really has focused on this area significantly. And then the HMRC basically indicated that in their investigations, that they have identified that UK profits don’t reflect the actual value created in the UK. They’ve used words like “careless and deliberate behavior requiring penalties.”
They really want to make an example of these multinationals, I think. And then that’s really what they seem to be set out to do. So with the profit diversion compliance facility, this whole transfer pricing disclosure tool that the HMRC has initiated, they’ve basically given notice to multinationals. They sent a bunch of letters out to target multinational companies who they basically have told, “We’ve done our research, we think that you’re not paying your fair share of taxes in the UK, we think you are diverting your profits to low tax jurisdictions. And we are coming after you!”
Basically, it’s sort of a warning letter. And in this warning letter, it’s notifying MNEs that “You need to send us additional information. And here we’re giving you a little bit of an olive branch because we know you’re doing wrong, but if you want to tell us what you’re doing wrong and how much you’re doing wrong, we’ll cut you a little break.”
So it’s an opportunity to self–assess, identify your own transfer pricing issues in order to mitigate how much penalties and/or adjustments the UK themselves or the HMRC themselves would potentially identify. So it does show that there’s this heightened sense of focus. And for multinationals receiving this letter, it puts them on edge to think, “Oh my gosh, okay, what do they have on me? Is everything right?” And then they’re going to have to reevaluate the appropriateness of all of their transfer pricing–related issues.
Matthew DeMello: That’s right. I feel like there’s another homework analogy here. Maybe the teacher has the homework, and the student doesn’t know – no, I’m kidding.
Even in the best of times, the HMRC is aware and focused on profit shifting by MNEs, we should note. But, even if that scrutiny seems heightened at this point, COVID deficits definitely added to this. They’re tracking what they believe is missing income. They’re setting up profits diversions tax to encourage MNEs to self-censor. And there’s no denying the focus on transfer pricing compliance, now, of course. But what does this mean for multinationals going forward in terms of just the realities they’ve got to accept about operating in the UK?
Mimi Song: I think the biggest challenge is that you are ultimately guilty until you’re proven innocent. You know, it’s this idea of, “Hey, multinationals, we know you’re doing this, so just fess up and tell us what it is that you’re doing and we’ll take it easy on you. So you really need to focus on making sure that your transfer pricing arrangements are considered arms length in accordance with the HMRC perspective and mitigate the challenges that they’re potentially going to be seeking.”
Matthew DeMello: And what are some strategies MNEs can employ, what are some best practices, and MNEs can employ to address those challenges.
Mimi Song: So intercompany agreements, policy documents, make sure that everything is consistent, it’s aligned. Make sure that all of your documentation requirements meet the local preferences so that you don’t necessarily have to worry about if you’re checking off all the boxes, because HMRC is pretty specific in terms of what they’re looking for. You need to make sure you have separate transfer pricing reports for all of the entities.
Now here’s where it gets interesting because you know, sometimes a multinational may just have a country specific report, but based on our experience, we know that multinationals who have been audited in the UK, they do realize that having separate legal entity reports in the UK is actually better and more important. Other things to note, the UK will challenge the use of CUP data, right? The comparable uncontrolled price method. They’ll want to look at that specifically.
They’ll want to challenge the applicability of CUP data because it’s easy to challenge CUP data given the high level of comparability required. So they’re going to want to look at that. They’re going to want local comparables. We know this, and there’s actually a sufficient amount of data on UK companies. So I think it’s called companies house or something along those lines, where it’s the local UK registry for all companies operating there. And they’re going to make sure that when they come and audit you, your documentation is prepared contemporaneously.
So they’re going to want you to hand over your analysis within the 30 days that they allot for you, because to be honest, that UK is tax return filing timeline is 12 months after the fiscal year. They’re one of those jurisdictions that give you the longest period of time. So not having your documentation within a year of the fiscal year–end close is not acceptable to them.,
Matthew DeMello: Allowing all of that time to hand in homework, you’re going to get the F if you really don’t make that really generous.
Mimi Song: Yeah. It’s a very generous deadline. It’s basically just have all your homework done before the end of the school year, that’s basically what’s happening here. Just know that the selection of your method has to be supportable, right? Because your method is going to be potentially challenged under audit. That’s the easiest way to figure out whether or not there’s an adjustable amount by changing the method. Hey, you apply to CUP method. What happens if I apply CPM? Oh, it means you owe more taxes in the UK. Well then how come that’s not a method that you chose to apply? This method is no good. So just having a certain level of awareness in terms of the various methods that are applicable, I think will just put you in a better position.
Matthew DeMello: Turning to our next jurisdiction, a very obscure one, the United States of America. I think if we needed at least two reasons that the U S would make our list, it’s the recent cases we’ve seen involving Coca-Cola and Whirlpool. But Mimi, tell us why did the U S make the list?
Mimi Song: So, yes, because they have some pretty landmark cases that they’ve recently won. And I’ll be honest, it’s not often that they win, especially when it comes to transfer pricing related issues. I would say over the past 20 years, there are some key cases that were ruled against the IRS. And yet, most recently they won the Coca–Cola case, where Coca-Cola now owes an additional $3.3 billion in taxes every year for a period of three years, actually. So in total, you’re talking about over a $9 billion adjustment. It’s significant.
And the case in and of itself is important because Coca Cola’s arguments were historically based on the outcome of their IRS audit back in 1996. So Coca-Cola said, Hey, IRS, you can’t challenge us because you already did. And you agreed on this back in 1996, right? Just to give a little bit of context here. Coca-Cola was being challenged because of the royalties being applied for certain IP related to its secret formulation that the whole entire supply chain between the bottler and the owner of the formula is being challenged.
There was too much profit being retained in those four jurisdictions where the activities were considered routine. Those were the bottling companies. And because they were considered routine the tax authority of the U S or IRS basically said, well, that doesn’t really make sense. Why is it that the entities that are performing their routine functions are the most profitable within the context of the entire value chain? And so the focus on the value chain is that much more important these days. And the IRS challenged the assertion against Coca-Cola to say that this doesn’t make sense. Profit is not being earned in the jurisdiction where that value is being created. And then a lot of the value with respect to Coca-Cola is in the formulation. It’s in the secret sauce.
Matthew DeMello: Turning to the next case in the rarity of the IRS winning these court cases. Another major case was Whirlpool. And what does this tell us about the challenges facing MNEs when it comes to the United States’ tax jurisdiction in transfer pricing.
Mimi Song: So the IRS with the Whirlpool case, we know that they’re basically they’re on a roll. Now they’re challenging this arrangement that Whirlpool created, where ultimately the sales were generated through its Luxembourg affiliate. And so right now, Luxembourg is considered a tax haven. What’s happening is the Mexican maquiladora was manufacturing goods, which then sold to the Luxembourg affiliate. And now all of that profit associated through the generation of the sale of these appliances or being quote unquote taxed in Luxembourg. But the IRS was asserting that ultimately this structure was diverting those profits and taxes away from the U S and they should have been rightfully taxed in the US. And this is one of those cases we know, right? Many jurisdictions out there are focusing on tax havens and intercompany structures that insert tax havens into the whole structuring order to take advantage of the lower tax jurisdictions. And then the Tax Justice Network had recently announced that an estimated $500 billion in corporate tax $500 billion is lost to tax havens every year. And we know that tax havens are an area of focus for many, many jurisdictions out there, because it is a way for multinationals to set up structures, to really divert profits away from, you know, high tax jurisdictions, like the US.
Matthew DeMello: So the IRS won a transfer pricing case over intangibles. As we went over with Coca-Cola, we can expect more scrutiny of intangibles. I will just say with my background in global policy, a conversation about tax havens writ large in America is long, long overdue inside, out of transfer pricing in corporate tax law. We’re going to see more cases, more investigations vis-a-vis Coca-Cola and Whirlpool. Whirlpool is based on a foreign based company sales income, or FBCSI, on tangible goods, appliances. Both cases show that multinational companies are employing questionable strategies that mean less money for the IRS. So if you are the IRS, you’re thinking, who else might be doing the same thing? Mimi, what does this mean for MNEs?
Mimi Song: I think MNEs need to be worried. Now, the IRS has a couple of wins under its belt, and now they know exactly what they need to do to target other multinationals operating under similar structures. Perhaps, you know, MNEs who had historically been relying on outdated structures that no longer were representative of value creation. Those are areas that the IRS can target now.
With the Whirlpool win, for example, there are lots of multinationals potentially that have a Luxembourg affiliate, whether or not they’re operating in a similar capacity has yet to be determined. However, with the information that the IRS has, they can target those companies now. They can audit those companies and focus on that and say, Oh, you have a Whirlpool structure. I’m going to come after you. Right. CBC reporting alone gives them visibility into this. Oh, they have a Luxembourg entity. And in Mexico, maquiladora, let’s call it, look at that. And you know, that income is not taxable under sub–part F so, so it gives them a lot of wind under their wings, if that’s the right expression, to be able to find the right multinationals, that they’re going to be able to target and actually come out with a fruitful adjustment.
Matthew DeMello: I don’t know if that was the right expression, but that is one of my favorite Bette Midler songs. So I will accept that. [Mimi laughs.] Now, what are some strategies that MNEs can employ to best address these challenges?
Mimi Song: Let’s take the Coca-Cola case, for example. If you have foreign offices with routine functions or functions that would be considered routine, be mindful of that and understand what piece of that, system profit is being retained by that routine entity, because that’s going to be an area of concern. And Coca-Cola’s clearly an example of that.
So if you have that sort of framework, make sure that you can articulate and explain what piece of the system profit is being retained by the routine entity. And so that you’re not triggering a red flag in that situation. And I think Jennifer Best at the IRS talked about sometimes they get documentation with just a list of facts and factors that described the business description, but it’s not a real analysis. And I think that’s a pretty telling statement because what the IRS is saying as part of their FAQs, or best practices, that they had given out, she wants taxpayers to take that list of facts and circumstances to the next level, and make sure that companies are giving a robust analysis of how their company’s facts and circumstances compare to the legislative framework and why it would be determined that those intercompany practices would be considered arms length. It’s not just a list. It is a true analysis that you need to be focused on.
And then in addition to that, you clearly have to make sure you’re explaining what sort of method you’re being applied. Do the outcomes actually make sense? Are you perhaps operating under a similar structure like Coca-Cola or like Whirlpool that you could easily be challenged? Because if you are, you may want to take a closer look at making some adjustments accordingly.
Matthew DeMello: On to the next jurisdiction on our list. It is Thailand. Mimi. What puts Thailand on the XBS list?
Mimi Song: Well, over the last few years, Thailand has actually been focusing on transfer pricing. They’ve passed transfer pricing–specific legislation. And we know that there are many multinationals that have manufacturing and distribution hubs in Thailand. So after January of 2019 Thailand, actually, they’re not an OECD country, but they wanted to be part of the OECD inclusive framework. And so as part of those minimum standards, they had to codify the arm’s length principle into their particular revenue code. They’ve also gone beyond just the minimum standards. They’ve been able to impart powers to their local tax authorities, right, their officers, to be able to impart transfer pricing adjustments, that from what they deemed to be non-arms-length transactions. They’ve included mandatory documentation requirements, as well as a new transfer pricing disclosure form. So they’ve done a lot here to focus on transfer pricing as an area for them to target.
And we know that in 2020, their rules continued to evolve. And they’ve also now issued additional rules for country by country reporting. Even in November, they issued new regulations that provided their tax officers with guidance on how they should be looking at internal and external comparables, which is better aligned with the OECD transfer pricing guidelines now, but it does go to show you that there’s a focus on education so that the tax officers understand what it is that they’re looking for and what they should be looking for.
And I think that there’s still an outstanding question of whether or not foreign comparable benchmarks would be acceptable because Thailand is one of those jurisdictions that we know they have a preference for local comparables. And we’ve talked about this before, but we see this a lot in those emerging market jurisdictions that want to see comparables operating in their particular jurisdiction, their local comps.
And I think a lot of that has to do with clearly geographic market comparability, number one, but also just lack of availability of information outside, two. So anyway, the disclosure form I think is important right now, you have to have the disclosure form for your fiscal year ended December 31, 2019. And then that was recently extended because of the pandemic, but expect to see that that continues to be a requirement on an annual basis for entities operating in Thailand.
Matthew DeMello: Absolutely. And just to summarize for our audience in terms of, of recent events in Thailand, new regulations, many subsidiaries operate in Thailand as low risk or routine businesses. They perform routine functions and assume routine risks. The Thai revenue department may expect a reasonable return on a year on year basis for such companies.
A new disclosure form is now in effect that we just described. The revenue department will now have significant data about taxpayers related party dealings in Thailand. That data will be used to analyze and formulate next steps for determining the selection of taxpayers for transfer pricing audits. There’s a new ruling to guide Thai tax officers about audits. And what do you think the Thai revenue office is planning from there? Mimi, what does this mean?
Mimi Song: I think in Thailand, you have to be mindful that the tax authorities are now focused on transfer pricing, and they’re empowered to make assessments or transfer pricing adjustments based on the guidelines as outlined in the OECD. They actually focus on creating a whole list of guidance related to market price transactions between related parties. It’s very similar to the OECD guideline framework, but that goes to show you that they are empowering and educating their tax officers to be able to look at taxpayers through the right lens, with the right information, that they are going to consider comparability of information that should be reported starting in 2020.
They’re going to look at that in more detail because they feel like the disclosure form in and of itself has not been enough information to focus their audits accordingly. And so now that they’ve initiated these original requirements, they realized, Hey, this is an area for us to really focus on. And this is an area that now we understand a little bit more. I think we need some more information in order to better target multinationals. So it means a lot more focus from the Thai tax story.
Matthew DeMello: And what are some strategies MNEs can employ to address these challenges?
Mimi Song: I think a lot of companies in Thailand, and I touched upon this earlier, right? Because you see a lot of manufacturing and distribution operations in Thailand, they have been impacted by the pandemic. And so part of the way that MNEs need to address the risk in Thailand is making sure that they have the appropriate level of documentation to demonstrate how the pandemic has impacted their business. Was profit reduced or were there losses incurred because of the lack of utilization of the capacity? Was it lowered market demand? Were there exceptional fixed costs that they had to deal with?
And so multinationals need to be mindful of describing the market situations that impacted their business, and they have to make sure to provide enough information so that tax authorities are not going to come back for more. I tend to feel that if you provide a sufficient level of information the first time and they don’t come back, that’s usually a good thing, you know?
So in these emerging market jurisdictions like Thailand, they do have an affinity towards the comparable uncontrolled price method. So to the extent that there are any CUPs available to be examined for purposes of the intercompany pricing, start with those first and make sure that if that is not the method of choice, if that’s not the primary method that demonstrates arms length pricing, make sure you address that head and that you explain so that the Thai tax authority doesn’t lean into that and say, the CUP method should be the best method and then apply an adjustment, right? So you’re going to have to just be prepared that they could challenge the selection of method. And it’s just about being proactive about that potential challenge.
Matthew DeMello: Last question, Mimi, because I think we’ve done all the rapid fire rounds we can, and we have all of your career advice logged into previous episodes. But one last question, no doubt. Many of your clients are listening to this episode. What do you want to say to them about the current transfer pricing environment?
Mimi Song: It’s interesting because I think who knew transfer pricing would be as amazing as it is today and fascinating as it is today? I mean, I always stayed in transfer pricing because I got to learn a lot about different businesses, but now that transfer pricing rules and regulations are evolving, many more tax authorities are becoming educated and focused on transfer pricing scrutiny.
You know, the idea here is that transfer pricing as a specialization is becoming more and more important. And for my customers and for my clients that are listening to this, transfer pricing education, as it pertains to your particular organization is going to be important. So you want to make sure that you know enough to be dangerous. You don’t have to become an expert in know about every jurisdiction, but I think at least, awareness and staying on top of the requirements and almost treating every jurisdiction with the same level of scrutiny is important because you want to take that holistic view. You don’t want to just focus on the jurisdictions that are high-risk only because eventually everyone’s going to be on this bandwagon. Every country is going to be high-risk and every country is going to make it mandatory to file the documentation. I think that’s the way that we seem to be going.
Matthew DeMello: Yes, especially just tracing country by country report requirements and seeing where that’s going that alone. Of course, so many other factors as well, point in that direction. But looking at that alone, I think really sets the table for where this is all going. Mimi, thank you so much again for joining us on the Fiona show this week to talk about these jurisdictions.
Mimi Song: Thank you so much. Always a pleasure, Matt.