The new Handbook, produced by the Steering Committee of the OECD Global Forum on Transfer Pricing, is a detailed, practical resource that countries can follow in developing their own risk assessment approaches aimed at (i) reducing “needless debates” among tax authorities, and (ii) efficiently using taxpayer and tax authority resources. 1 The Handbook is open to public comment through September 2013.
In a previous publication from the OECD,2 tax administrations, businesses, and advisors all agreed that effective transfer pricing risk identification is essential for quicker, more cost-effective audits and inquiries. To this end, many countries have recently focused significant attention on the means they use to identify and assess transfer pricing risk, as well as the tools they use for selecting cases for audit.
Although the Handbook is written for the tax administrator, it also offers multinational enterprises (“MNEs”) a framework under which to assess their transfer pricing exposure and vulnerability to a transfer pricing audit. Additionally, the Handbook provides some insights into the OECD’s (and therefore that of many member countries’) thinking regarding additional steps that MNEs could take to document their intercompany prices.
We highlight a few of the factors that could lead to transfer pricing audit risks, as summarized in the Handbook:
- Lack of appropriate transfer pricing documentation;
- Perceived misalignment of profitability levels compared to industry standards (though it is noted that segmented data needs consideration, and "profitability tests" should only be used to assess the "general reasonableness" of a return);3
- Recurring losses, "low profits," or significant variations in year-to-year effective tax rates;
- Considerable transactions with companies in low-tax jurisdictions;
- Considerable intra-group services;
- Financial transactions (e.g. intercompany debt, interest expense) with related parties; and,
- Payments of royalties, transfers/valuations of intellectual property, and management fees to related parties in low-tax jurisdictions.
It is interesting to note that the OECD has the perception that intercompany services transactions, even those involving high value services, are “often not fully documented” (emphasis ours).4 In addition, there are numerous references in the Handbook to transactions with low-tax jurisdictions. While the OECD is generally careful to acknowledge that simply having such transactions is not, on its face, inconsistent with the arm’s length standard, it is clear that such transactions continue to receive greater scrutiny.
The OECD also points out some situations that indicate a low level of transfer pricing risk (i.e., a scenario where a MNE has “consistent transfer pricing policies which are compliant with the arm’s length principle”).5 Furthermore, the Handbook summarizes where information can be found to prepare a transfer pricing risk assessment and suggests the use of information returns (e.g., 5471s / 5472s in the United States), company websites, public marketing materials, and transfer pricing documentation. The burden of providing such information is on the taxpayers.
The information in the Handbook is consistent with prior guidance from regulators and transfer pricing practitioners, and provides MNEs with a starting point in assessing their own transfer pricing profile and potential risk for audit. We have seen a decided increase in transfer pricing activity around the world, so accurate self-assessment is more important than ever.
Chinese Provide Further Comment on Location-Specific Advantages and Other TP Issues
In October 2012, China’s State Administration of Taxation (“SAT”) shared its view that the OECD Guidelines do not provide sufficient guidance for pressing issues faced specifically by developing countries, such as location-specific advantages (“LSAs”).6 On March 11, 2013, at a conference sponsored in part by Bloomberg BNA, Liao Tizhong, deputy director general of international taxation for the SAT, further expounded upon the importance of addressing LSAs caused by comparative market conditions. We highlight the key points of his comments below.
According to Tizhong, the SAT uses a four-step approach to determine whether additional considerations should be examined with respect to LSAs:
1. Identifying whether an LSA exists.
2. Determining whether the LSA generates additional profit above the routine return.
3. Quantifying and measuring the additional profits arising from the LSA.
4. Determining the transfer pricing method to appropriately allocate the LSA additional profits.
Tizhong cautioned that while identifying and quantifying potential cost savings (e.g., lower labor, capital, technology) generated by LSAs is relatively straightforward, it is more difficult to quantify the “market premium” (i.e., qualities such as market size and government incentives that could make a particular location more profitable) that certain LSAs may generate. Tizhong recommended economic modeling as a first step, with econometric analysis and game theory as other potential avenues to explore when attempting to determine a market premium generated by LSAs.
In addition to the challenges and importance of recognizing and measuring LSAs, Tizhong also addressed several other transfer pricing matters that are at the forefront of the SAT’s focus:
Lack of Comparables – As with most developing countries, China has a limited number of public companies. This is due to a manufacturing-based economy, a decreasing number of third-party arm’s length transactions, the level of integration of a Chinese operation into the multinational parent company, and other factors. The SAT addresses the lack of comparables by making transfer pricing adjustments to foreign comparables that take into account differences in geographic factors when using the transactional net margin method. Alternatively, the use of the CUP and profit-split methods can alleviate this issue; unfortunately, these methods are not always available.
Transfer Pricing Examinations – In China, transfer pricing cases are subjected to three levels of panel reviews: (i) city (prefecture) level, (ii) provincial level, and (iii) the SAT. The city review addresses whether the case should be selected for additional review or closed. The provincial level then conducts the second level of review, and the SAT conducts the final review and has the ability to overturn decisions made by lower-level expert panels (however, this is rare). The three-level review is designed to promote fairness to both the taxpayer and the tax authority, something that is not always possible to achieve through the courts as they rely upon the SAT for guidance in transfer pricing matters.
Transfer Pricing Audit Targets – China currently focuses on MNEs that fit any of the following fact patterns: (i) frequent related party transactions, (ii) abnormal losses or gains, (iii) regular losses that are not corrected by the business, (iv) failure to report sufficient documentation, or (v) adoption of ‘unreasonable’ pricing policies.
It is evident from Mr. Tizhong‘s comments that the SAT will continue to focus on transfer pricing matters and is busily filling in the gaps in terms of its approach to common issues such as comparables, adjustments, and audit practices. MNEs located or operating in China should be vigilant in setting up and documenting their operations in a way that minimizes exposure. In addition, whether operating in China or other developing countries, MNEs should evaluate the existence of potential LSAs that could impact intercompany pricing.
OECD Section E – Redraft on Safe Harbors
On May 16, 2013, the OECD Council approved the revision of Section E, which covers safe harbors, in Chapter IV of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“TPG”). The new guidance is intended to alleviate administrative burdens for taxpayers, particularly smaller ones with less complex transactions, as well as provide guidance to developing countries concerning the optimal use of audit resources.
The use of bilateral or multilateral safe harbors, in appropriate circumstances, may provide a significant relief from compliance burdens without creating problems of double taxation or non-taxation. To facilitate negotiations between tax administrations, the revised Section E provides sample memoranda of understanding (“MOUs”) from which competent authorities can take guidance in establishing bilateral safe harbors for certain transfer pricing transactions (e.g., low-risk manufacturing, low-risk distribution, and low-risk research and development services). While the TPG recognizes the possibility of “safe harbor shopping,” it puts the onus of accepting bilateral or multilateral safe harbors on the country executing the MOUs. The TPG acknowledges the potential trade-off between administrative simplicity and erosion of a country’s own tax base, a factor which needs to be considered in the policy decisions of each individual tax administration. The sample MOUs and the contained revisions will also provide some high-level guidance on the definitions of the “Qualifying Enterprise” and the “Qualifying Transactions.”
We will discuss the revisions and additional guidance of Section E in more detail in a future edition of Transfer Pricing Times.
1.See Paragraph 3 of the Handbook.
2.The OECD Forum on Tax Administration published a report entitled “Dealing Effectively with the Challenges of Transfer Pricing” in January 2012.
3.See Paragraph 56.
4.See Paragraph 73.
5.See paragraph 88.
6.The SAT’s comments on LSAs were included as part of Chapter 10.2 of the United Nations’ Transfer Pricing Manual for Developing Countries, approved on October 15, 2012, and devoted to China Country Practices.