Transfer Pricing Under the Microscope

The challenge of keeping transfer pricing risk under control just keeps getting tougher. The number of countries with regulations and penalty regimes has grown steadily over the past decade. More and more jurisdictions are adopting documentation rules, including major trading nations. Israel, Sweden, and Singapore, for example, have adopted such rules since 2004. While many tax authorities have adopted the guidelines set forth by the Organisation for Economic Co-operation and Development (OECD), they vary in their interpretation and application of the rules, leaving multinationals with plenty of room for uncertainty about the adequacy of their compliance efforts, the likelihood of an audit, and the potential for financial statement inaccuracies.

Companies' transfer pricing practices are receiving increased attention from tax authorities in the United States and around the globe, according to Steve Harris, principal and global leader with KPMG's global transfer pricing resolution network. To understand why the IRS is interested, you don't have to look much further than the country's current deficit. "There are a bunch of budgetary pressures that are putting an extra burden on the IRS to be as diligent as they can in making sure that nothing is left on the table that should be addressed," Harris says. "The IRS has also begun to prioritize the types of transactions that they're asking their auditors around the country to take a closer look at, and transfer pricing issues are certainly part of that."

It's much the same story around the world. While overall corporate tax rates are declining worldwide, authorities are ramping up their efforts to ensure that international companies pay their full share. And they're working more closely together in pursuit of that goal. In 2006, for example, tax administration heads from more than 30 countries meeting under the auspices of the OECD's Forum on Tax Administration issued the Seoul Declaration, a commitment to improve cooperation to counter "unacceptable tax minimization arrangements."

But cooperation only goes so far in national tax policy -- and competition between jurisdictions only adds to the pressure on multinational enterprises. "There's a sort of a ratcheting up; as one country starts to step up its enforcement or tighten its rules, other countries feel obliged to take a look at theirs to make sure that they have a similar enforcement framework that taxpayers can operate in," notes Harris.

Many developing economies -- Ecuador, Indonesia, and Vietnam, for example -- have established transfer pricing regimes in the past few years, adding to the risk management challenge. "If you're a multinational company and you have operations in 30 countries around the world, you can't necessarily just think about the ones where you have the largest amount of transactions or a long history of working with the tax authority," Harris points out. Plus, it takes a while for tax authorities with newly minted transfer pricing bodies to learn the ropes and develop a consistent approach to tax examinations.

A new KPMG report offers the following pointers on managing transfer pricing risk:

• Develop controls that enable you to identify and assess risks systematically. These should include a list of material intercompany transactions, a description of the policies used to price the transactions, and a description of the steps used to document that the policies are followed. "The starting point for any kind of effort to improve or maintain a good transfer pricing system is to know exactly what's happening in the company on a global basis," says Harris.

• Check for red flags. The list of items that might catch the eye of tax authorities is long (see below) and not all of them are intuitively obvious. High profitability levels can draw scrutiny, but so can losses over a long period. Cost-sharing arrangements and royalty payments are areas of particular interest for revenue bodies, according to Harris.

• Identify options for resolving disputes. At this point, the organization should identify its objectives for the risk management plan. Is the main goal to minimize conflicts with tax authorities? Manage predictability for the financial statements? Once its aims are clear, a company can consider its options for resolving any issues that may arise and decide whether it wants to wait for an audit or opt for an advance pricing agreement.

• Develop the documentation. This step comes last, not early in the process, because its scope will depend on the risk assessment. The required paperwork can vary from one country to another, and compliance can be expensive and burdensome for companies with complex international structures; you want to make sure that the money you spend on documentation goes to the areas where it can do the most good. KPMG recommends a core documentation study based on OECD guidelines and local documentation for areas of greatest potential exposure.

The KPMG study, "A Meeting of Minds -- Resolving Transfer Pricing Controversies" is available here.

Transfer Pricing Red Flags

1. Persistent losses or low operating profits

2. Sharp changes in profitability from prior year(s)

3. Different prices/markups charged between: related and unrelated parties for similar transactions; various related parties for similar transactions

4. Lack of (sufficient) documentation

5. Absence of or non-adherence to intercompany agreements

6. High royalties with licensee exhibiting low profits or operating losses

7. Royalties charged for soft intangibles; i.e., intangibles that are not legally protected, such as business processes/systems/methods

8. Significant intercompany management fees

9. Transactions with group company in tax haven

10. Significant asset impairment charges, restructuring charges, inventory write-offs

11. Significant year-end adjustment to intercompany prices

12. Actual behavior not consistent with documented transfer pricing policy

13. Closing costs (especially when company was making profits)

14. Separation of functions and risks that does not make sense from a business perspective

Source: KPMG International