Five tips on how to minimize transfer pricing-related tax risk
Transfer pricing is one of the most difficult areas of taxation and the number of transfer pricing related tax controversies continues to grow. As transfer pricing is not an exact science, and the arm’s length standard is always subject to interpretation, all transfer pricing disputes cannot be avoided. However, by taking the following measures, companies should be able to minimize some of their transfer pricing related tax risks, and prevent situations arising where transfer pricing is an easy target and an adjustment to taxable income a low hanging fruit for the tax authority to pick.
Tip 1: Update intra-group agreements
Written intra-group agreements have become very important, since they are the basis for any transfer pricing analysis. Putting key terms of intra-group relationships in writing in a signed agreement is a simple way of committing the relevant group companies, but also of communicating the terms to the tax authorities, if necessary.
However, the written agreements fulfil their purpose only if they are up to date and complied with. Consequently, companies should regularly review the contents of their intra-group agreements and update them, if necessary, to reflect any changes that have been made to intra-group transactions.
Tip 2: Check that the results fall within the inter-quartile range
Companies agree to adhere to the arm’s length principle in their transfer pricing policies. Huge effort is put into preparing, or at least drafting, transfer pricing documentation with an extensive explanation of the group’s business, group companies’ functions, assets and risks, as well as the terms of related party transactions.
However, this is not enough: transfer prices should actually be at arm’s length. This requires that the actual results of the tested group companies or their intra-group transactions are at the arm’s length levels, e.g. in practice they fall within the inter-quartile ranges of the benchmark studies. Companies should make the necessary year-end adjustments or true-ups to the transfer prices to actually reach the arm’s length results.
Tip 3: Identify intangibles
The definition of intangibles for transfer pricing purposes is wide. In addition to registered intangible assets or intangibles recognized for accounting purposes, intangibles for transfer pricing purposes also include trade secrets, know-how and other intangible assets that can be controlled and have value (i.e. they would not be disclosed to a competitor or a third party without compensation). In most cases, for example, sharing best practices does not require separate compensation as the benefits to group companies are equal to their input for the group’s common good. However, all intangibles should be properly identified and adequately documented to avoid unnecessary and burdensome questions from the tax authorities.
Tip 4: Charge interest on intra-group receivables
The transfer pricing of financial transactions is not limited to charging arm’s length interest on intra-group lending, but also, for example, the trade receivables and accounts payable have to fulfil the arm’s length criteria. If interest on late payments is charged to third-party clients, it needs to be charged to group companies as well.
Even though limited risk entities generally earn a guaranteed return, the non-charged interest income or unpaid interest expenses are not offset against the transfer pricing adjustments on products or services, since financial income and expenses are reported for accounting purposes below the operating profit level, which is relevant for product pricing purposes. Companies should monitor the levels of trade receivables from intra-group sales, and consider charging interest on late payments.
Tip 5: Let a specialist review your transfer pricing
Transfer pricing compliance requires finding a balance between reasonable effort (cost) and adequate/acceptable contents. A quick and dirty-approach to yearly transfer pricing compliance may keep the effort at a reasonable level, but prove to be worthless if a transfer pricing controversy arises.
However, much depends on the degree of transfer pricing risk and the willingness of the company’s leadership to assume such risk. Do you know the risks? A fresh pair of eyes may spot gradually evolved issues that have not been detected by those working with transfer prices on a daily basis. A transfer pricing specialist also knows where to look. If you can avoid a transfer pricing dispute by conducting a transfer pricing review, it is money well spent.
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Article written by Senior Advisor Merja Raunio.