Some foreign tax authorities argue that the profitability of their local entities would tend to be higher than what is typically observed in North America and Western Europe. The tax authorities in China and India are notorious for arguing that their local affiliates deserve high profit margins under the arm’s-length standard.
Multinationals often have foreign distribution affiliates and contract manufacturers with limited functions and assets and then sensibly establish transfer pricing policies that grant these foreign affiliates with modest but stable profit margins. While the Internal Revenue Service (IRS) would also expect foreign affiliates with limited functions and assets to have modest profit margins, foreign tax authorities often have expectations of much higher levels of operating profits for their local jurisdictions. Such divergent expectations among national tax authorities lead to the risk of double taxation.
As a simple example, suppose that the typical distribution affiliate has $200 million in sales per year and that the multinational grants these affiliates with profit margins equal to 2% or $4 million per year. If the foreign tax authority in any one nation expects that the profit margin should be 8%, there is the possibility of double taxation on the difference of $12 million in that nation alone.
Let’s also assume that the typical contract manufacturing affiliate incurs costs equal to $500 million per year and is afforded profits equal to a 5% markup over these costs or $25 million per year. If its local tax authority expects this markup to be 20%, there is the possibility of double taxation on the difference of $75 million.
Multinationals often evaluate the appropriateness of transfer pricing policies for such affiliates using an analysis of the relative profits of such entities as compared to the relative profits of third-party companies deemed to be comparable to the affiliate under evaluation. The IRS refers to such analyses as the Comparable Profits Method, while the OECD Transfer Pricing Guidelines uses the term Transactional Net Margin Method (TNMM). For affiliates in Canada and Western Europe, multinationals and tax authorities have the luxury of using data from comparable publicly traded companies in the same region as the affiliate under evaluation.
Regional comparable data based on publicly traded companies may not be as prevalent in other parts of the world, however, including Latin America, Eastern Europe, Asia and Africa. Some of the tax authorities in these regions often argue that the profitability of their local entities would tend to be higher than what is typically observed in North American and Western Europe. The tax authorities in China and India are particularly notorious for arguing that their local affiliates deserve high profit margins under the arm’s-length standard.
Foreign tax authorities often have access to financial information for regional third-party private companies. If these tax authorities use this information to assert under a tax audit that the transfer pricing be adjusted so as to afford the local affiliate with greater profits, the multinational will face double taxation unless the IRS agrees to this transfer pricing adjustment. The IRS, however, is not likely to agree unless a coherent argument is presented.
The individuals in charge of navigating such disputes need access to similar financial information for regional third-party private companies in order to craft an appropriate position that would hopefully create a mutual understanding between the IRS and the foreign tax authority in order to alleviate double taxation.