Transfer pricing - Keeping the Revenue at arm's length

Mention transfer pricing, cross-border trade and inter-companyup to $150bn last year. In the UK, legislation and new powers for the Inland Revenue are set to stem the tide. transactions to an accountant and you are likely to have them on the defensive. Mention it to a tax official and they will be suspicious. Mention it to a finance director and they will tell you straight: it’s a big problem.

The issue of transfer pricing – the practice of valuing an item that is to pass between two related companies in different parts of the world – is a complex one. There is no simple solution to the problem of pricing goods for which there is no real market. And because the prices are set by the buyers, the practice is open to abuse.

It is a process that is easy to manipulate. If the price of goods coming into a country is set high, for example, then the taxable profits of the purchasing company are reduced. The cash used to buy the goods is effectively transferred to the partner company which could be resident in a country with lower tax rates. And because the flow of trade between multinational companies represents up to two-thirds of the world’s international cross-border commerce the sums involved are huge, according to Price Waterhouse.

A study carried out by the University of Florida last year estimated that the US government had lost $150bn in taxes through companies fixing the price of goods at an abnormal level to avoid tax.

Such statistics have frayed state-side tempers. Byron Dorgan, the Democrat senator for North Dakota, has been on the war-path claiming some companies have been selling toothbrushes to themselves for as much as $17 a piece so that they can take profits out of the States and move them to cheaper tax havens off-shore.

“This is a massive problem and it is getting worse,” claimed Dorgan.

“The number of foreign-based companies doing business in this country has more than doubled in the last four years. Many of these multinational firms are not only ripping off the federal treasury, they are adding to the deficit and creating an unfair advantage to themselves when they compete against honest US companies who do pay taxes.”

While tax authorities around the globe have been getting themselves in a flap about all the cash they imagine is slipping through their fingers, finance directors have been feeling the heat.

Accountants Ernst & Young recently carried out a study on the “current practices, perceptions and trends” in transfer pricing in its 1997 Global Survey and found it was at the top of finance directors’ corporate worry list. When respondents were asked to name the major international tax issue that they expected to cause them most trouble within their own companies over the next two years, transfer pricing topped the list with 52%. Double tax relief came a poor second with only 16% of respondents out of the 393 multinational companies and 76 subsidiaries surveyed saying it was a problem.

Much of the worry seems to stem from the fact that nearly two-thirds of the multinationals in the study reported that their inter-company transactions had already been the target of a tax authority examination, while 80% respondents expected a transfer pricing examination within the next two years. In particular, inter-company services were considered to be most susceptible to transfer pricing disputes.

While finance directors may be able to cope with tax enquiries of a more mundane nature without batting an eyelid, only half the multinationals were able to successfully defend the prices they had given their goods when challenged.

The reason for this seems to be that FDs and tax officials are reading from a different book when it comes to shaping their pricing policies.

In fact, there is no simple formula for pricing goods which are sold in this way (see page 38).

“If you have a unique product, how can you guess or calculate its true market price?” asks Christopher Adams, a corporate tax partner and cross-border trading price specialist at Arthur Andersen. “Even when you look at other companies with similar products, all of their prices are intra-group controlled as well. There is simply no real market for these products as they do not have any third-party manufacturer distributing them anywhere in the world. It is a nightmare for finance directors to value and for tax authorities to police.”

The problem in the UK has been compounded by the ambiguous approach the authorities have taken to giving companies guidance on how best to price their products. The basic legislation has not moved since 1951 when it was introduced – 14 years before corporation tax was invented. Under the current rules, the Inland Revenue has to make what is called a special direction for a transfer pricing bill. It is the only tax law in this country where the Revenue cannot collect any tax through an assessment until such a direction is given.

But things are about to change. As part of the former Conservative government’s Spend to Save tax avoidance initiative, the then Chancellor Kenneth Clarke set up a special transfer pricing squad. The group was not formally announced to the press, but Clarke did signal in key speeches that the practice was to be reviewed. The first fruits of that process were published by Labour successor Gordon Brown on 9 October this year. It is a consultation document containing draft legislation aimed at bringing UK transfer pricing policy into line with other, more stringent, jurisdictions, such as Canada and Australia.

But the scope of the draft legislation has taken many in the tax community by surprise. In reality the proposals go much further than predicted and introduce strongly-worded regulations which, among other things, extend the scope of the kind of transactions covered by the rules and set harsh penalties for any failure to comply with the new measures.

Companies will have to apply the so-called arm’s length standard when trading with their subsidiaries, which means they will have to pretend that their subsidiaries exist in the open market and deal with them on the same terms as they would with outside companies.

While this is accepted as a practical approach to setting prices – and one which exists in practice in most companies – finance directors are concerned at the proposal that companies must begin to account for their transactions on complex self-assessment forms and support their conclusions with extensive and time-consuming documentation.

“How does the FD know that their returns have been completed according to arm’s length standard unless he has gone through the whole process?” asked Bob White, partner for UK transfer pricing policy with accountants Deloitte & Touche. “If there’s no documentation to back up his signature then that’s leading him to the risky area of penalties for negligence.”

Although there will be no automatic requirement to disclose information on transfer pricing when submitting tax returns, finance directors must be in a position to offer such documentation and calculations if the Revenue demands them.

“This will certainly put extra responsibility on FDs as there will be a fair amount of extra, record-keeping,” says Richard Baron, taxation director with the Institute of Directors. “Rather than waiting to be asked, you will have to confess your mistakes first, and there will be a big bump in compliance costs caused by changing over to the new system.”

There are holes in the proposals. The Revenue has failed to set a minimum requirement for the nature and quantity of records that a company needs to keep if it is to escape censure. Finance directors and their advisers will be left to work it out for themselves if the proposals stand and that will lead to uncertainty when the time comes for an enquiry.

As if that were not bad enough, there are tough new penalties for those who fall foul of the new rules. If the revenue is not satisfied with its return, it can fine a company up to 100% of the tax on its transfer pricing adjustment, subject to any mitigation. And, although a company only has to show a “reasonable attempt” to reflect arm’s length prices, in practice it would be too easy for inspectors to claim otherwise.

Previously, companies found to have been negligent in calculating their transfer prices only had to give up the unpaid tax plus interest. The new proposals will also impact on a much wider, European scale as they focus more on profits rather than price, allowing UK companies to bundle transactions together for analysis.

This will provide finance directors further food for thought as it appears to contradict the OECD Model Treaty (Associated Enterprises) which places emphasis on prices rather than profits. In many other respects the proposals confirm or run roughly parallel to OECD rules which were created to appease tax authorities who wanted to approach the assessment of transfer pricing deals in their own particular way.

“The confirmation of OECD guidelines is definitely a major plus as this provides interpretation and consistency,” says Marvin Rust, a senior tax manager at Arthur Andersen. He says the inclusion of OECD guidance should give FDs a key to the thorny problems of what kind of documentation the Revenue will require on the transfer pricing methods they have selected and what factors they need to take into account when deciding their policies.

Others are not convinced. “The Revenue has just dropped the OECD rules into the legislation without identifying how they will be specifically interpreted,” says Baron. “The way this has been done may put more power into the hands of the Revenue than we would like to see.”

The legislation is still only in draft form and consultation is taking place. According to a Revenue spokesman: “The document puts forward what we think needs to be done, but we are not saying, ‘Here is what is going to happen’. The whole point behind it is to get people to tell us what they think about it.”

If the UK has been able to wait since 1951 to change its practice on transfer pricing, another few months are not likely to make that much difference. That does not mean to say FDs are going to be free to idle away their time until the goal posts have been finally planted though.

They will need to get busy now if they are to have a chance to meet the transfer pricing requirements in time for the new corporate self-assessment regime. Since this is likely to affect accounting periods starting during 1998 it leaves finance directors less than 12 months to prepare. If they are unable to submit their tax returns in line with arm’s length standards, then they are leaving themselves wide open to a tax investigation.