Transfer pricing in the 21st Century
How can multinationals comply given that regulations vary from jurisdiction to jurisdiction? We sat down with CrossBorder Solutions’ Chief Economist Mimi Song, Founding Senior Account Executive Christy McDonald, and Director of Sales Michael Wallack to see how MNEs can stay compliant in the new world.
Transfer pricing in the spotlight as tax authorities’ enforcement practices become more sophisticated
In recent years, a joint effort by OECD member countries to address Base Erosion and Profit Sharing (BEPS) —along with the enormous pressure that governments are feeling to raise revenue in their respective jurisdictions—has greatly increased the transfer-pricing audit risk for multinational corporations (MNCs).
In 2017, MNCs were assessed $50 billion in adjustments, and in 2019 that number is likely to rise to $200 billion. Take Malaysia, for example. The government there has explicitly said that they’re going to fix a $500 million deficit through transfer pricing adjustments.
MNCs operating in countries around the world must overhaul transfer pricing strategies, so they’re aligned with regulations in those jurisdictions. Tax authorities are increasingly investing huge amounts of time, money and effort into improving compliance (and capturing lost tax revenue). On the other hand, some MNCs still don’t understand the ways in which their current transfer pricing strategies put them at increased audit risk.
How have transfer pricing documentation requirements evolved?
Gone are the days when a generic report was sufficient enough to satisfy taxing authorities in different jurisdictions.
“Today, it’s a completely different world. You need hyper-localized studies specific to the rules and regulations of each country and jurisdiction. Given the preferred formatting semantics, you’re dead in the water. They’re handing out adjustments like it’s going out of style,” said Michael Wallack.
Many countries have adopted their own transfer pricing regulations. For MNCs, that means they need to customize their documentation—master and local files—based on the regulations in that particular jurisdiction.
What do these increasingly comprehensive and country-specific regulations mean for my MNC?
For the past 15 years, transfer pricing compliance has been a “check the box” exercise. Documentation requirements did not change from year to year—what worked for one tax authority worked for all the others, too.
However, according to Christy McDonald, “There was a real awakening that happened among the tax authorities in the last two or three years that made them take a step back and say, not only do I want to have further detail about what’s happening in our country, but there may be a way to draw some revenue back into our own economies by taking a deeper look at this.”
Today, tax directors must adhere to an increasingly complex regulatory landscape. Whether the MNC is in five countries or 150, transfer pricing documentation must meet regulations in every jurisdiction, which is a costly compliance burden. Who has the budget to hire consultants in all of the jurisdictions where they have operations. However, the cost of not meeting these regulations is punitive. MNEs may leave themselves open to transfer pricing adjustments and penalties, and given that tax authorities share information, if they are in trouble in one jurisdiction, they are probably headed for trouble in others.
Many MNCs have faced an increased burden related to managing and documenting activities related to transfer pricing. Based on a survey of multinational companies from early 2019:
- 78% of respondents rated transfer pricing adjustments as the number one tax issue facing their MNC.
- 75% said that transfer pricing was a core focus of a past audit.
- 58% said that an audit resulted in an adjustment.
- 18% had penalties imposed while 24% had penalties threatened.
What are best practices related to documentation requirements?
MNCs often make the mistake of believing that they can take a reactive approach to documentation. It’s not uncommon for CFOs to subscribe to a “risk-based approach,”, producing documentation only every third year. The thinking is that passable reports can be cobbled together quickly in response to an IDR or audit notice. The challenges with this approach are two-fold:
- By the time you get audited, key individuals who are familiar with the facts and circumstances around your transfer pricing practices may have left the company.
- Taking a reactive approach means fighting your way out of a corner. Scrambling to put together documentation–working to speak to local controllers and tie information together, in a very haphazard way doesn’t put you in a strong tax position.
Therefore, a best practice for MNCs is to produce documentation in real-time to prepare for the eventuality (some would say, inevitability), of being audited. If you’ve already gone through the effort of ensuring your transactions meet the arm’s-length standard, producing documentation is not a big step beyond that. Preparing documentation proactively also creates an evidentiary trail of what’s happened in your business over the course of the last several years, which will help you construct a consistent and appropriate narrative to share with tax authorities.
When it comes to being audited, “worse than a monetary penalty is the fact that you don’t get to control your story. All of your transfer pricing documentation or narrative, and the economic analysis, none of that is actually admissible in the court of law if you were to go into a controversial situation,” said Mimi Song.
Tax directors at MNCs must implement a proactive documentation strategy in anticipation of IDRs. Part of that broader transfer-pricing strategy includes a systematic approach to keeping abreast of countries’ regulation changes and how those changes will affect compliance
For more details about worldwide transfer pricing compliance, listen to this episode of The Fiona Show