The increasing number of cross-border transactions combined with the greater complexity of group structures can lead to ever-greater risk in tax planning and, in particular, in transfer pricing. European-based groups of companies doing business in the United States can face significant challenges partly because of the need to deal with two or more tax authorities whose perspective on particular transactions may be very different.
Scrutiny by tax authorities
Tax authorities are becoming more skilled in transfer pricing matters, and there is an increasing focus on intercompany transactions involving transfers of intangible assets and services. Transfer pricing documentation requirements are now very widespread, and markets and regulators are showing an increased interest in tax reporting. For example, in the United States, companies are generally required by FIN 48 to evaluate their uncertain tax positions. As a result, they may not be able to recognize all tax benefits. Another challenge that taxpayers are facing is the increased coordination between tax authority units that deal with different taxes, including indirect taxes (such as VAT). This leads to a greater possibility of joint audits.
Tax authorities in Europe closely scrutinize intercompany transactions involving moving of functions or assets between the group entities located in different jurisdictions. They may question the substance of these transactions and look closely at the value transferred to ensure that their fisc is protected.
Failure to plan properly for transfer pricing risks can result in significant tax exposure. Inability of companies to effectively deal with transfer pricing issues could damage their relations with the tax authorities, leading to increased scrutiny in later years and the need to devote more resources to defending their tax positions. The tax problems may lead to negative publicity with resulting damage to the company’s image and brand. Any increase in tax reserves may hit reported profits, resulting in a decrease in shareholder value and a negative public perception of the management.
Source of transfer pricing risks
Transfer pricing risks may result from different sources. For example, they could be caused by discrepancies in the way the business is organized and the way the business is described in the company’s transfer pricing documentation. For instance, due to a change in the company’s business model, a distributor entity became a limited risk distributor with the transfer pricing documentation still reflecting the prior arrangement. Particular care is also needed on issues related to the existence of permanent establishments, especially when dependent agents are involved. A lack of alignment between different business lines and legal entities within a group may lead to difficulties in both reporting and compiling transfer pricing documentation. One of the common mistakes some companies make is involving their tax departments, including transfer-pricing specialists, late in the game when a transaction has been already set up. The lack of coordination at the planning phase of a project can magnify transfer pricing risk exposure.
The changing business environment and the role of intangible assets, and services, may lead to disagreements with tax authorities over key business value drivers. Such disagreements could lead to disputes over determination of values attributable to jurisdictions where the intangible assets or service functions are located. The existence of valuable unique intangibles, for example, may greatly complicate searches for comparable and reliable market benchmarks leading to wide ranges of possible results.
Internal risk management
The tax department should be in a position to participate in discussions on any significant business changes from the start. Transfer pricing considerations should also be taken into account in decisions on changes in the group structure or the location of assets and functions. Decision makers in the company must be in a position to understand the potential tax risks, assess tax risk levels and the possible consequences. Above all, when transfer-pricing input has been given and the plans are carried out, they should be implemented, as agreed, to determine that the approach as implemented is reflected in the documentation.
A systematic analysis of transfer pricing risks should include the identification of areas of potential exposure, which typically involve complex or high value transactions. Other factors to be taken into account include the documentation requirements in each jurisdiction. Transfer pricing planning should also be coordinated with other areas, such as customs duties.
Once the risk exposure areas have been identified, a decision should be made on how to address these risks. The company could take either a defensive or a proactive approach or a combination of the two in addressing the identified risk exposures. In certain circumstances, the company may have a limited number of options, which should be carefully evaluated to foster a balanced and beneficial approach. A defensive approach could involve adequate documentation of internal decision-making, the preparation of transfer pricing studies and the development of supporting documentation, such as intercompany agreements, analysis of transfer pricing policy and the retention of important records. A proactive approach could be used in certain cases, for example, by notifying tax authorities of particularly complex transactions or structures, implementing a policy of periodic monitoring and necessary price adjustments, or entering into an advance pricing agreement (APA).
Managing risk: Advance pricing agreements
There is increasing use of APAs as an effective tool in managing transfer pricing risks. The United States, for example, has one of the oldest and most experienced APA programs in the world. European countries are also adopting and expanding their APA programs. For example, Her Majesty’s Revenue and Customs (HMRC) in the United Kingdom recently introduced: “advance thin capitalisation agreements”, in addition to the regular APA program.
APAs can be valuable in cases where transfer pricing is difficult because of the lack of market benchmarks, where tax administrations can take potentially diverging views about intercompany arrangements, and where there is a high risk of audit. Apart from traditional and known benefits of APAs, companies can benefit from APAs in non-transfer pricing areas. For example, in certain cases, negotiating an APA with tax authorities may lead to a release of tax reserves. Stability of reporting and cash management are other potential key advantages.
Dispute resolution procedures
Where a dispute with the tax authorities arises, and there is a danger of double taxation, a mutual agreement procedure (MAP), if available under an applicable income tax treaty, can be used to help resolve the position. Under the MAP, the competent authorities of two countries are involved in the dispute attempt to resolve double taxation through a negotiation process. The MAP process can be lengthy and does not always result in a resolution. However, some treaties now contain a binding arbitration provision that is generally expected to accelerate and facilitate the resolution of the MAP cases.
European groups operating in the United States should be aware of transfer pricing risk factors and be prepared to take steps to manage such risks, either defensively and/or proactively.
About the authors: John Neighbour is a Global Transfer Pricing Services (GTPS) partner with the KPMG member firm in the UK and is based in London. Sean Foley is a GTPS principal with the KPMG member firm in the US and is based in Washington, DC.
The authors would like to thank Alexey Manasuev from the KPMG member firm in the US and Peter Hann from the KPMG member firm in the UK for their contributions to this article.
The views and opinions expressed herein are those of the authors and do not necessarily represent the views and opinions of KPMG’s network of firms.
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity.