The new rules on transfer pricing

One of the key action areas from the OECD BEPS (Base Erosion and Profit Shifting) initiative is the introduction of new rules on transfer pricing. Put simply, transfer pricing relates to how companies, which form part of the same group, pay each other for goods, services, intangible assets and similar transactions.

Traditionally, companies have used transfer pricing as a means of reducing their overall tax burden, and look to move profits from higher to lower tax jurisdictions, structuring their operations to ensure that the tax they pay is minimised. There has been nothing inherently illegal in this – it was part of business strategy to take advantage of differing corporate tax rates and treaty provisions to reduce the overall tax paid by a group.

However, all that is now changing, and the practice of multinationals allocating income to lower tax countries and expenses to higher tax jurisdictions is now coming under increased international scrutiny and censure.

The OECD, through BEPS, which has not only been approved and endorsed by the G20 Group of Finance Ministers, but also been supported by laws and recommendations adopted by many developed countries and the EU, wants companies to align where they pay taxes with where they have economic substance i.e. where they have operations and employees.

This means an end to the practice of allocating too much value to low-tax countries, where a group has few (or even no employees), and too little to those higher tax regimes where they many employ most of their people and sell the bulk of their products and services.

For multi-nationals, this marks a substantial change.

There will be much greater transparency required regarding the transfer pricing practices of a business, and a correspondingly greater risk of challenge from local tax authorities where the profitability of a jurisdiction is not sufficiently aligned with its economic substance. Greater focus will be placed on the attribution of capital and intangibles, and the alignment of profit with the location of key decision-makers and company management.

Under the new framework, a heavy emphasis will be placed on documentation, with a requirement for companies to provide a detailed country-by-country overview, and specific transfer pricing information for each country in which they operate.

This documentation will need to provide as much transparency as possible to tax authorities regarding a company’s activities, and how profits are aligned with tangible economic substance, with a much greater emphasis placed on tangible physical assets and employees.

The additional reporting and compliance burden for companies is going to be significant, and there are also concerns that what has, hitherto, been confidential commercially sensitive information will now be disclosed in a wider public domain. Nevertheless, these changes are coming and companies need to prepare for them.

BEPS is also going to force a radical change as to how IP (intellectual Property) is treated. Currently, a company may choose to have its IP located in a low (or favourable) tax jurisdiction with few employees, such as Switzerland, Luxembourg, or the Caribbean. However, such “brass-plate” operations will no longer be allowed under the new rules. Companies will need to have employees, and key decision-makers, in jurisdictions where IP is based.

This is a significant departure for companies who may need to consider where their IP is located.

One option would be to spread it around places where they already have senior people based, but this could include high tax countries.

Another alternative is to move people to low tax jurisdictions – such as Cyprus – where there IP may be already based, or to structure operations so that staff and IP are shifted to such a jurisdiction.

The new transfer pricing rules will dictate a major shift in the way that multinationals structure their operations, and will place a much greater emphasis on the alignment of economic activity and value creation with the payment of tax. Not only will the involve a reorganisation of operations in some cases but a considerable increase in reporting and the cost of compliance.

The corporate tax landscape is changing, and with the increased requirements for transparency and the need to justify economic decisions, groups have to accept that what, why, and how they do things will become a matter of public scrutiny and debate.


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