Transfer pricing perspectives: Winds of Change - PwC

2 Transfer Pricing Perspectives. October 2011

ContentsRussia adopts new transfer pricing rules: time to change “wait and see” attitude p.6The changing landscape of Value Chain Transformation p.14Enhancing shareholder value with transfer pricing integration – TPi p.24The role of risk in transfer pricing p.32Successful management of the transfer pricing audit process p.44Advance Pricing Agreements in the Asia Pacific p.56Transfer pricing for financial transactions p.64Case law developments: transfer pricing meets business reality p.72OECD: Where to from now? p.76

Russia adopts new transfer pricing rules:time to change “wait and see” attitude6

Key features of the new RussianTP rulesCompared to the current Russian TP rules,the new rules appear to be more technicallyelaborate and in broad terms better alignedwith the international TP principles setout by the Organisation for EconomicCooperation and Development (OECD).Based on the current wording of the newTP law, it may be concluded that onlytransactions involving goods, work andservices can be subject to the new TP rules.Transactions dealing with intellectualproperty (IP) rights or other objects ofcivil rights, as well as transactions wherethe pricing mechanism is set as a rate(e.g. interest rate, commission) are notformally subject to TP control. However,as mentioned above, it is still possible thatcertain amendments will be introduced tothe TP law, e.g. clarification on transactionsthat, as currently written, seem to be out ofscope of the new rules.Further in this article we provide a briefrecap of the TP law, analyse potentialpitfalls that taxpayers can face, as wellas outline recommendations on how toprepare for the new TP rules.I. Controlled transactionsThe TP law provides for a list oftransactions subject to TP controlby focusing more on related‐party 1transactions and including only certaintypes of third‐party transactions.Cross‐border transactionsAs to cross‐border transactions, thefollowing operations will be subject toTP control:• All related-party transactions, includingsupply arrangements with third‐partyintermediaries (no minimum financialthreshold starting from 2014);• Third‐party transactions involvinggoods traded on global commodityexchanges that fall within commoditygroups such as crude oil and oilproducts, ferrous metals, non‐ferrousmetals, fertilisers, precious metals andprecious stones if aggregate income ofsuch transactions exceeds 60m RUB(approx. US$ 2m) per calendar year;• Third‐party transactions withparties incorporated in blacklistedjurisdictions 2 (i.e. offshore zonesthat grant beneficial tax regimes anddo not exchange information withtax authorities of other countries)if the aggregate income from suchtransactions exceeds 60m RUB (approx.US$2m) per calendar year.Russian domestic transactionsAs to transactions in the Russian domesticmarket, only related-party transactions canbe subject to TP control.For the following domestic transactions,a 60m RUB (approx. US$ 2m) financialthreshold applies:• The subject of a transaction is an objectof an assessment to mineral extractiontax calculated at a percentage taxrate; or• One of the parties to a transaction isexempt from profits tax or applies a 0%tax rate; or• One of the parties to a transaction isregistered in a special economic zone(such transactions will be controlledstarting in 2014).1 The TP law provides for a list of criteria for recognising the parties as related and similar to international TP practice the main criteria is the direct and indirect ownership threshold of > 25%. However, theTP law reserves courts’ right to recognise parties as related based on factors not specified in the law.2The list of jurisdictions is determined by the Russian Ministry of Finance.8 Transfer Pricing Perspectives. October 2011

Starting in 2014, domestic related-partytransactions will also be controlled if one ofthe parties to a transaction applies a unifiedagricultural tax or a unified imputedincome tax on certain type of activities, andthe aggregate income exceeds 100m RUB(approx. US$ 3.5m) per calendar year.For all other domestic related-partytransactions, a 3bn RUB 3 (approx. US$105m) financial threshold applies toidentify if a transaction is subject to TPcontrol under the new TP rules. Also, therewill be certain domestic transactions ofthis type that are exempt from TP control,i.e. transactions between membersof a domestic consolidated group oftaxpayers 4 and transactions concludedbetween profit‐making Russian companiesregistered in the same administrativeregion that do not have any subdivisions inother administrative regions within Russiaor abroad.II. TP methodsThe TP law outlines five methods similarto those used in the international TPpractice (e.g. OECD TP Guidelines, US TPregulations, etc.), in particular:1. Comparable uncontrolled price(CUP) method2. Resale price method3. Cost plus method4. Transactional net margin method5. Profit split methodThe CUP method has the first priority,whereas the profit split method serves as amethod of last resort. In all other cases, thebest‐method rule applies.Although the TP law provides someguidelines on how to apply each of themethods, it is not clear whether themethods will work similar to those appliedin the international TP practice.Finally, the TP law envisages the possibilityof establishing the transaction price/valueinvolving an independent appraisal in thecase of one‐off transactions when none ofthe above TP methods can be applied.III. TP reporting anddocumentation requirementsTaxpayers will be obliged to file a noticeon controlled transactions (i.e. submitsome limited information on the natureof controllable transactions) and keepspecific TP documentation, if the totalamount of income received by the taxpayerfrom all controlled transactions with thesame counterparty exceeds 100m RUBmln (approx. US$ 3.5m) in 2012. It isintended that the above threshold will begradually decreased.The deadline set for filing notices tothe local tax office is 20 May of the yearfollowing the calendar year when thecontrolled transaction occurred.As for the TP documentation, thetax authorities cannot request suchdocumentation until 1 June of theyear following the calendar year whenthe controlled transaction took place.Taxpayers will have 30 days following thetax authorities request to provide the TPdocumentation.IV. Advance pricing agreementsOnly “major taxpayers” 5 may consider anopportunity to conclude an APA with theRussian tax authorities under the newTP rules. The TP law also provides for anopportunity to enter into a bilateral APA.The Russian tax authorities will have sixmonths to review an APA application,extendable to a maximum of ninemonths. Concluded APAs would be validfor three years and may be prolongedfor an additional two years upon thetaxpayer’s request.3This financial threshold will be reduced to 2bn RUB (approx. US$ 70m) in 2013 and to 1bn RUB (approx. US$ 35m) in 2014.4The law on consolidated taxpayer regime was approved by the State Duma in 2010 during the first reading [the law was approved in the first of three readings]. No subsequent readings have yet beenscheduled. The law on consolidated taxpayer regime is expected to be enacted simultaneously with the TP law.5Special criteria are set by the Russian Tax Code for companies to be regarded as major taxpayers, i.e. annual tax payments exceeding 1bn RUB (approx. US$ 35m) or annual revenue/assets exceeding20bn RUB (approx. US$ 726m).Transfer Pricing Perspectives. October 20119

The changing landscape ofValue Chain Transformation14

The trend of centralisation in multinationalcompanies (MNCs) has accelerated over time alongwith continued evolution of integrated businessmodels, as new ways to unlock value in organisationsare identified.Hastened by advances in technologyand growing globalisation of servicesindustries, and also fuelled by the need toexpand into new markets for growth, newand increasingly sophisticated players havecome to the fore of regional and globalValue Chain Transformation (VCT).This evolution has extended to regulatoryauthorities, which have matured in theirthinking and approach in parallel withMNCs. Motivated to share in the valueglobalisation has created, and morerecently protecting their share in the faceof global economic turmoil, regulatoryauthorities have paradoxically createdboth new opportunities and challenges forMNCs seeking to navigate business in anincreasingly global business environment.The Traditional VCT LandscapeHistorically, VCT models were commonlycharacterised by an emphasis on tangiblegoods and centralised supply chainmanagement as MNCs sought to captureefficiencies and scale benefits afforded bycentralised planning and consolidationof production activities. This extendedto commercial activities, with a focus onleveraging intellectual property acrossterritories and delivering central brand andproduct strategies for local execution.15

These business models commonly resultedin ‘principal’ structures which interposeda specific group entity into the supplychain with central ownership of highvalue functions, assets and risks, and theproliferation limited risk manufacturingand selling arrangements in local businessunits. However, principal structures areincreasingly being adopted for centre‐ledand service‐based structures, focusing oncreating value through local operationswithout necessarily interposing thePrincipal in the MNC’s transactionalsupply chain.The growth of centre‐led and service‐basedmodels has, in the large part, been drivenby a change in business models fromtraditional ‘bricks‐and‐mortar’ operations,to globally mobile and virtual workforces.The continuing emergence of e‐commerceand service‐based industries has furtherunderlined the changing VCT landscape.Figure 1The traditional VCT landscapeBenefitWave 3Against this landscape is the growingsophistication of revenue authorities.Continuing exposure to VCT‐basedstructures is resulting in increasingscrutiny of global and regional principalmodels, particularly with respect to anyresulting exit charges, but also giving riseto an increasing number of jurisdictionsoffering principal‐structure incentives.The relocation of business operations,including pre‐existing regional structures,to the traditional principal locations ofSwitzerland and Singapore is being metwith a rise in the level of competition fromjurisdictions such as Malaysia and Thailandin Asia and Ireland in Europe. Thesecountries are offering tax and operationalincentives to retain existing MNCs andattract new investment.Wave 1Supply chain reorganisationWave 2IP/brand centralisation• High value and strategic services• Internal business processes• Commercial risk retention/stewardshipVCT approach16 Transfer Pricing Perspectives. October 2011TangibleIntangible Tangible Intangible Tangible Intangible

The new frontier – centre-led modelsSupply chain coordination and intellectualproperty leverage continue to be corecomponents of centralised business models.However, VCT models are increasinglyencompassing inherent organisationalvalue drivers through strategic centre‐ledfunctions. In particular, recognition andinclusion of key decision-making processes,ways of doing business and internalpolicies and procedures as key businessdifferentiators, are driving commercialand business efficiencies leading to greaterprincipal-related reward.Nevertheless, the growing sophisticationof revenue authorities’ knowledge andunderstanding of VCT‐based businessmodels will require diligence by taxpayersto evidence the shift in functions, assetsand risks from local country operationsto the centre appropriately. Experiencedemonstrates that failure to evidenceand support a shift of functions, andparticularly risks; to the principalappropriately, creates a myriad of potentiallocal tax and related compliance exposures.Figure 2The new frontier – centre-led modelsValue driversTraditional approachThe New FrontierInternal policies and proceduresKnowledge sharingResearchWays of doing businessKey decision-making processesCentralisation within principalStrategy formulationIP/brand centralisationIP/brand centralisationSupply chain reorganisationSupply chain reorganisationTransfer Pricing Perspectives. October 201117

Services principal models – theemerging principal structureService‐focused MNCs are increasinglylooking to implement principal structures,with the services business developmentand delivery theoretically fitting neatlyinto a number of commonly recognisedcentralised operating models.In considering the potential applicationof VCT to a services business, it is criticalto consider what are the value drivers andprocesses associated with providing theservices that will inform the appropriatebusiness model:• Do they differ fromproduct‐related businesses?• Is there a need for more ‘local’content and (versus remote services)local solutions?• Where are the solutions coming from– are local services using IP from the‘hub’, what if local relationships andlocal people functions are drivingthe value?Having identified the value driversand models, determination of how toremunerate local services will necessarilyrequire consideration of:• The link to value drivers and risks• Whether a routine level of reward forthe local business units (e.g. cost plus)is reasonable• Whether other pricing models(cost sharing, profit split) aremore appropriate• How to remunerate ‘down time’ or‘excess capacity’The foundation of such considerations iscommon across all principal models, bethey supply chain, intellectual property orservices-based models. However, there arespecific considerations for service‐basedmodels, including:• Multiple ‘hats’ ‐ what if an employeein Country A provides services toCountry A and Country B. Shouldthere be a mark‐up to Country A or costallocation only?––What if Country B pays for part ofthe employee’s costs already?––Which entity should employ people– principal only or the principal andthe local entity?• Some customers require one globalcontract while others require contractsfor each local entity:––Does this change the risk profile?––Is there value in the contract itself?• Personal tax position of roamingemployees and whether they will besubject to tax in multiple locations.While specific service-relatedconsiderations will exist, the commercialbenefits of a services principal modelmay be material and could extend tothe centralisation of locally generatedknow‐how, customer contracts,quality control standards and strategicbusiness decisions.Figure 3Service provider continuumBenefitRoutine service activities =routine (say cost +) returnSupportservices/RHQResidual profit after‘sub-contractors’ remuneratedRemuneration method reflectsvalue and risk allocation (e.g.profit split of value-basedservice feeSharedservicesFranchiseeCan be viewed as a journeyIntegratedservicespartnerFull servicesprincipalLevel of centralisation18 Transfer Pricing Perspectives. October 2011

Limited risk entities and true‐upsunder a principal structure: are theycoming under threat?With the evolving nature of VCT‐drivenstructures, revenue authorities are seekingto retain revenue at stake from outboundmigration of local functions, assets andrisks. Local entities are now viewed asmore than just implementers, and shouldbe rewarded for their skill and decisionsto increase revenues or decrease costs.Consequently revenue authorities areincreasingly challenging the concept of‘low’ or ‘no’ risk entities. At issue is whether,under a centralised model, local factorsand decisions as drivers of profitability arebeing appropriately remunerated.This question is prompting some revenueauthorities to adopt new approacheson how local operations should beremunerated vis‐à‐vis the key strategicdecisions and initiatives driven by thecentre. These may include:• application of profit split methodsthat share potential upside betweenprincipal and local business units• looking at profit share arrangements forhigher value add services• scrutinising appropriateness ofguaranteed return approach for ‘limitedrisk’ entities.Conversely, the shift in focus to alternatemechanisms with which to remuneratelimited risk entities, coupled with concernsexpressed by MNCs in gold-plating localbusiness unit losses in the wake of theglobal economic downturn, brings withit a challenge to the concept of true‐upmechanisms commonly relied upon under acentre‐led business model.This reflects the view by a growing numberof revenue authorities and MNCs that lowprofitability or losses in local business unitsmay arise from non‐TP factors (affirmedin recent Australian court decision),coupled with reluctance by more andmore organisations to fund loss-makingcompanies continually.Figure 4True-ups, becoming increasingly more difficultIncreased sophistication of revenue authoritiesGreater scrutiny of true-upsLinkages between the commercial reasoning forthe true-up payments and the amounts (e.g. marketpenetration strategy)The substance of the commercial arrangementWhether true-ups are inherent in the industryTax treatment of receipts or payments (e.g. are theydeductible in accordance with tax law?)Whether losses are the result of local factors or theprincipal’s direction/decisionsEvidence of true-ups in arm’s-length situationsImplications for corporate tax, customs duty, withholding tax, cash positionApproaches differ between revenue authorities, e.g.• disallowance of deductions• partial compensation based on specific costs• full transfer pricing adjustmentsto targeted returns.Transfer Pricing Perspectives. October 201119

What does the shift in perceptionof limited risk entities undera centre‐led model meanfor taxpayers?To help mitigate potential claw‐back ofprofits to, or retention of profits by, limitedrisk entities under a principal model, athorough assessment of value drivers atthe local entity level and in the principalis required:• What has caused local entities’ results tobe outside an arm’s-length range?• Is it the result of local orprincipal‐led decisions?Taxpayers should supplement value‐driverassessments with a critical analysis of theirtransfer pricing model:• Is a profit/loss-sharing mechanismbeyond the typical ‘low risk’ positiveprofit range appropriate?• Can it be evidenced back toarm’s-length arrangements andcontractual agreement?In such circumstances, certainty of risk andthe profit outcomes of limited risk entitiesunder a business model may be obtainablethrough Advance Pricing Arrangements(APAs). APAs can give taxpayers certaintyunder a principal model and managepotential double‐tax exposures fornon‐treaty jurisdictions (e.g. Singaporeand the US).Exit charges… still evolvingIn some cases the transition by localbusiness units to a fixed return, limitedrisk model following VCT, is resulting inlong‐term reduction of local operatingreturns. Increasingly, the issue is a keyfocus of tax controversies in relation tobusiness restructurings arising fromVCT. It has led some revenue authoritiesto deem exit charges on restructures asa mechanism to claw back the loss ofpotential future earnings.In this regard, more than ever before,guidance to MNCs and revenue authoritiesnow exists as to how to consider andanalyse exit issues in the context ofVCT‐based restructures. In particular:• OECD Guidelines reflect a strongattempt to highlight the issues andprovide a framework with whichrevenue authorities should operate• Country-specific guidelines (e.g.Australia) and prescriptive approacheshave emerged (e.g. Germany).With the growing focus on exit charges,several new issues are gaining momentumthat will require specific focus by taxpayersimplementing principal‐based structures:• Are intra‐country exit chargesare applicable?• Is an employee an organisation-ownedasset – can an employee transfer createan exit charge?• Is simply deviating from the existingtrading model enough to trigger anexit charge?• What are the expectations of the partiesand does the transaction have realeconomic substance?Taxpayers should supplement value‐driverassessments with a critical analysis of theirtransfer pricing model20 Transfer Pricing Perspectives. October 2011

Is it possible to mount an argumentagainst exit charges when creating aprincipal model?We are also clearly witnessing a growingsophistication of revenue authorities’appreciation and understanding of VCTmodels, as well as an acknowledgementof business value drivers that underliethe business transformation. This inturn however, brings an increasing levelof challenge to principal structures andprovides various avenues for constructiveengagement on the issue of exit charges,which are commonly focused around:• Sound commercial reasons supportingthe business restructure from the localbusiness unit’s perspective• Availability of independent comparablearrangements that support the modeland the local entity’s decisions• Financial and other analysis thatreconcile the movements in returns tothe compensation received• Robust policies and processes thatensure the substance and form of thenew arrangements align.Figure 5Exit charges: evolving solutionsManaging exit issuesArm’s length circumstances Internal alignment Arm’s length consideration Commercial rationaleConsider what a third partywould do in the circumstances• Would a third party expectto pay for what theyare receiving?• Would a third party beexpected to receivecompensation for what theyare giving up?Evidence from arm’slengtharrangements and/ortransactions• Ensure substance and legalform are aligned• Establish appropriatelyguardrails – policiesand processes• Honour the agreementsBusiness value changeanalysis, having regard to“profit potential”• Who’s profit potential?• What guarantee of suchpotential?GFC has arguably hasteneda rethinkNovel solutions• Options• Milestones• Sharing of benefit inthe short term.Emphasis on the‘business decision’• Short versus long-termstrategy• Alternatives to therestructure• Link to ‘investment’decisions and return oncapital invested.Transfer Pricing Perspectives. October 201121

What is the role of the parent entityin a centre‐led business model?Historically, under principal‐modelstructures, activities performed by theparent entity may have been categorisedas non‐chargeable shareholder activities orhave been remunerated on a cost plus basisreflecting ‘routine’ value.At question is whether stewardshipactivities are being undertaken merely toprotect the parent’s investment, or whetherthey are strategically driving elements ofan MNC’s business, particularly under aprincipal structure.For example, the parent may bear therisk of not just a lost investment but alsothe costs associated with ‘bailing out’ asubsidiary. Certain business decisions of aprincipal will also be made with key inputsof the parent, which brings into questionhow the parent should be remunerated forits input.The Global Financial Crisis and thepotential for a double‐dip recession,amplifies the need to consider the role ofthe parent entity in any principal structure.Figure 6Considering the role of the parent entity in any principal structureParent may be required to intervene where the financial and functionalcapability of the principal is insufficientIncreasing focus by revenue authorities on• the concept of ‘passive association’• the value attributable to parent for intra-group fundingParent’s stewardship role vs guaranteeGlobal markets are becoming increasingly volatile and ‘high risk’ eventsimpacting on company/brand reputation must be managed22 Transfer Pricing Perspectives. October 2011

Value Chain Transformation –beyond the horizonThe Value Chain Transformation landscapeis undergoing change from its historicalroots of interposed supply chain andintellectual property based structures tocentre‐led and serviced-based models. Atthe same time, the evolution of the VCTlandscape is being matched by a growinglevel of sophistication of jurisdictionalrevenue authorities.Looking beyond the horizon,the VCT landscape will continueto evolveLooking beyond the horizon, the VCTlandscape will continue to evolve. Weexpect to see revenue authorities deepentheir understanding of VCT-basedstructures and for this to be matchedwith a growing selection of countriesoffering principal structure business andtax incentives.It is expected that the focus on exit chargeswill continue to grow and evolve, howeverat the same time, it is expected revenueauthorities will better understand thecommercial drivers behind the rationalefor change.While risks will continue to exist withrespect to VCT structures, it is expectedthat a heightened understanding of suchstructures and the operational benefits theydeliver will lead to an increased prevalenceof centre‐led and service-based principalstructures going forward.AuthorsHelen FazzinoPartner, PwC Australia+61 (3) 8603 3673helen.fazzino@au.pwc.comBen LannanPartner, PwC Australia+61 (7) 3257 8404ben.lannan@au.pwc.comBrad SlatteryDirector, PwC Singapore+65 6236 3731brad.slattery@sg.pwc.comEd FreemanSenior Manager, PwC Australia+61 (7) 3257 5200ed.freeman@au.pwc.comTransfer Pricing Perspectives. October 201123

Enhancing shareholder value withTransfer Pricing Integration – TPi24

Governments around the globe are focusing ontransfer pricing enforcement as a preferred methodof augmenting tax collections, and multinationalcompanies are being targeted for increasinglyaggressive tax and transfer pricing audits. Proactivelymanaging transfer prices accurately and efficientlyacross different jurisdictions and developing strategictransfer pricing policies with effective tax ratebenefits is critical. The following article addressessome best practices and potential approaches tomore effective transfer pricing management thataim to achieve deeper integration with business andfinance operations.Transfer Pricing Perspectives. October 201125

Current situation in transferpricing managementHistorically, tax and transfer pricingmonitoring and adjustments have involvedmany ad hoc processes and technologysolutions, involving data manipulation,complex spreadsheet models, manualreconciliations and redundant effort toreport and analyse. Additionally, thesetools have typically developed as taxdepartment-only solutions, not properlyaligned with the rest of the company –whether across functions, such as businessoperations, accounting, treasury and IT, oracross jurisdictions.Some common symptoms of transferpricing management challenges are:• Large transfer pricing true-ups at yearor quarter-end• Time-consuming effort to documenttransfer pricing compliance• Poorly controlled and overly complexspreadsheet models disconnected fromfinancial systems to calculate andreconcile legal entity financials• Difficulty obtaining accurate prices(standard cost versus true cost) andidentifiers (location, ship from/ship to)at transactional level• Lack of clear transfer pricing guidanceand procedures at business levelPost SOX 404 and similar governmentallyinstituted developments require taxfunctions to operate with the same levelof transparency and rigour as the rest ofthe finance organisation. While many taxdepartments have made great headwayto improving direct tax reporting andcompliance, integrating transfer pricinginto the finance function and the broaderenterprise is still a work in progress.Transfer pricing integration –best practices to considerTransfer pricing integration (TPi) canbe summarised as aligning a company'sbusiness, accounting, IT, legal and taxfunctions to implement and monitortransfer pricing policies and proceduresmore effectively.While there is no single answer that fitsthe needs of every company, there arecertain best practices common to successfultransfer pricing integration.Organisation/Strategy:Transfer pricing integration starts withorganisational strategy. All companyshould have a comprehensive and proactivestrategy to set and monitor its transferpri.e. and to prevent and manage disputes.Companies' strategy should be reviewedregular basis to reflect any changesin business flows and organisationalstructure. The strategy also needs to bereviewed against regulatory changes sincemore countries adopt formal transferpricing requirements each year.Just one weak link in the chain may resultin a wide range of impacts includingfinancial exposure for unexpected taxassessments, interest, fi.e. penalties, andeven double taxation. Other consequencesmay include management disruptioncaused by a complex and prolonged taxdispute or negative impact to the company'scorporate brand and reputation.People:Successful implementation of a globaltransfer pricing strategy requireseffective management of company staffand resources. Multinational companiesshould take proactive steps to identify,train and maintain adequate resources inaccounting, tax and IT to address transferpricing requirements.Effective communication to all stakeholdersis critical. Transfer pricing requirementscan be quite complex to administer,constantly change and must be consistentlymonitored. Communication should includeregulatory rationale behind transfer pricingpolicies, detailed procedural guidance,as well as mechanisms to address newfact patterns and obtain feedbacks. Forexample, companies undergoing significantand frequent business changes should putin added emphasis on monitoring howthose changes impact the transfer pricingstrategy set in place.26 Transfer Pricing Perspectives. October 2011

ProcessesTransfer pricing management rarely failsdue to flawed strategy. Rather, failure ismost often a result of not executing thestrategy within the organisation, and notachieving cross-functional integration.Transfer pricing strategy should besupported not only by processes performedby traditional accounting and tax functionsbut also by such functional areas such asmaterials management, logistics, treasury,shared services and legal. Implementingtransfer pricing policy changes oftenrequires process changes to these‘upstream’ functional areas as well as taxand accounting processes.Therefore, it is optimal to incorporatetransfer pricing-specific process bestpractices into transfer pricing procedures.Some examples are:• Assess and update inventory ofintercompany transactions• Document transfer pricing processesin detail• Review and update intercompanyagreements to ascertain flexibility• Create a centralised ‘transfer pricingdesk’ and develop service levelagreements to support the business withtransfer pricing issues• Define procedures for true-ups andperiodical transfer pricing adjustments,and establish logical controls• Create and update transfer pricingcontrol documentation and testplans for compliance with internalaudit standards• Maintain global (master) and countryspecifictransfer pricing documentationThese new processes must not be a onetimeeffort, but should be integrated andinternal i.e. so they ultimately becomeembedded into everyone along the valuechain of the company.TechnologyIn the current economic environment,tax departments may find resistanceto adding resources to support transferpricing integration. As a result, successfulintegration depends in large measureupon the technology improvements in thecompany's finance and tax systems.Some examples of opportunities to achievetransfer pricing integration throughtechnology improvements include:• Coordinate with IT to update ERP to bemore TP relevent• Configure Business Intelligence(BI) tools to build legal entity andsegmented financials• Deploy a tax data mart that storesextracted transactional data forTP analysis• Configure reporting tools withTP‐relevant reporting• Create custom models forTP adjustments• Create executive dashboard to monitorkey TP KPIs• Deploy Knowledge/DocumentManagement tool to compileTP‐relevant documentsTypically, ERP-enabled integrationprovides most opportunities in transferpricing management, as ERP systems haveeffective automation and standardisationcapabilities built in. For many companies,their ERP and related financial systems donot fully capture and report the complexmix of cross-border product, service, costand intellectual property transaction dataneeded to support the transfer pricingstrategy. Updating configuration of masterdata, intercompany accounting, pricingstructure and parallel ledgers can enhancethe effectiveness and efficiency of transferpricing management.Even if ERP enhancement projects cannotbe undertaken for business reasons, taxdepartments are recognising that anytechnology innovations for transfer pricingintegration should be geared towardenterprise-level, systematic solutionsthat leverage the ERP, financial reportingsystems, tax applications and otherenterprise collaboration tools, supported byorganisational and process improvements.The trend is definitely to move away fromdepartment-level, desktop-level band-aids(e.g. Excel spreadsheets).Transfer Pricing Perspectives. October 201127

The "TPi" platform vision represents PwC'sthought leadership to achieve transferpricing integration in a more efficient andaccelerated manner at enterprise levelTPi – PwC's approach to transferpricing IntegrationThe “TPi” platform vision represents PwC'sthought leadership to achieve transferpricing integration in a more efficient andaccelerated manner at enterprise level.It provides industry leaders with a newperspective on transfer pricing strategicplanning and management, and has thecapability to transform disparate datasources into a timely information source,communicated in a consistent reportingformat. TPi enables leaders to:• Proactively monitor transfer pricetargets across various economic entitiesglobally so that action can be takenimmediately to remedy outliers• Plan and strategically execute new orcomplex transfer pricing policies bymeasuring and modelling the potentialimpact in future reporting periods,often without a substantial ramp-upin headcount• Meet bottom-line objectives and delivervalue to shareholders by enhancingeffective rate benefits• Achieve enhanced cost savingsthrough automationThe TPi vision is a custom-configured,integrated process and technology solution.It is not about inventing new technologiesor building new software or reports. TPiwill leverage your company's existinginfrastructure and data resources, tailorthem to affect an enhanced tax solution,and provide a more effective managementand reporting tool.TPi vision focuses on two core features:• Provide access to consistent, reliableand timely financial data across globalbusiness operations• Summarise key data for easy viewingand fast decision-making in the form ofa dashboard, based on user elections28 Transfer Pricing Perspectives. October 2011

TPi – Data ManagementMost multinational companies typicallyuse different enterprise resource planning("ERP") systems for accounting andfinancial reporting globally. Differentaccounting principles and various ERPconfigurations result in challenges whentrying to extract consistent tax data fromdifferent ERP systems. As raw data maybe used across multiple tax processes, it isparamount that the data can be accessed inan effective and timely manner, and thatthere is accuracy, integrity and consistencyin the data output.Figure 1Illustration of TPi Data ManagementFinancial source systemsFinancial consolidation(e.g. Hyperion)ERP(e.g. SAP, Oracle)Misc GL systemsWeb-enableddata collectionOn-site and off-site stakeholdersTax operations managementDashboard/web portalDocumentmanagmentWorkflowmanagementEntitymanagementThe TPi Data Management approachfocuses on leveraging the company'sexisting ERP, consolidation and businessintelligence (BI) systems, storingtax-sensitive data in a repository andcataloguing them in a manner that supportsadditional modelling and analyses.Fixed assets(e.g. BNA)Sales & use tax(e.g. Vertex)OtherBusiness intelligenceTax systemsTax provision softwareAs illustrated here, the pillar of TPi isits platform, which has the capability toextract financial data across the company’svarious ERP and other financial sourcesystems, and create an output of datain a consistent and streamlined format.The TPi platform can be activated andrefreshed in a timely manner to support theDashboard application.Extract, Transform& Load toolsWork in processTax data repositoryCompliance softwareAudit defense softwarePlanning defense softwareTax data archiveTransfer Pricing Perspectives. October 201129

TPi – DashboardAfter the extraction process, thestandardised and streamlined data isexported to the TPi dashboard. Thispresents the C-suite with a bird’s eye viewof the overall transfer pricing activitiesacross the global enterprise.The dashboard shown here showcases fourkey applications in each quadrant:• The upper left quadrant presents anoverview of the economic structureof the global company including thelegal entities and relevant businesstransaction flows.• The upper right quadrant is theperformance matrix. This is a high levelrepresentation of the global entitiescategorised by geographic region,transaction materiality and magnitude.The performance matrix uses a coloursystem to highlight where transferpricing is out of alignment (i.e. thered box). By clicking on any box in theperformance matrix, a new screen witha pie chart will open. The pie chart isdesigned using a layering concept; themore you click, the deeper the layersand the more detailed the informationavailable (i.e. from high level financialinformation to segmented financialinformation by function to financialinformation by product SKU).• The lower-left quadrant presents anaction calendar.• The lower-right quadrant presentsaccess to the “Transfer PriceAdjustment” function. This function isdesigned for transfer pricing volatilityanalysis. Users can manually enter thetransfer prices they desire to identifythe financial statement impact.The apps in the TPi Dashboard canbe tailored to provide different viewsor tools as appropriate. For example,performance matrix by region and entitiescan be modified to track performance byvalue chain.TPi – our approachWhile the core components of TPi – DataManagement and Dashboard – are relevantfor all companies, each company’s factpattern and needs are unique and soare your business, tax and technologychallenges. No commercial softwarecurrently works out-of-the-box to addressthe complex challenges of transferpricing management.The goal behind PwC’s TPi platformvision is to accelerate the integrationand enhancement of transfer pricingmanagement. Based on your company’sspecific needs, we can leverage our knowhowto provide technology services to buildon your pre-existing technology frameworkand customise a solution specifically toyour company’s transfer pricing needs. Webelieve you will make significant steps inenhancing your overall value chain, as wellas reduce the risks of transfer pricing errorsand audits.Figure 2The TPi DashboardFigure 3TPi ProcessExisting infrastructureExisting data resource(e.g. ERP systems)TPi solutionPwC’sknowledge of:• Industry bestpractices• Market trendsTailored solution30 Transfer Pricing Perspectives. October 2011

ConclusionTPi changes the historic and tacticalapproach to tax technology fromautomating the data collection processand standardising compliance proceduresto providing a window into the comingreporting periods. The future and strategicapproach to tax technology is establishinga data collection process that is efficient,flexible, reliable and strategically alignedwith business goals and objectives. Inshort, TPi will provide any multinationalorganisation with timely and accurateinformation for making strategicbusiness decisions.TPi will provide any multinationalorganisation with timely and accurateinformation for making strategicbusiness decisionsAuthorsJorgen Juul AndersenPartner, PwC Denmark+45 3945 3945jorgen.juul.andersen@dk.pwc.comAndrew HwangManaging Director, PwC US+1 646 471 5250andrew.k.hwang@us.pwc.comKevin McCrackenPartner, PwC US+1 408 817 5873kevin.mccracken@us.pwc.comTransfer Pricing Perspectives. October 201131

The role of risk intransfer pricing32

The question of who takes risky decisions, andwho bears the consequences of those decisionshas always been very important in transfer pricinganalysis. Chapter 9 of the OECD Transfer PricingGuidelines features a section specifically on thissubject, the publication of which has underlined thesignificance of the issue, particularly in the context ofbusiness restructurings.This article considers the implications of the OECD guidance on situations whererisky decisions are taken in a part of a multinational that does not naturally bear theconsequences of the decisions. It goes on to consider techniques to address this issue,with particular focus on operational structures where entrepreneurial decision-makingis centralised. Finally, we provide some insight on risk in the transfer pricing perspectivefrom Germany, Canada and India.Transfer Pricing Perspectives. October 201133

A simplified illustration of the issueThe issue has traditionally arisen mostfrequently in practice in industries wherelong‐term contracts are common andearly‐stage decisions on specificationand price can have significant profitor loss repercussions over the life of acontract. These may relate to industrieslike professional services, financial orcommodity trading, and construction,but for the purpose of illustration wewill consider the kind of contract that acomponent supplier might enter into in theaerospace industry. For simplicity, assumeall of the key contractual terms, includingspecification and prices are decided bya contracting committee in location A.That committee will also decide whichof the manufacturing entities within thegroup should deliver the contract; in thiscase, location B delivers the contract inits entirety. The costs of the committeeare recharged throughout the group on acost‐plus basis.Location B sells finished parts directlyto the customer. Six years in to a 25-yearcontract, location B is experiencing heavylosses, with no prospect of significantimprovement. Mainly, this is a consequenceof unrealistic assumptions made by A in thecontracting process.The OECD Guidelines say that if risks areallocated to the party to the controlledtransaction that has relatively less controlover them, the tax authority may wish tochallenge the arm’s-length nature of suchrisk allocation 6 . In this simplified example,location B did not have control over thedecisions that gave rise to risks that it hasborne to its detriment. One might say that,at arm’s-length, B would have been morecareful about accepting the contract, butin practice B had no choice, it was a ‘donedeal’. Cases like this often end up witha lump‐sum transfer pricing adjustmentbetween location A and B, such that A bearsthe portion of the loss which has arisenas a consequence of the decisions whichit took during the contracting process.Important supplementary issues then needto be addressed, in particular in respectof the nature and timing of this adjustingpayment and the associated accounting andtax consequences.A critical aspect that is left out of thisexample in order to keep it simple is thelocation of the capital within the groupwhich underpins the ability to take thecontract risk in the first place. Often thisis in neither location A or B, and alsoneeds to be taken into account in thepricing solution. The main purpose of theillustration is to point out that the needfor mechanisms to match the outcome ofa risky decision with the location of thedecision is not new. In practice adjustmentsof this nature have in the past been mainlyabout loss reallocation, because losses getmost tax authority attention. But as theOECD Guidelines point out 7 , by definitionthere should be potential for upside anddownside in the risk‐taking location 8 . Justas there was no mechanism in the exampleto attribute losses to location A, therewould equally have been no mechanismto attribute profits had the risks forwhich they were responsible resulted inhigher profitability.6OECD Transfer Pricing Guideli.e. Para 9.22.7OECD Transfer Pricing Guideli.e. Para 1.45.8“Usually, in the open market, the assumption of increased risk would also be compensated by an increase in the expected return, although the actual return may or may not increase depending on thedegree to which the risks are actually realised” (OECD Transfer Pricing Guideli.e. Para 1.45).34 Transfer Pricing Perspectives. October 2011

Why cost plus might be the wrongpolicy for people who take keydecisions about riskFor many MNCs, significant strategicdecisions that are taken in a central locationhave a material bearing on the ultimateprofit or loss outcome achieved throughoutthe organisation. The issue becomesparticularly noticeable and problematic inan example like the one given above, butit is inherent to some extent in all but themost decentralised organisations.Traditionally, the costs associated with thesenior decision-makers would probablyhave been part of ‘head office costs’ andrecharged with a mark‐up. For many MNCsthis is still the most practical approach todealing with this issue, especially wherelocal operating companies play an activeand influential role in the governanceprocess, or where the assets and capitalunderpinning the risk‐taking capacityof the group are spread around theoperating companies.The OECD Guidelines stress though, that “itis the low (or high) risk nature of a businessthat will dictate the selection of the mostappropriate transfer pricing method, andnot the contrary” 9 . Generally speaking,a given risk is ‘moored’ to a business ifthat business houses the people who takesignificant decisions about that risk 10 .It is clear that, on this basis, a cost‐plusrecharge is not inherently the right transferpricing mechanism to remunerate theentity that houses the key decision-makers.The costs of employing the people whomake the decisions bear minimal, if any,relationship to the financial consequenceof the decisions. Charging out those costson a marked‐up basis means that, as aresult of the transfer pricing mechanism,the employing entity bears virtually no riskat all.If not cost plus, then what?The issue is essentially about creatinga mechanism in which the entity orentities which house the risk‐takers (orentrepreneurs 11 ) get a return that variesdepending on the success or otherwise oftheir strategies. Specifically, paragraph9.39 of the OECD Guidelines states that theparty bearing the consequence of the riskallocation should:• Bear costs of managing and mitigatingthe risk• Bear costs that arise from therealisation of the risk (includingbooking provisions)• Generally be compensated by anincrease in the actual returnThis can happen naturally if transactionflows and the transfer pricing policy arecapable of alignment. In the aerospaceexample above this would have happenedif A, in addition to negotiating the contract,had actually entered into the contractwith the original equipment manufacturer(OEM). In that case A would have soldparts directly to the OEM, and could havebought the parts from B at a price whichgave B a return appropriate to its role inthe arrangements (presumably a contractmanufacturing type of return). Ultimately,under this model, A would naturally havemade the loss that became a separatetransaction in real life.9OECD Transfer Pricing Guideli.e. Para 9,46.10 Whilst the concept of ‘significant people functions’ explicitly makes the location of key decision makers a ‘mooring’ point for allocating profit to branches, the OECD Transfer Pricing Guidelines makeit clear that Article 7 and Article 9 of the OECD Model Tax Convention on Income and on Capital 2010, don’t work in the same way, and that for Article 9 contracts remain the starting point in analysingwho bears what risk. Contracts are not definitive, though, and in several examples the OECD Transfer Pricing Guidelines imply that where the underlying substance (usually defined by who makes whatdecisions) is at odds with the contractual terms, then the substance will dictate the ‘true allocation of risk’ (e.g. OECD Transfer Pricing Guideli.e. Para 1.66).11Entrepreneur - a person who sets up a business or businesses, taking on financial risks in the hope of profit. Oxford Dictionaries, www.oxforddictionaries.com/definition/entrepreneur.Transfer Pricing Perspectives. October 201135

This would also happen naturally ina typical principal structure, wherethe profits of the lower risk parties aregenerally stable as a consequence of theprices at which they buy from or sell to theprincipal, and the profits of the principalfluctuate as a consequence of the successor failure of their market strategy, andinvestment decisions.If entities do not own any intangibles thatare unique it may be possible to applya TNMMWhere substantially all of the significantdecisions have been centralised, suchthat the business operating model has thecharacteristics of a principal structurein every respect apart from the factthat transactions do not flow throughthe principal, then it will be necessaryto introduce a mechanism to deliverthe appropriate, variable return to thedecision‐making entity. It will also benecessary for the entities that do not takesignificant decisions to have a less variablereturn that appropriately rewards them fortheir functions, assets and more limitedrisks. If those entities do not own anyintangibles which are unique 12 it may bepossible to apply a TNMM to these localentities, and ascribe the residual profit orloss to the decision-making entity. Whereunique local intangibles or barriers to entryexist, it would be necessary to factor thesein to the local return.36 Transfer Pricing Perspectives. October 201112 See OECD Transfer Pricing Guideli.e. Para 2.60 for adescription of non-unique intangibles. Broadly speaking thesemight be the type of non-unique intangibles which one wouldexpect potential comparables to possess.

It is not easy to deal with risk in a profit splitmodel, especially if a contribution approachis used. In a profit split that allocates aportion of the total profits or losses of anMNC to each party based on a formula, therisk is spread amongst the profit‐sharingparticipants. In some cases that will beappropriate. In cases where the significantdecision-makers are centralised in onelocation, it will be necessary to introducefeatures that limit the extent to which theparties that do not take significant decisionsexperience volatility associated with theoutcome of those decisions. In such case, aresidual approach to the profit split method,separating routine reward and profits to besplit on an economically valid basis may bemore appropriate.The end result of an approach of this kindis an overall allocation of profit or lossthat is similar to that which would arisein a principal model, but it is achievedby introducing a payment between theentrepreneur and the local business todeliver an appropriate arm’s-length,lower-risk return to the local business.This payment works in the same wayas the adjustment described in theaerospace example.Payments of this kind can be very largein amount, and will appropriately be thesubject of scrutiny by tax authorities,particularly if they are payments out of aterritory. The issues that will need to beaddressed vary depending on the factsand circumstances of the case, and differdistinctly by industry and geography.However the following aspects are almostalways challenging:• How should the payment, and theagreement between the partiesunder which the payment is madebe characterised?• Will the payment be deductible underlocal tax rules, or will it be deemed to bea distribution?• Is there a two‐way flow of services,where the adjusting payment representsthe net result of a barter? This may wellhave VAT implications in a number ofterritories• Often in addition to control of risk, theentrepreneur owns rights to IP, whichis made available to the local entities.Does this make a component of thecharge subject to withholding tax?• Are exchange control issues in point?It is normally possible to overcome orminimise the impact of issues of thiskind, but not always, and this is not anexhaustive list.It is not easy to deal with risk in a profitsplit model, especially if a contributionapproach is usedTransfer Pricing Perspectives. October 201137

Why would a business agree to sucha mechanism?There are innumerable instances ofparties seeking to limit their risk at arm’slength.What they are prepared to payin order to do so depends on the natureof the risk being minimised, and thetechniques used will vary depending on thecommercial circumstances.In instances where parties are transactingwith one another from an operationalperspective, the risk can be managedthrough the contractual terms. In principalstructures, risk can be determined inthe contract and through the pricingmechanism, much in the way that it wouldbe in any arm’s-length sub‐contractingsituation, such that the sub‐contractorsdo not bear risks over which they do nothave control.Where the parties are not transactingwith one another operationally, then aseparate mechanism is required to rewardor penalise the party taking the risk. Atarm’s-length, the kind of mechanismsavailable will range from traditionalinsurance (which mitigates, rather thantransfers risk) to complex risk-sharingmechanisms included in Public PrivatePartnership (PPP) contracts.In the case of PPP contracts, significantrisks may be transferred from governmentto a private sector company. The PPPcontract will often set out in detail thepotential risks, which risks each partyshould bear, who is responsible forarranging insurance, and the process forrisks that become uninsurable.In a typical insurance case, the insurerwould not necessarily have control over therisk that is being underwritten, whereas theOECD Guidelines state that in arm’s-lengthtransactions it generally makes sense forparties to be allocated a greater share ofthose risks over which they have relativelymore control.One may argue that in practice, for sometypes of insurance, the underwritingparty will try to exert some control overthe risk by way of conditions attached tothe insurance (e.g. requiring to activatea burglar alarm in a home each timeone leaves the house, the minimumrequirements for locks, the use of firealarms). However, in a commercial context,traditional insurance will not play amajor role in controlling the risks whichit has underwritten. But, it is importantto remember that insurers are involved inmany situations where risk events occurand insurance claims are made. This wealthof information and experience meansinsurers are often able to provide guidancearound common risk causes and effectivemitigation or control approaches. A goodrelationship with an insurer may enable oneto tap into that experience to help reducerisks, become more attractive to insurersand hopefully achieve a lower premium.Increasing outsourcing of services alsoallows transfer of some risks to theproviders of these services. However, it’simportant to recognise that not all risks canbe ‘outsourced’ and that some risks, evenif managed by third parties, will ultimateremain with the company. A clear exampleof this is reputational risk.Where the parties are not transactingwith one another operationally, a separatemechanism is required to reward orpenalise the party taking the risk38 Transfer Pricing Perspectives. October 2011

ConclusionIt will not always be the case that acost‐plus recharge is the right transferpricing mechanism to remunerate the entitythat houses the strategic decision‐makerswho take crucial decisions about riskswithin an organisation. Therefore, onemay need to consider different rechargingmechanisms to deliver the appropriate,variable return to the decision‐makingentity. Conversely, it may be appropriate forthe entities which do not house significantdecision‐makers to have a less variablereturn, but one that appropriately rewardsthem for their functions, assets and morelimited risks.Depending on the facts and circumstancesit may be possible to apply a TNMM tothese local entities, and ascribe the residualprofit or loss to the decision-making entityor apply a residual approach to profit splitmethod, separating routine reward andprofits to be split on an economically validbasis. However, there may be range ofrecharge techniques available includinga payment between the entrepreneur andthe local business to deliver an appropriatearm’s-length, lower risk return to the localbusiness. Different tax authorities willadopt different approaches to challengingstructures of this nature and the primaryobjective of a defensible transfer pricingstrategy would be to mirror, as far aspossible, what third parties do in similarcircumstances. This will normallydepend on the risk being minimisedand the commercial circumstances ofthe case but will usually range fromtraditional insurance to complex risksharing mechanisms.Given its importance to transfer pricinganalysis, it is necessary to adopt a rigorousapproach for identifying and valuingrisk in a business. Increasingly, actuarialtechniques are being adopted to supporttraditional transfer pricing analysis.In the section below Alpesh Shah, fromPwC’s Actuarial Risk Practice provides uswith his point of view on risk in generaland the scenario outlined in this articlein particular. We have also asked transferpricing specialists from Germany, Canadaand India for insights from their countrieson how risk may be reflected in transferpricing mechanisms, and how the taxauthorities in their jurisdictions wouldapproach these issues.Transfer Pricing Perspectives. October 201139

Perspectives from an ActuaryFramework for capturing riskThe risks within a business that reallymatter should ultimately be tied to thebusiness’s strategy and objectives. Key risksare events that may disrupt the ability ofthe business to create or maintain value forshareholders or key stakeholders.In order to ensure a comprehensiverisk‐identification approach, a variety of keyingredients are necessary. These include:• Broad involvement in risk identificationapproaches from a range of peoplefrom different parts of the businessto help drive a wider perspectiveof risk-identification. This includesinvolvement of more senior peoplein the process to draw out keystrategic risks.• Consideration of a range of risk areas,from a broader view than just safetyand compliance to include strategic,financial and reputational risk driverswill be essential.• Looking outside the company tocompetitor and industry experiencefor sources of risk to which others havebeen exposed.• Consideration of ‘black swans’ mayinclude risks that would have a verymaterial impact on the business buthave a very low likelihood of occurring.In such case rather than consideringthe likely cause, event and consequenceof these very remote risks, focusing onthe consequences will make it easier tocapture these risks.Many organisations will have identified arange of risks and captured them, typicallyin a risk register. However, these risks willoften only be considered as discrete events(i.e. each risk will have a fixed likelihoodof occurring and a fixed impact if it wereto occur). More often than not, risks arenot discrete but have a range of possibleoutcomes. Consideration of the rangeof outcomes of key risks allows a morecomprehensive evaluation of the potentialimpact of extreme outcomes, which areoften those that are of interest whenconsidering who should bear the risk.Principal‐type structuresFrom the actuarial perspective, in thescenario where the local company bearsno volatility of cash flows and all of theuncertainty of cash flows is borne by thecentral company, the key is to understandthe nature of the variability in cash flowsthat is being borne by the central company.Historical cash flows will provide anevidence base as to what the volatility ofcash flows is.Where historical data is sparse, it may bepossible to estimate the volatility of cashflows by making some assumptions aroundtheir distribution based on the limited dataavailable or in an extreme case, by makingan assumption as to how managementwould expect cash flows to vary.Once a distribution has been identified,it will be possible to estimate the averageexpected cash flow and also the rangearound that average. This can be measuredby way of standard statistical metrics suchas standard deviations or the expectedoutcome at a given confidence level (e.g.95th percentile outcome).The reward expected by the risk-bearingcompany will be determined as thecombination of the following factors:• The average cost expected from thedistribution of cash flows• The cost of holding capital to ensurethe entity can withstand volatility ofcash flows to a particular level. As thecompany needs to hold this capital, thecompany should be compensated for theopportunity cost of doing so.In such cases, the amount of capital neededwill be determined by the differencebetween the average expected cashflows and the cash flows at a particularlyadverse scenario. The level of severityof the scenario will need to be defined.In the insurance industry this is definedas the 99.5th percentile outcome (i.e.the one-in-two-hundred years adverseoutcome). The extent of this over andabove the average expected outcome willbe the capital which will be needed by therisk‐bearing company.Risks over which neither party to atransaction has controlIn a scenario when the party responsible forsetting overall strategy and responding tochanges takes the consequences of positiveor negative changes and shelters otherparties in the group from these kind of risks(economic conditions, money and stockmarket conditions, political environment,social patterns and trends, competition andavailability of raw materials and labour)determining the effect of macroeconomicand other external factors on that party’scash flows and profiles may be complex.However, if the relationship between thesefactors and the company cash flows can bearticulated as a formulaic relationship, thenit is possible to model how the volatility inthese external factors may drive volatilityin company cash flows. However, someexternal factors are not quantitativelymeasurable and so may not lend themselvesto the same detailed analysis as others.40 Transfer Pricing Perspectives. October 2011

Perspectives on risk from GermanyIn German transfer pricing rules, thedefinition of function that applies tobusiness restructurings does not apply inthe very same sense for regular function,asset and risk analyses. For functionalanalysis purposes German transfer pricinggenerally distinguishes between functions,risks and assets. Accordingly, the definitionfor business restructurings seems to bebroader. When defining a function forbusiness restructuring purposes, theGerman transfer pricing regulations statethat it should include the assets (especiallyintangible assets), advantages as well as theactivity-related chances and risks.In the reallocation of functions, referenceis made to the functional analysis ofthe entity before and after the transfer.Accordingly, a risk is a part of the function,but the regulations remain relatively silentwith regard to the relevance of risk as partof the overall analysis.The Administrative Principles availablein Germany, which are, however, notbinding on a taxpayer, include examples fortaxable restructurings. Examples providedinclude the conversion of a fully‐fledgedmanufacturer to a contract manufactureror of a fully‐fledged distributor to a limitedrisk distributor. In the case of theseexamples, only risks may be reallocated.The German regulations use the terms“chances” and “risks” in parallel; it shouldgenerally be possible to allocate certainprofits to the risks. Accordingly, if thereduction in profits is commensurate withthe reduction in risks, this should not,under arm’s-length considerations, giverise to an exit payment. Also from theperspective of the German rules, eventhough the transfer of risks may qualify asa potential “transfer of function” and thetransfer package may come up with someresult, this should still be negligible due toreference to arm’s-length behaviour.Additionally, professional Germantax practitioners may notice someinconsistencies between Chapter 9 of theOECD Guidelines and German transferpricing package rules in relation to thereallocation of risk (these however, havenot been considered by the GermanMinistry of Finance as problematic issues).MNCs, when considering reallocation ofrisks, need to be careful of moving risksin isolation (e.g. via contractual allocationknown for limited risk distributors andcontract manufacturers). Otherwise theexperience of the German tax authorities israther limited.Also, the valuation of risks for Germantax purposes is rather difficult andnot widely applied by tax authorities.Additionally, reallocation of risk may beseen as artificially structured, but thiswill normally depend on the industry(e.g. global trading in financial sector israther common).Finally, the most common German taxauthority challenges relating to risk issueswould be claiming more profits for valuablefunctions (which, for German purposes,includes risks) performed in Germany orchallenging inbound fees.The valuation of risks for German taxpurposes is rather difficult and not widelyapplied by tax authoritiesTransfer Pricing Perspectives. October 201141

The recent decision of the Tax Courtof Canada (“TCC”) in Alberta PrintedCircuits Ltd. v. The Queen included someinteresting observations regarding risks42 Transfer Pricing Perspectives. October 2011Perspectives on risk from CanadaThe Canada Revenue Agency (CRA) wasactively involved in developing Chapter 9of the OECD Guidelines, but it is too soonto tell how it will interpret and apply thisguidance. That said, the CRA has statedthat business restructuring is a primaryarea of focus, and this is evident from itsaudit activity. Subsection 247 (2)(b) ofCanada’s Income Tax Act actually gives theCRA a specific statutory tool (in additionto a broad General Anti-Avoidance Rule)to support “re‐characterisation”. Thissubsection, which has been actively usedby the CRA since its introduction in 1997,addresses transactions that “would nothave been entered into between personsdealing at arm’s-length” and, in certaincircumstances, authorises the CRA toamend these to transactions “that wouldhave been entered into between personsdealing at arm’s-length” under arm’s-lengthterms and conditions. As of June 2011,48 re‐characterisation cases have beenconsidered (such cases must be reviewedand approved by a senior CRA committeebefore they can be pursued by auditors),with 11 assessed and 10 ongoing. It is ourexperience that the allocation of risk istypically an important factor in these cases;audits routinely probe where risks aretruly borne and whether the ‘risk-bearer’has the financial capacity and managerialsubstance to bear the risk.However, even with Chapter 9 in hand asa defence, taxpayers should be aware thatthe CRA strongly endorses a transactionalapproach to transfer pricing. For example,a “risk-transfer payment” that reduces aCanadian entity’s profit to a certain levelmust be strongly supported by evidenceof the arm’s-length nature of the actualpayment (i.e. matching the payment withwhat the payment is for) rather than relyingon a TNMM analysis to support the profitleft behind in Canada.The recent decision of the Tax Court ofCanada (“TCC”) in Alberta Printed CircuitsLtd. v. The Queen included some interestingobservations regarding risks. The caseinvolved Alberta Printed Circuits Ltd.’s(“APCI Canada’s”) payment of service feesto a related company in Barbados (“APCIBarbados”). The TCC found that APCIBarbados (as a captive service provider)bore the biggest market risk because ithad only one customer (i.e. APCI Canada,the service recipient), leading the TCCto conclude that APCI Barbados couldnot be an appropriate tested party forapplication of the TNMM. As this scenariois common in related party transactions,a careful analysis of the balance of risksin service-provider transactions should beincluded in any Canadian transfer pricingdocumentation. Further, because theCRA places a lot of weight on the terms oflegal agreements, companies that want togenuinely transfer the significant risks ofa service provider should ensure that therelevant intercompany service agreementdoes achieve this risk transfer. For example,in the event of a closure (e.g. if servicesare no longer required), agreeing that theservice recipient is responsible for closurecosts is one step to support a lower riskprofile for the service provider.

Perspectives on risk from IndiaThe Indian transfer pricing code does notspecifically discuss the circumstancesunder which it may be appropriate forthe Income Tax Department (ITD) tore‐characterise a transaction based ona purported allocation of risk that doesnot accord with economic reality. Thecode envisages that the characterisationof an entity should be based on thefunctions performed, assets employedand risks assumed by the enterprise.Several Indian rulings 13 have genericallyendorsed the principle of aligning theeconomic substance of a transaction withits contractual terms, and stated thatthe higher the risks assumed by a party,its expectation of returns should also behigher.For the ITD to disregard a transaction,it would have to demonstrate that thetransaction is a sham (lacks substance) or isnot permissible under law. In the absence ofsuch a determination, while the ITD couldre‐price the transaction under the transferpricing code, it may not disregard thetransaction altogether. A transaction couldbe viewed as lacking commercial substanceif the purported risk allocation is notconsistent with the functions performed bythe parties, or where risks are allocated toparties that do not have adequate controlover the creation of such risks.The following are some examples where theITD has sought to reallocate risks (and theassociated return) in specific situations.In the case of an Indian taxpayer thatprovided contract R&D services to a globalMNC (an associated enterprise, the ITDchallenged the mark‐up earned on totaloperating cost. It was alleged that thetaxpayer performed key functions in India(which created R&D risk for the overseasMNC) such as:a. identification of products tobe developedb. formulating R&D strategyc. approving the R&D budgetd. decision to abort further R&DThere are also instances of high‐pitchedtransfer pricing litigation in the Indiansoftware industry, wherein the disputeappears to be whether the Indian taxpayer(a contract software developer) rendereda service or transferred an intangible assetto the overseas associated enterprise. Theissue seems to be the same – whether thecontractual allocation of risk between theparties was consistent with their conductand where the significant people functionswere located.An opposite example is seen in regionalprincipal structures, wherein the principal(entrepreneur) entity is located outsideIndia and the Indian affiliate merelyperforms routine manufacturing anddistribution functions relating to thedomestic Indian market. This could createa situation where the entrepreneurialfunctions reside outside India, while theresidual profits are trapped in India. Attimes, taxpayers have sought to remit suchresidual profit (after retaining a routinereturn for the Indian manufacturing anddistribution functions) to the overseasentrepreneur through royalties, which aretypically determined through a residualprofit‐split approach. In such cases,tax authorities have not only intenselyscrutinised the royalty payment from atransfer pricing and tax characterisationstandpoint, but also sometimes asserted thecreation of a Permanent Establishment inIndia of the overseas entrepreneur.It may be mentioned that classical principalstructures, which typically envisage twodifferent entities in India performingseparate contract manufacturing anddistribution functions for an overseasentrepreneur, are presently not feasible forregulatory reasons. Under exchange controllaw, an Indian distributor taking deliveryof goods (belonging to the overseasentrepreneur) from an Indian contractmanufacturer for sale in the Indian market,would not be able to pay the overseasentrepreneur for the goods as there is noimportation into India.AuthorsIan DykesPartner, PwC UK+44 121 265 5968ian.dykes@uk.pwc.comElisabeth FinchPartner, PwC Canada+1 604 806 7458elisabeth.finch@ca.pwc.comBipin PawarPartner, PwC India+ 91 22 66891320bipin.pawar@in.pwc.comLudger WellensPartner, PwC Germany+49 211 981‐2237ludger.wellens@de.pwc.comAlpesh ShahDirector, PwC UK+44 20 7212 4932alpesh.shah@uk.pwc.comSonia WatsonDirector, PwC UK+44 20 7804 2253sonia.watson@uk.pwc.comJustyna DziubaSenior Associate, PwC UK+44 20 7213 4847justyna.a.dziuba@uk.pwc.com13Mentor Graphics (Noida) Pvt Ltd v. Dy. Commissioner of Income tax (ITA No. 1969/D/2006) and E-Gain Communication Pvt Ltd v. ITO (ITA No. 1685-PN-07).Transfer Pricing Perspectives. October 201143

Successful management of thetransfer pricing audit process44

In 2008, we published an article entitled“Global best practices in preventing transferpricing audits and disputes”. This was oneof a number of articles contained in a specialedition of Transfer Pricing Perspectivesfocused on what was then termed the“emerging perfect storm” of transferpricing audits.Three years later, and the “perfect storm”is upon us. It would be a challenge to findan MNC that has not been subject to atleast one transfer pricing audit over thepast three years somewhere in the world.Indeed, in most cases MNCs will havefaced, and will continue to face, multipleexaminations in multiple jurisdictions.As part of corporate governanceprocedures, most MNCs attempt to use bestefforts to follow the practices describedin our 2008 article within the scope ofthe resources available to them in orderto prevent audits from arising in the firstinstance. Even so, the number of transferpricing audits being conducted globallycontinues to rise, in spite of the increasingnumber of taxpayers using advance pricingagreements (APAs) to manage their largesttransfer pricing exposures.With transfer pricing audits a virtualcertainty, rather than a possibility, thisarticle is designed as a “Part II” to our 2008publication. That is, even if all the bestpractices for preventing a transfer pricingaudit have been adopted, an investigationis still commenced – then what next? Thisarticle goes to the next stage in the transferpricing audit life cycle by providing a“how to” guide for managing the actualexamination process itself. Moreover,although there are of course distinctdifferences in how audits are managedand conducted by tax authorities aroundthe world, the best practices describedherein should be applicable regardless ofthe location of the audit. Likewise, whilethis discussion is specifically focused ontransfer pricing audit management, manyof the practices described are helpful in themanagement of any audit process, whethertax, customs, regulatory, or otherwise.Transfer Pricing Perspectives. October 201145

Best practices for transfer pricingaudit managementUnderstand the audit environmentUnless the tax authorities have turnedup at the door with armed police and arecarting away documents in boxes (whichunfortunately does happen in somejurisdictions), taxpayers usually have someadvance notification that an audit willcommence, even if it is only a few days.Within that time frame:• It is critical to understand what typeof audit is being conducted. Is this adedicated transfer pricing audit, inwhich case transfer pricing will be thesole issue discussed? Or is it a generaltax audit, during which transfer pricingissues will be only one of a number oftax issues covered?• It is helpful to find out, if possible,the background to the members ofthe examination team that will beconducting the audit. How familiarare they with transfer pricing issuesin general? How familiar are theywith industry-specific issues thathave an impact on transfer pricing?Will the revenue authority use any“outside” experts?• It is also important to find out whetheran audit has actually started orwhether there is a prior process of‘risk assessment’ which, if handledcarefully, might mean that an audit isnot required.While it should be obvious, understandingthe type of audit being conducted willlead to better decision making, both inrelation to the taxpayer’s internal resourceallocation and in relation to developmentof the audit strategy. A general tax audit,where transfer pricing may be furtherdown the list of issues to be covered,is likely to require less input from theglobal or regional transfer pricing team,as many of the corporate income tax,withholding tax, or sales tax issues tobe covered can only be addressed by thelocal finance team that manage the booksand records of the local entity underaudit. In the preliminary stages of suchan audit, it may therefore be enough foroverseas management simply to monitorthe progress of the audit, having preparedthe local finance team to recognise whatquestions asked or information requestedby the tax authorities might lead into thetransfer pricing area. In contrast, wherethe audit is to be solely focused on transferpricing issues, the resource allocationfrom overseas may well be more intensive,and likely to start at an earlier stage of theaudit process.In the same vein, the type of auditbeing conducted will have an impacton development of the audit strategy inrelation to transfer pricing. For a generaltax audit, the best strategy is often towait for transfer pricing issues to beraised by the examination team, i.e. to bereactive to requests for information ratherthan proactive. On the other hand, for adedicated transfer pricing audit – wheretransfer pricing will be the only topic in theaudit process – a taxpayer should typicallybe more active in laying out its positionin relation to the pricing policies adoptedearly on, so as to control the direction anddiscussion of the audit more closely. Thisis particularly important in jurisdictionswhere the burden of proof rests with thetaxpayer in the first instance; however,even in jurisdictions where the taxpayerdoes not have the burden of proof, such apresentation will ensure that there is noimplicit shifting of the burden from theexamination team to the taxpayer as aresult of the taxpayer’s inactivity.46 Transfer Pricing Perspectives. October 2011

The taxpayer will also want to understandthe key transfer pricing issues that therelevant tax authorities are focusingon and developing (e.g. impact of lossoperations, transfers of intangibles,permanent establishment matters, businessrestructuring, allocation of managementexpenses). Further, it is important tounderstand how such issues have beenresolved in other cases on their meritsand through the alternative disputeresolution processes.Further benefit may also come fromunderstanding the experience andbackground of the specific members ofthe examination team. Although suchinformation is not publicly available in allcountries, even where it is not, experiencedadvisors may be able to provide valuableinsight on this issue from their personalknowledge of the local audit environment.In conjunction with an understanding ofthe type of audit that is being conducted,knowledge about the specific examinersinvolved may help to drive a taxpayer’saudit strategy. In a general tax audit, wherenone of the examiners are understood tohave detailed transfer pricing experience,transfer pricing issues may well be movedfurther down the list of concerns to be dealtwith in the audit. In contrast, in the sametype of general tax audit, but where it isknown that one or more of the examinershas transfer pricing experience, a taxpayermay adopt a slightly more proactiveapproach to presenting and explainingtransfer pricing issues than wouldotherwise have been the case.Likewise, where none of the examinationteam is understood to have any familiaritywith the taxpayer’s industry, particularlywhere industry factors play a large part indriving transfer pricing results or policies,more focus may be given to educating theteam members about those issues and theindustry itself at the start of the audit,before any discussion of specific transferpricing policies is even raised. Moreover,even where the examination team isknown to have some understanding ofthe industry, where economic conditionsor other factors that may have an impacton transfer pricing or profitability haverecently changed, it may be necessary toprovide background and education on thechanges that have occurred as well. Specificexamples include impact of the globalfinancial crisis (particularly on the financialservices industry), the impact of naturaldisasters (such as the recent earthquakeand tsunami in Japan) on the high techmanufacturing and automotive industries,and political unrest (e.g. recent turmoilin the Middle East and its impact notonly on the oil industry itself, but also onsecondary manufacturing industries thatare heavily reliant on oil-based products,such as plastics).Further benefit may also come fromunderstanding the experience andbackground of the specific membersof the examination teamTransfer Pricing Perspectives. October 201147

From the time notification of an audit isreceived, it will also be important for theglobal or regional tax/transfer pricingteam to demonstrate their strong supportfor management of the local entity48 Transfer Pricing Perspectives. October 2011Support local managementFrom the time notification of an audit isreceived, it will also be important for theglobal or regional tax/transfer pricing teamto demonstrate their strong support formanagement of the local entity, who willactually be meeting with the examinationteam on a day-to-day basis. This supportgenerally comes in two parts:• Ensuring local management that theglobal and/or regional tax/transferpricing team is available at all times toprovide information, answer questions,or assist with the audit in any otherway that may be required duringthe audit process. Invariably, whilelocal management are often quitecomfortable negotiating with the taxauthorities in relation to income tax,withholding tax, or sales tax issues, theyare often less confident about discussingtransfer pricing issues, an area aboutwhich they may feel less knowledgeable.Consequently, the knowledge thatglobal and/or regional tax/transferpricing teams are ready, willing, andable to help at any time can greatlysmooth the management of transferpricing queries from the examinationteam as they arise during the course ofthe audit.• Providing local management withguidance about the transfer pricingissues that are likely to arise during theaudit process (often based on experiencewith audits in other jurisdictions) andhow questions about those issues shouldbe answered. The issues raised willdiffer among taxpayers, but typicallycover: unusual profit/loss results;transfer pricing policies outside ofwhat is typically seen in the industry;management services charges; businessrestructuring transactions; treatmentof intangibles; and problems arisingfrom implementation of stated transferpricing policies.Although it is expected that discussionsof this kind with local management willbe held regularly as part of the generaldevelopment and implementation oftransfer pricing policies within an MNC,it is helpful to reiterate these pointsagain once the start of an audit has beennotified by the examination team. This isparticularly the case in countries where thepenalties for tax or transfer pricing noncompliancemay have adverse consequenceson business operations, such as loss ofcustomer confidence or reputation in themarketplace, or regulatory implications.Developing and maintaining a strongrelationship with local management willensure that transfer pricing questionsraised by the examination team, includingrequests for information that are likelyto lead to transfer pricing questions, arebrought to the attention of the global orregional tax/transfer pricing team as earlyas possible. It should also ensure that thereare no inaccurate explanations of transferpricing policies to the examination team,which will be difficult to correct at a laterstage in the audit process.

Proactive preparationTransfer pricing audits are inevitably timeandresource-consuming, and often involvethe preparation and submission of copiousamounts of documents and informationto the examination team. Consequently,advance preparation of such information,however limited, can help to relievepressure on staff resources once the audithas started. This will give more time for thetaxpayer to focus on audit strategy duringthe audit itself, without losing valuabletime to preparation of documentation forsubmission that could have been preparedin advance.Where there are specific documentationrules in a particular jurisdiction, thetransfer pricing information to besubmitted may be clear and is likely to bereadily available (in the form of transferpricing documentation). In contrast, wherethere are no formal documentation rules,it may be more difficult to know exactlywhat information the examination teamwill request to be submitted. Nevertheless,an experienced advisor should be ableto provide a summary of the typicallyrequested information to enable certainadvance preparation. Even where thereis a clear documentation requirement ina particular jurisdiction, an experiencedadvisor should be able to confirm whatadditional information, if any, is also likelyto be requested by the examination team.In addition to documentation that mayneed to be submitted to the examinationteam, advance preparation may alsocover briefing interviews with keymembers of local management whoare likely to be called for interviewsduring the audit process. The purpose ofthese briefings should be (i) to alleviatepotential uncertainty that the prospectiveinterviewees may be experiencing, (ii)to reassure those interviewees that theywill likely be able to answer questionsasked, and that if they cannot answer, it isperfectly reasonable and expected to sayso, and (iii) to define the one or two keymessages that need to be communicatedto the examination team. Indeed, it isimportant that interviewees are notoverloaded with “points to remember,” asany advantage to having the briefing maywell be lost in such cases.Develop a strategy for meetingswith the examination teamA common response from global or regionaltax/transfer pricing management in theevent of an audit in a local jurisdiction isto request a meeting with the examinationteam themselves, to explain the group’stransfer pricing policies in person.Although this desire is understandable (andmay be appropriate in certain situations)given that overseas management is likelyto have the best understanding andoverview of those policies, it is often notthe preferred strategic approach, even if thecommon practical difficulties of languagecan be overcome.In the case of a general tax audit,particularly in countries where such auditsoccur on a cyclical or regular basis, theattendance of overseas management atan audit meeting can raise questions andmay even create confusion in what wouldotherwise be a regular audit process. Inaddition, in many countries where status isa critical part of the business environment,such as parts of Asia, attendance byoverseas senior management at an auditmeeting may require the examinationteam in turn to bring their seniorpersonnel to attend the meeting as well.Raising the profile of the audit process toa higher level within the tax authoritiesin this way may not necessarily be therecommended approach.On the other hand, there are somejurisdictions where it may well behelpful for overseas tax/transfer pricingmanagement to attend one or moreaudit meetings as a sign of respect forthe examination team. The timing anddiscussion content of such meetings,however, should be discussed well inadvance with experienced advisors whohave a good understanding of the localaudit environment. Questions to considerinclude: Should the meeting be arrangedas a brief “courtesy” meeting only? Shouldit be held at the company’s office or thetax authorities’ building? Is translationnecessary? If so, should it be consecutiveor simultaneous translation (both ofwhich have different strategic advantagesand disadvantages)? Such questions areall relevant to the establishing of a goodworking relationship with the local taxauthorities, which is a critical factor inmanaging the audit process.Transfer Pricing Perspectives. October 201149

Carefully monitor informationrequests and submissionsDuring the audit process, it is likely thatthe examination team will make a numberof requests for information to be submittedby the taxpayer. Sometimes these requestsare made in writing; however, it is notuncommon for many of them to be madeorally to local management as theyattend meetings with the examinationteam. Particularly where the number ofrequests is extensive, it is generally goodaudit management to ask that they bemade in writing to facilitate the trackingand submission process. Whether it isappropriate to make such a request froma strategic perspective will depend on (i)the particular type of audit, (ii) whetherwritten requests are commonplace, and(iii) if such a request is unusual, whatimpact it will have on the relationship withthe examination team for the duration ofthe audit.In addition, it may be that many of therequests made by the examination teamappear unnecessary, and in some caseseven unrelated to the transfer pricing issuesat hand. In many jurisdictions, however,refusal to submit requested informationmay have an adverse effect on the auditprocess, and thus should be consideredvery carefully even if the taxpayer believessuch information is unnecessary fordetermination of any transfer pricingissue. As a result, in some cases it maybe more beneficial for a taxpayer tosubmit unnecessary information, simplyto continue to maintain a cooperativerelationship with the examination team.In other cases, particularly where thevolume of requests is onerous or where theinformation-gathering phase of the audithas been underway for some time with noend in sight, it may be appropriate for thetaxpayer to proactively negotiate with theexamination team as to what informationmay not need to be provided (or may besubmitted orally rather than in writing).The timing of submitting requestedinformation should also be managedcarefully. To ensure that an auditprogresses smoothly, requested informationshould be submitted without undue delay,often within two to four weeks, althoughthis will depend on the jurisdiction,the type of audit, the stage of the auditprocess, and the information requested.For example, information that a taxpayeris legally required to have to hand, such astransfer pricing documentation (in somejurisdictions), intercompany agreements(in almost all jurisdictions), and accountingbooks and records (in all jurisdictions),may have a much shorter timeframefor submission (a few days or weeks),which may not be negotiable. In contrast,information that the taxpayer is not legallyrequired to have at hand, or which maytake time to collate, such as transfer pricingdocumentation (in some jurisdictions),segmented financial statements (in manyjurisdictions), or financial informationabout overseas related parties (in mostjurisdictions) may be submitted under morerelaxed deadlines, which are often open tonegotiation with the examination team.Not only the timing of the submission, butalso the form of submission of information,should be strategically considered andmay be subject to negotiation with theexamination team. For sensitive orextremely complicated information, astrategic decision will need to be madeabout whether the information should besubmitted in writing only, or whether itshould be accompanied by an explanationor presentation by the taxpayer as well.This may be the case for a particular typeof industry or product with which theexamination team may not be familiar;a transfer pricing methodology that isnot commonly seen in the jurisdiction(or at least not commonly used for thetransactions under audit) such as a profitsplit; or where the economic analysiscontains certain steps not typicallyadopted in the jurisdiction (such asuncommon adjustments to comparabledata, uncommon statistical analyses, orwhere the taxpayer’s results are unusual orunexpected, e.g. long-term losses).It is also not uncommon for audit requeststo be badly drawn up and to ask forinformation or documents that either donot exist or are unlikely to shed muchexplanation on the transfer pricing issues.It is then worth considering whether it isbetter for a taxpayer to take the initiativeand provide information or documentsthat have not been requested if this willshorten the process and bring the audit to aspeedier and more successful conclusion.50 Transfer Pricing Perspectives. October 2011

Dealing with risk assessmentsMuch of the above advice applies equallyto a risk assessment. A number of taxauthorities use a process of risk assessmentbefore committing resource to a full-blowntransfer pricing enquiry. This processallows a taxpayer to demonstrate that itstransfer pricing is in order, that its policiesare sound and that they are correctlyimplemented – in short, that it presents alow risk of transfer pricing non-compliance.This requires an understanding of how atax authority views transfer pricing risk,but this will generally revolve around thesize of the intra-group transactions, thecomplexity of these, (for example, whetherthey involve intangibles) and the taxpayer’scompliance history (is there a trackrecord of failure to apply transfer pricingpolicies properly?).While risk assessments can deflect theonset of an audit if handled properly, careneeds to be taken that the risk assessmentdoes not slip into an audit by default, orbecome an opportunity for an extensive‘fishing expedition’. Advisers can usuallyhelp steer the path of a risk assessment and,if an audit is inevitable, make sure that thisis opened and handled in the proper way.Care needs to be taken that the riskassessment does not slip into an auditby default

To set the base for such strategy, the likelyoutcomes for the audit process need to beclearly understoodDevelop an audit strategyIn addition to the practical management ofthe audit process discussed above, in termsof meetings with the tax authorities andthe submission of requested information,an overall strategy for the audit needsto be developed. To set the base for suchstrategy, the likely outcomes for the auditprocess need to be clearly understood. Ifit is possible for the audit to be concludedwith no adjustment, then the audit strategyis likely to be focused on educating the taxauthorities about the reasonableness ofthe taxpayer’s transfer pricing proactively,so that the examination team can reachtheir conclusion as quickly and efficientlyas possible.In contrast, if the taxpayer may anticipatethat the ultimate conclusion of an audit willresult in an adjustment regardless of howreasonable the taxpayer’s tax or transferpricing policies are (frequently the casein certain Asian countries). In this casethe audit strategy is likely to be focusedon identifying those issues that are nonnegotiablefrom the taxpayer’s perspectiveand those on which the taxpayer may bewilling to compromise, with the ultimateaim of achieving the next best result tono assessment at all – that is, as small anassessment as possible. In a general taxaudit, the taxpayer may have a numberof issues upon which it is willing to makecertain compromises. The taxpayer maybe more willing, for example, to accept anadjustment on the reclassification of certainexpenses as non-deductible than it may bewilling to accept the examination team’sselection of an alternative transfer pricingmethodology or set of comparables leadingto a higher range of possible transferprices. In contrast, in a specialist transferpricing audit, the list of technical issuesmay provide less room for such negotiation,unless the taxpayer has multipleintercompany transactions. Nevertheless,it may still be possible to negotiate in suchcases, e.g. across taxable years rather thanon the technical issues covered by the audit.52 Transfer Pricing Perspectives. October 2011

Once a taxpayer has identified its (non-)negotiable issues, the focus of the auditwill be to direct the examination team’squestions to those areas where the taxpayercan most comfortably agree to acceptan assessment. This may be managedthrough the manner in which informationis submitted, or in the drafting of thesubmitted data itself.Some tax authorities have publisheddeadlines for completing an audit. Inthe UK, for example, the typical time tocomplete a non-complex transfer pricingaudit is 18 months, and the tax authorityofficials have to report to their managementon their progress at regular intervals.This is often supported by an agreed plandrawn up by the taxpayer and the taxauthority, setting out a detailed timetableof actions, specifying how the audit willproceed, when information requests willbe made, at what date information will beprovided, and when meetings will be heldto review progress or reach a conclusion.This may well be a useful approach inother jurisdictions, as it shows a positiveand willing approach by the taxpayer andhelps to manage the progress of the audit.It is however important that the taxpayershows its commitment to the plan andensures that resources are made availableto complete their side of the plan’s stepson time. If possible, negotiate a successfulresolution of the audit.In those countries where an auditadjustment is inevitable, the taxpayer’sattention will eventually turn tonegotiating as successful a resolution ofthe audit as possible. Of all the stages inthe audit process, and of all the practicesdiscussed above, the process of negotiationis likely to be the most impacted bycultural differences among jurisdictions.As a result, this is the area most likely tobe best handled by local management orexperienced local advisors. Nevertheless,to ensure that the negotiation discussionsoperate as smoothly as possible, theglobal or regional tax/transfer pricingteam must provide clear guidance anddirection on what may and what may notbe conceded, i.e. what the parameters ofthe negotiation are and what is consideredto be a successful resolution of the matter.This process will be helped if the personconducting the negotiation has beeninvolved in the entire audit process, andhas full background on the life of the audit(e.g. what issues were not raised, whatissues have been conceded by either theexamination team or the taxpayer, etc.).For this reason, if third party advisors areto be involved in negotiation discussions atsome stage, it is helpful if those advisors areinvolved in the audit from the start (even ifthey do not necessarily attend all meetingswith the examination team) and areprovided with timely updates of meetings,information submitted, etc.A successful negotiated conclusion to anaudit that satisfies both the examinationteam and the taxpayer is obviously thepreferred outcome in most cases. Taxpayersshould be wary, however, of makingcompromises to settle an audit unless theyare clear about what the consequences ofthose compromises are on the settlementprocess. For example, to secure a lowerassessment amount, a taxpayer may bepressured to give up its rights to legalappeal or mutual agreement procedures.Although certain taxpayers may accepta compromise in these circumstances ifthe resulting benefit in terms of reducedassessment amount is sufficientlylarge, it is important that the taxpayerunderstands clearly the implicationsarising from any compromises made oncurrent and future audits and settlements.In such cases, an experienced advisoris invaluable for explaining the possibleoutcomes and implications of the finalnegotiated resolution.There will often be cases which are verydifficult to settle. This may be because bothsides have taken positions on the audit thatmake it very hard for them to find a way toreach a satisfactory resolution. On otheroccasions a tax authority audit team maywell continue to ask for more informationwithout giving any clear idea of what theirconcerns are. In these situations, an advisorcan often help to break the deadlock, byfinding a way to bring a fresh look at thedispute, moving away from the detail andfocusing instead on the principles involvedand the bigger picture.Finally, there may be cases where theexamination team’s position is completelyuntenable, yet they are unwilling to listento any counter argument raised by thetaxpayer. In such cases (and depending onthe jurisdiction), there may be occasionswhen it is necessary for a taxpayer toraise its concerns to a higher level withinthe local tax authority, either to provokea more reasonable response from theexamination team (in many cases unlikely),or to place the tax authority on noticethat the taxpayer feels strongly about theparticular issue (and thus may be likelyto pursue its remedies further). As thisapproach frequently has a negative impacton the relationship with the examinationteam, it is generally only used in themost severe cases; literally, cases wherethe audit position could not deterioratemuch further. Moreover, understandingthe structure of the local tax authoritiesand identifying the appropriate seniorperson to be approached are also key toobtaining benefit from such a strategy.Consequently, it is not recommended that ataxpayer adopt such approach without thebenefit of consultation with experiencedlocal advisors.Transfer Pricing Perspectives. October 201153

Lay the groundwork for postassessmentoptionsDuring the course of an audit, it maybecome clear that the examination teamis intent on making an audit assessment,and that such assessment is unlikely tobe something to which the taxpayer canagree (e.g. a significant transfer pricingassessment that will have an impact onfuture as well as past years). In such cases,it is important that the taxpayer use theremaining time available in the audit tostart setting the stage for a future appeal(whether administrative or judicial), or useof mutual agreement procedures. In manycountries, unless information is submittedduring the audit process, it cannot besubmitted at any subsequent hearing. Inother countries, despite whatever viewthe examination team have themselvestaken on the taxpayer’s transfer pricing,they are under an obligation to handover any alternative written positionsubmitted by the taxpayer when the caseis referred for administrative appeals,court proceedings or mutual agreementprocedures. Consequently, regardless ofhow futile the matter may seem in the faceof an unyielding field examiner, it maybe important for the taxpayer to prepareand submit a written submission paperoutlining its position and the reasons fordisagreeing with the position taken by theexamination team.In the case where an audit adjustmentis going to produce a material instanceof double taxation and the taxpayer isdetermined to use the mutual agreementprocedure to try to resolve this, it may bepossible in certain jurisdictions to get thecompetent authorities involved beforethe assessment is finally determined andpossibly even before the audit is formallyconcluded. Again, this is an area wherea local advisor will be able to share theirexperience and give a view on whether anearly approach to the respective competentauthorities might be appropriate.Whatever the options available for postassessmentaction, it is critical not tooverlook possible time limits for action,especially if the audit is protracted and theyears slip by. The importance of makingearly claims under the mutual agreementprocedures, for example, cannot beover emphasised.54 Transfer Pricing Perspectives. October 2011

ConclusionAlthough it goes without saying that doingeverything possible to prevent a transferpricing audit from commencing is animportant tax management tool and shouldnot be disregarded, it is no longer enoughto hope that by doing so a transfer pricingaudit will not eventuate. Instead, it is alsoincumbent on the taxpayer to be awareof best practices for managing the audititself, so that if an audit does begin, it ishandled so as to achieve the best possibleoutcome for the taxpayer, bearing in mindthat in many countries the best outcome isa relatively small audit adjustment (wherethe possibility of no adjustment being madeat all is less likely).Through the adoption of the best practicesdiscussed above, it is hoped that taxpayerswill be able to achieve this goal, while atthe same time reducing the pressure ontime and resources that the typical transferpricing audit produces.To set the base for such strategy, the likelyoutcomes for the audit process need to beclearly understoodAuthorsMei GongPartner, PwC China+86 2 323 3667mei.gong@cn.pwc.comLyndon JamesPartner, PwC Australia+612 8266 3278lyndon.james@au.pwc.comDavid SwensonPartner, PwC US+1 202 414 4650david.swenson@us.pwc.comRyann ThomasPartner, PwC Japan+ 81 3 5251 2356ryann.thomas@jp.pwc.comSanjay ToliaPartner, PwC India+91 22 6689 1322sanjay.tolia@in.pwc.comDiane HayDirector, PwC UK+44 20 721 25157diane.hay@uk.pwc.com55

Advance Pricing Agreementsin the Asia Pacific56

The Asia Pacific (APAC) region is increasingly regarded bymultinational corporations (MNCs) as the key driver for globalgrowth and expansion. This has led to a surge in cross bordertransactions within APAC region and between the APAC regionand the rest of the world. Furthermore, as corporate structuresare less driven by geographies and more by other businessdrivers like product/business units, corporate structuresare ever more crossing geographical regions and countryboundaries. However, tax authorities are still, and will alwaysbe, dictated by national boundaries. As such, in recent yearstransfer pricing has become a central issue for MNCs and therelevant tax authorities. While the arm’s length principle isfollowed by most tax authorities in the APAC region to evaluateinter-company transactions, different interpretations andemphasis may lead to different outcomes. Hence, tax authoritiessee transfer pricing as a soft target with the potential to producea sizeable increase in tax revenue. This potentially results ineconomic double taxation and an increase in the effective taxrate of MNCs.Transfer Pricing Perspectives. October 201157

As MNCs look to Asia to drive theirglobal revenue and profits, countriessuch as China and India are mindful ofthe importance of their markets and willseek to attribute more profits to theirjurisdiction. As emerging markets, they willseek to challenge and to develop new andinnovative means to achieve this outcome,for example, expansion of permanentestablishment concepts and locationsavings. Revenue authorities in headquarterlocations such as Singapore will alsoseek to build substance in their countryand will zealously guard any attempt toallocate or transfer profits out through theuse of purely tax driven structures to taxhaven countries.In order to manage the increasinguncertainty in transfer pricing across theAPAC region and to strive for known taxtreatment of complex business structuresor changes, MNCs are once again looking toengage with tax authorities prospectivelywith the greater use of Advance PricingArrangements (APAs). APAs are bindingadvance agreements between the taxauthorities and the taxpayers that set outthe method for determining transfer pricingfor specified inter-company transactionsunder specified conditions.In the past, transfer pricing documentationprovided MNCs with a front line of defenceshould the tax authorities come knockingon their doors. Increasing levels of scrutinyand disclosure requirements globally arenow challenging MNCs to manage their taxrisk more proactively. The ever evolvingand increasingly complex tax environmentand uncertain tax disclosure requirements,is forcing global tax directors to thinkbeyond the traditional transfer pricingdocumentation and to consider how tomanage their tax and transfer pricing riskswith greater certainty.Revenue authorities are increasinglyfocused on scrutinising operatingstructures perceived to lack “economicsubstance”, and the new chapter inOrganisation for Economic Corporationand Development (OECD) guidelines fortransfer pricing on business restructuring(Chapter IX) has given tax authoritiesclear guidelines on how to approach suchissues. Tax authorities in the APAC regionare applying these principles in testingwhether MNCs are implementing businesstransactions which are operationallydriven, not merely tax driven. Japan,China, and Singapore tax authoritieshave clearly stated these requirements inbilateral APA cases. In short, the messageto MNCs is not to rely just on traditionaltransfer pricing documentation butalso to ensure that there is evidence ofthe operational changes/benefit thatunderlie any tax benefits associated withbusiness change. This is the test that taxauthorities in these countries are using innegotiating APAs.The remaining discussion in thisarticle provides a snapshot of the APAdevelopments in APAC countries wherewe assess the countries in terms of thecomplexity of their local transfer pricingenvironment and their relative experienceon bilateral/multilateral APAs. Thediscussion also includes a statisticalrepresentation of the total bilateral/multilateral APAs concluded by therespective countries. 1Revenue authorities are increasinglyfocused on scrutinising operatingstructures perceived to lack“economic substance”1Statistics provided up to 2009 based on information published by revenue authorities in the region.58 Transfer Pricing Perspectives. October 2011

As can be observed from the diagramopposite . tax authorities in the APAC regionhave varying degrees of experience in APAnegotiations and outcomes. However, thatdoes not necessarily coincide with the levelof attention and scrutiny given to intercompanyarrangements by the revenueauthorities. This potentially presents achallenge to many MNCs considering APAsas a strategy to manage their tax risk in theAPAC region.Considering this snapshot of issues andthe overview provided above of APAs inthe APAC region, a number of questionsmay arise for MNCs. If a company hasundertaken business restructuring forits APAC operations for example, howshould APAs be utilised strategically tomanage associated tax risks? What aboutMNCs who have not undertaken businessrestructuring but have a stable businessand transfer pricing model though areprone to challenge by the tax authorities– is an APA an option for them? Would itmean that taxpayers in countries whichhave significant experience in negotiatingbilateral APAs, will experience fewer issueswhen approaching the tax authorities for anAPA? For countries that are still in the earlystages of developing an APA programme,should taxpayers still be looking at APAsas a way to manage tax/transfer pricingrisks? Fundamentally, given the disparityin the APA experience and approach ofdifferent APAC tax authorities, can taxdirectors in the region use APAs effectivelyas a cornerstone to support their transferpricing policy?There are no easy answers to the questionsabove. However, it is interesting to notethat many MNCs have navigated the abovechallenges to their advantage to managethe risk proactively by strategically usingthe APA regime.It is a known fact that many MNCs haveset up regional headquarters or tradingoperations in Singapore and that incometax rates in Singapore are predominantlylower than the income tax rates of themajority of Singapore’s primary tradingpartners. Despite this, the Inland RevenueAuthority of Singapore (IRAS) is increasingits focus on transfer pricing issues. Thetreaty provisions and the domesticprovisions enable the IRAS to acceptrequests from taxpayers to enter APAs.What does this mean for MNCs who useSingapore as regional headquarter locationand in many cases restructure theirbusiness operations to use Singapore as ahub for inter-company trading activities?Figure 1Overview of APAC APA landscape7006005004003002001000 8 13 0India (NA) 3Singapore (2006)China (2002)Indonesia (2010)127Total number of bilateral/multi-lateral APA cases concluded by 2009 - bycountry (start year of APA programme)Australia (1991)685Japan (1997)2The statistics are based on certain published information and some other information which comes, to the best of our knowle.g. from our interaction with the tax authorities.3N.A. refers to not applicable.Transfer Pricing Perspectives. October 201159

As more transactions involve Singapore as alocation for MNC headquarters or trading hubs,Singapore will increasingly be a party to issuesof double taxation that may arise in the region60

As more transactions involve Singapore asa location for MNC headquarters or tradinghubs, Singapore will increasingly be a partyto issues of double taxation that may arisein the region. One strategy to manage thiscould be to use the Mutual AgreementProcedures (MAPs) in the event that the taxauthorities of Singapore’s trading partnersattack such business restructuring. Thismay be a reactive approach to managingdouble taxation which does not provideupfront certainty to MNCs and their taxdirectors. In such cases, APAs could beused as an alternative or complimentarystrategy to apply a proactive approachto seeking certainty and managing thetransfer pricing risks associated withbusiness restructuring. The attractivenessof APAs is also enhanced by the fact thatIRAS has historically shown a willingnessto adhere to the principles outlined in theChapter IX of the OECD Guidelines, onbusiness restructuring.MNCs could take advantage of theopportunity this presents to manage theirtransfer pricing risks and the potential fordouble taxation by opting for bilateral APAswith countries who also have experiencein dealing with bilateral APAs, such asJapan or Australia. In these jurisdictions,the revenue authorities, in principle, bothfollow the guidance outlined in Chapter IXof the OECD Guidelines. MNCs may alsoconsider using the bilateral APA mechanismas an option to resolve related tax issuessuch as exit taxes on conversion of thebusiness models. In adopting this strategy,MNCs should equip themselves with robusttransfer pricing and tax analysis if theyare willing to use the APA mechanism toresolve potential issues.While MNCs can consider applyingfor APAs to deal with a change in thebusiness structure, APAs can also be usedeffectively to gain certainty on existingstructures for future years where businessand transfer pricing models are prone tochallenge by tax authorities. In doing so,there is also a potential to resolve issuesarising in years prior to the APA. Thenew APA programme introduced by theAustralian Taxation Office under PracticeStatement Law Administration ‘PSLA2011/1’ earlier this year for example,indicates that such opportunities may beavailable to taxpayers, where the facts andcircumstances are sufficiently similar, andtherefore methods and outcomes agreedunder an APA may be used to resolveissues arising in years prior to the APA. Infact, the newly released programme hasreignited, with the encouragement of theAustralian Taxation Office, the interest ofAustralian taxpayers in APAs as a potentialsolution to their transfer pricing and relatedtax challenges after a number of years ofreduced confidence in the programme.In spite of this, it is still challenging tonegotiate a bilateral APA successfullywithout proper preparation and carefulmanagement of the discussions with taxauthorities. As is the case for MNCs, taxauthorities also need to commit significantresources to bilateral APA negotiationsand accordingly, a commitment to provideadequate support and cooperation isrequired from the taxpayers.Unfortunately bilateral APAs are notthe answer to all transfer pricingconcerns. Many MNCs who have tried tonegotiate bilateral APAs in China havebeen frustrated by a long pipeline ofAPA applications for consideration bythe Chinese Competent Authority (CA)due to the increased demand for APAsfrom Chinese taxpayers in recent years.The APA programme has long passedthe “infant stage” and all the teethingproblems associated with that, and israpidly growing in popularity. Therefore,the State Administration of Taxation (SAT)has become highly selective in acceptingAPA applications and taxpayers now needa creative and compelling strategy to givetheir case some priority.Similarly, the National Tax Agency (NTA)in Japan also has a large inventory ofbilateral APA cases, and the number ofsubmissions annually continues to increase(partly due to increasing numbers ofAPA renewal applications). In order toaddress this increasing inventory, theNTA has implemented accelerated reviewof APA applications and, additionally, isreaching agreement on bilateral APAswith treaty partners in fewer meetingsthan historically.Transfer Pricing Perspectives. October 201161

Despite the increasing popularity in somecountries in the region, there are stillcountries in APAC which do not provideformal APA guidelines or have as muchexperience in APA negotiations such asIndia and Indonesia. In these territories, arobust strategy to building the case beforethe tax authorities is imperative. India andIndonesia for example, are well-known tobe aggressive on the audit front for transferpricing matters. To the extent available,the APA mechanism would thereforeprovide an important avenue to taxpayersto manage their transfer pricing risks inthese territories.However, the formal APA regime in Indiais still being designed. The proposed draftDirect Tax Code which will replace theexisting Income Tax Act (and is proposedto be effective from April, 2012), includesprovisions for taxpayers to apply for anAPA. The tax advisory community ofwhich PwC has been at the forefrontof discussions has been pushing thegovernment to incorporate global bestpractices in drafting the APA rules. Whilethe currently proposed draft legislation issilent on the matter, senior governmentofficials have expressed a view that Indiamay include a bilateral APA mechanismwhich would be welcomed by tax directorsof MNCs operating in the region.On the other hand, the IndonesiaDirectorate General of Taxes (DGT)released APA regulations in Indonesia on 31December 2010, providing some guidanceto taxpayers on the application of andprocess for APAs in Indonesia. Based oninteractions with the Indonesia Taxationoffice (ITO) to date, it is clear that the ITOis keen to implement the APA mechanismand anticipates success from the process.Based on this, it can be expected thatgiven the increase in local transfer pricingdisputes involving increasingly complexissues in the region, many MNCs will beconsidering adopting a proactive approachto managing their transfer pricing risk.In this increasingly complex environmentwith an intensified transfer pricingcompliance focus by tax authorities, MNCsare wise to consider a strategic approachto managing their risks. As a key plankto these strategies, tax directors shouldconsider using APAs as a way to seekcertainty and reduce the risk of doubletaxation in the region.Despite the increasing popularity in some countriesin the region, there are still countries in APAC whichdo not provide formal APA guidelines or have asmuch experience in APA negotiations such as Indiaand Indonesia62 Transfer Pricing Perspectives. October 2011

AuthorsSpencer ChongPartner, PwC China+86 21 2323 2580spencer.chong@cn.pwc.comNicole FungPartner, PwC Singapore+65 6236 3618nicole.fung@sg.pwc.comRahul MitraPartner, PwC India+91 124 3306501rahul.k.mitra@in.pwc.comMichael PolashekPartner, PwC Japan+81 03 5251 2517michael.polashek@jp.pwc.comJeremy Capes-BaldwinDirector, PwC Australia+61 2 8266 0047jeremy.capes-baldwin@au.pwc.comFalgun ThakkarSenior Manager, PwC Singapore+65 6236 7254falgun.d.thakkar@sg.pwc.comAy-Tjhing PhanPartner, PwC Indonesia+62 21 5212901ay.tjhing.phan@id.pwc.com

Transfer pricing forfinancial transactions64

Conceptualising the challengeIntra‐group financial transactions,including related party loans, guarantees,cash pooling and other forms of financing,are increasingly receiving close attentionfrom tax authorities around the world.There are four major reasons for thisincreased focus:• The pricing of financing arrangementsis complex and has been exacerbated bythe financial crisis• The amounts at stake can be significant• There has been limited guidancefrom the Organisation of EconomicCooperation and Development(“OECD”), which has requiredtaxpayers and local tax authorities tointerpret best how the arm’s-lengthprinciple should be applied, often withdiffering outcomes• These issues are being tested in thecourts and recent decisions haverequired taxpayers to consider theimpact of passive association whenpricing financial transactions atarm’s length.The onset of the financial crisis in 2007resulted in a reduction in liquidity, a spikein both short-term and long-term fundingcosts, an increased requirement for parentcompanies to provide subsidiaries withguarantees in order to access third partybank funding, and increased corporatebond issuance to replace traditional bankfunding. Changes in the availability,structure and cost of funding at bothan industry-wide and group level hasimplications for internal financingarrangements for all types of MNCs. Thesearrangements are further complicated bythe extent to which MNCs have branchand/or subsidiary structures, as tax rules inmany countries often discriminate betweenthese two forms when applying thincapitalisation rules and the arm’s-lengthprinciple to pricing financial transactions.This type of concern and the lack ofOECD guidance are increasing tax risk formost multinational groups in this area oftransfer pricing.At the same time, the regulatorylandscape has continued to evolve withincreasing reporting and documentationrequirements, stricter penalty and interestregimes as well as a higher visibility oftransfer pricing to management throughreserves for uncertain tax positions andlosses incurred during the financial crisis.Thin capitalisation and fundingtransactions: approachesacross AsiaIn most jurisdictions, tax authoritiesfocus both on the pricing of related partydebt as well as whether the quantum ofthe debt complies with the arm’s-lengthprinciple. This second test is known asthin capitalisation and it is utilised bytax authorities to limit tax deductions onexcessive levels of debt. Often, there aredifferent rules (normally more beneficial)for the amount of debt a financialinstitution is able to hold compared tocompanies operating in the non‐FS sector.Transfer Pricing Perspectives. October 201165

Some countries adopt safe harbourrules in relation to the amount of debt acompany may hold (e.g. debt-to-equityratios) or the rate at which interest paidto related parties may be deducted (e.g.LIBOR caps). Increasingly, tax authoritieswithout safe harbour rules are comparingthe results under the safe harbour rulesof other countries with levels that wouldbe derived under an arm’s-length debttest and taxpayers are expected to defendthe difference. Conversely, for countriesthat have safe harbour rules, tax-payersmay be looking to depart from these onthe rate of interest paid in favour of thearm’s‐length principle as borrowing costshave significantly exceeded LIBOR baserates since the global financial crisis.The thin capitalisation landscape acrossAsia is diverse but many tax authoritieshave paid attention to strengthening thincapitalisation regimes over recent years.While Singapore does not have any specificthin capitalisation regulations, the transferpricing and the anti‐avoidance provisionscontained in the domestic legislation maybe invoked to challenge related partyfinancing arrangements. In China however,since 2008, if an enterprise wants to claima tax deduction for interest expenses inexcess of the prescribed debt-to-equityratio (which is 2:1 for non‐financial and5:1 for financial institutions), it can doso only to the extent that it has preparedthin capitalisation documentation todemonstrate that the amount, interest rate,term, financing terms, etc. conform to thearm’s-length principle.In Japan, in broad terms, the thincapitalisation rules set out that if theannual average balance of interest‐bearingdebt to a foreign controlling shareholderexceeds three times the capital contributedby the foreign controlling shareholder (ordebt‐to‐equity ratio of a corporation with asimilar type of business), the excess interestexpense paid or payable to the foreignparent corporation is not deductible.More recently, in June 2011, Taiwan issuednew thin capitalisation rules applicableto non‐financial institutions. The newrelease requires companies to disclosetheir debt‐to‐equity ratio with their taxreturn. Interest on debt exceeding theprescribed ratio (3:1) versus equity cannotbe recognised as an expense and deductedin the tax computation.Thin capitalisation regulations are yet tobe introduced in India. The General Anti-Avoidance Rules, if finally enacted in theform in which it has been incorporated inthe draft Direct Tax Code placed beforethe Parliament, would empower the taxauthorities to recharacterise loans intoequity (by introducing guidance on thincapitalisation), which the tax authoritieswere hitherto not authorised to do underthe existing Indian TP Rules.The Indian transfer pricing regulations,while being wide ranging, do not addressspecific positions and treatments on alltypes of transactions. The definition ofinternational intra-group transactionsincludes the borrowing and lending ofmoney and any transaction that has aneffect on the profits, losses, incomes andassets of an enterprise. Accordingly, allkinds of financial transactions (e.g. loans,guarantees, cash pooling arrangements)would appear to be covered by the ambit ofthe transfer pricing regulations. However,there are no defined positions around thetreatment of financial transactions froma transfer pricing perspective, unlike theposition papers that have been issuedby the Australian Tax Office (ATO).Accordingly, for financial transactionsinvolving India, one would have to fall backon international principles that provideguidance around intra‐group servicesand judicial precedents, both nationallyand internationally.66 Transfer Pricing Perspectives. October 2011

During the course of recent transferpricing audits, the Indian tax authoritieshave sought to challenge interest freeloans, particularly in an outbound loancontext. Adopting scientific approachesto credit rating and benchmarking is anincreasing expectation of the Indian taxauthorities from Indian tax-payers wishingto develop sustainable positions in the areaof intra‐group loans. Similarly, intra‐groupguarantees have also been a matter ofintense discussion in India, necessitatinga careful and detailed approach towardssuch arrangements.In Australia, the ATO has recently issuedfinal guidance on the interaction of transferpricing and thin capitalisation. The taxruling reiterates that transfer pricingrules apply first to determine an arm’slengthinterest rate for a related partyloan, which is then applied to the actualamount of the debt. The thin capitalisationprovisions then operate to determinethe debt deductions based on prescribedratios. Australian taxpayers (includingbranches) are generally restricted underAustralia’s thin capitalisation rules to 3:1measured with reference to eligible assetsnet of eligible non‐debt liabilities. Alldebt is included, whether from related orunrelated parties. It is also possible to relyon an ‘arms‐length debt’ test to support ahigher level of debt. Australian financialentities (including branches) are restrictedto a 20:1 ratio measured in basicallythe same way but with concessions foron‐lending and borrowing against cashand certain highly‐rated assets (e.g. REPOsecurities, A‐rated subordinated debt andBBB-rated senior debt).While the thin capitalisation provisionscontinue to govern the actual amount ofdebt, in the ATO’s view, the arm’s-lengthinterest rate must ‘produce an outcome thatmakes commercial sense’.Interest ratesLocal transfer pricing rules across Asiarequire that interest rates on intercompanyloans should be consistent with the arm’slengthprinciple. Typically, in order todetermine the arm’s-length rate on arelated party loan, taxpayers need to gothrough the following steps:• Compare the loan parameters ofthe tested transaction to the loanparameters of transactions betweenthird parties• Assess the stand alone credit rating ofthe borrower• Substantiate the economic rationaleof the terms and conditions ofthe transaction• Where there are no internalcomparables, determine the pricethrough a robust economic analysis andbenchmarking of external comparableinterest rates or credit spreads for thegiven credit rating of the borrower andthe specific terms and conditions ofthe transaction• Document the arrangement withtransfer pricing documentation andretain agreements, calculations, etc• Review and monitor the arrangementregularly (especially in casethe transaction includes call orprepayment options).Although this process appearsstraightforward, there is little guidanceon how it should be applied in practiceeither from the OECD or from most localtax authorities.Loan guaranteesA loan guarantee is a binding arrangementwhere one party, the guarantor, assumesthe debt obligation of a borrower in case ofdefault. Many subsidiaries relying on localfinancing from third parties face demandsfor such guarantees. Where an explicitguarantee is made by the parent or anothergroup company and the benefit of providingthe guarantee (in terms of interest saved)can be clearly demonstrated, a guaranteefee should generally be charged for transferpricing purposes. For branches however,it is generally not appropriate to charge aguarantee fee as, in accordance with theOECD Guidelines, a branch is deemedto have the same credit rating as itshead office.Local transfer pricing rules across Asiarequire that inter company guarantee feesshould be set at levels that are consistentwith the arm’s-length principle.Transfer Pricing Perspectives. October 201167

In setting related party guarantee fees,taxpayers will need to consider thefollowing key questions:Traditionally, many taxpayershave evaluated the credit ratingof their subsidiaries ona standalone basis• Has an explicit guaranteebeen provided?• What is the nature and background ofthe guarantee?• Would a third party lend at all withouta guarantee?• Can the guarantor charge for it?• What is the borrower’s credit ratingand borrowing ability withoutthe guarantee?• What is the interest benefit receivedby the borrower from the guarantee ifcompared to the interest rate that theborrower would have achieved withoutthe guarantee?• Based on a range of arm’s-length prices,how would third parties split the benefitthe guarantee creates and ultimatelywhat is the appropriate guarantee fee?One approach to setting guarantee feesis the interest saved approach. Under thisapproach, the difference between theinterest rate charged on the guaranteedloan and the interest rate that the borrowerwould have paid on a standalone basisis the maximum guarantee fee that theguarantor could charge. This fee couldbe reduced so that both guarantor andborrower benefit from the arrangement.Another approach to setting a guaranteefee is to focus on the guarantor.Theoretically, a guarantor would charge aprice that reflects the probability of default,the expected loss in the event of defaultplus a certain profit element.68 Transfer Pricing Perspectives. October 2011

Passive associationIn performing a transfer pricing analysisof guarantee fee arrangements, explicitguarantees, as described in the previoussection, should be differentiated fromimplicit guarantees, where only thebehaviour of the parties suggests that aguarantee exists (e.g. a parent companyproviding financial assistance to astrategically important subsidiary). TheOECD Guidelines state in paragraph 7.16that “[…] an associated enterprise shouldnot be considered to receive an intra‐groupservice when it obtains incidental benefitsattributable solely to its being part of alarger concern, and not to any specificactivity being performed. For example,no service would be received where anassociated enterprise by reason of itsaffiliation alone has a credit‐rating higherthan it would if it were unaffiliated, butan intra‐group service would usually existwhere the higher credit rating were due to aguarantee by another group member […]”.Traditionally, many taxpayers haveevaluated the credit rating of theirsubsidiaries on a stand‐alone basis (i.e.under the assumption that the borroweris an independent entity that is notrelated to the lender). This approach isarguably consistent with the separateentity approach formulated by theOECD in Article 9 of the OECD ModelTax Convention and referenced in theOECD Guidelines.From a practical perspective, althoughthe concept of passive association seemsinconsistent with the arm’s-lengthprinciple, several tax authorities appear tohave embraced the concept that the creditrating of the parent has a “halo‐effect” onits subsidiaries.The Canada Revenue Agency hasattempted to argue in the context ofpricing intra‐group credit guarantee feesthat a third‐party lender would lend toa subsidiary of a major multinationalgroup (or, more broadly, assume its creditrisk) at a lower rate than that implied bya pure “stand‐alone” result in light of itsaffiliation with its parent. Such a “passiveassociation” argument raises several keyissues, ranging from the empirical (towhat extent do lenders account for groupaffiliation of subsidiaries that are notformally guaranteed by their parent) to thetransfer pricing specific (such as whethera consideration of the potential linksbetween a parent and its subsidiary areconsistent with the arm’s-length principle).On December 4, 2009, the Tax Court ofCanada ruled in favour of General ElectricCapital Canada Inc. and allowed thecompany to maintain deducted guaranteefees of CAD 136 million for financialguarantees provided by its US‐basedparent, observing that the 1% guarantee feewas equal to or below an arm’s-length price.The decision was later confirmed by theFederal Court of Appeal in December 2010.Both Moody’s Investors Services andStandard and Poor’s provide some notchingguidance on how to account for the “haloeffect”. However, this adjustment stillremains quite subjective and is treateddifferently by different tax authorities.Taxpayers will therefore need to balancecarefully their intra‐group financialtransactions policy depending on thejurisdictions in which they operate.Transfer Pricing Perspectives. October 201169

The building blocksThe building blocks for a defensibleapproach to financial transactions transferpricing are:The blueprintStakeholders across tax, accounting/controlling, treasury and the CFO needto be involved in the process and theirbuy‐in secured.Building the policyThe transfer pricing policy in this areashould be flexible enough to balance thetypes of transactions and requirementsof different countries with the magnitudeand often large volume of transactions.The transfer pricing mechanism should bereviewed regularly to consider the impactof changes in the market, regulations or theunderlying transactions.DocumentationAppropriate transfer pricing andcommercial documentation (e.g. executedagreements specifying terms andconditions) supporting the arrangements,both at a headquarter and local level,should be maintained in case of atransfer pricing audit. Companies needto make a strategic decision on theirdocumentation approach, ranging from acentralised ‘masterfile’ approach to local‘standalone’ documentation which includeslocal agreements. The quantum of thetransactions and associated tax risk shouldhelp inform this decision.Defence under auditControversy management requires keystakeholders to deal with the tax authoritiesand to give consistent messaging, supportedthrough the provision of the ‘right type andamount’ of information. Taxpayers shouldknow the options that are available to themand monitor regulatory developments andtrends. Companies should reconcile the TPpolicy in place with the actual amounts thatget booked in the accounts to ensure thepolicy is implemented appropriately andcan be defended as such under an audit.Advance Pricing AgreementFinancial transactions do not traditionallyfeature in many APAs, however, taxpayersmay want to reconsider this avenue asa way to eliminate or reduce tax riskssurrounding financial transactions. Thedecision to do so should depend on thestrategic importance and quantum ofthe transaction.Stakeholders across tax, accounting/controlling, treasury and the CFO needto be involved in the process and theirbuy‐in secured70 Transfer Pricing Perspectives. October 2011

ConclusionsTransfer pricing for financial transactionsis still evolving at the same time as itincreases in prominence. Companies needto develop a strategy for dealing with theissues, documenting them and dealingwith the transfer pricing audits that willinevitably arise in this area.AuthorsMichel van der BreggenPartner, PwC Netherlands+31 (0) 88 792 75 23michel.van.der.breggen@nl.pwc.comDanielle DonovanPartner, PwC Australia+61 (7) 3257 8102danielle.donovan@au.pwc.comRalf HuessnerAssociate Director, PwC Hong Kong+852 2289 3568ralf.rh.heussner@hk.pwc.comPrashant BohraSenior Manager, PwC Australia+61 (3) 8603 4087prashant.bohra@au.pwc.comAdditional credit toDavid McDonaldDirector, PwC Hong Kong+852 2 289 3707david.mcdonald@hk.pwc.comAdditional credit toDhaivat AnjaraPartner, PwC India+91 22 6689 1333dhaivat.anjaria@in.pwc.comRyann ThomasPartner, PwC Japan+ 81 3 5251 2356ryann.thomas@jp.pwc.comPaul LauPartner, PwC Singapore+65 6236 3733paul.st.lau@sg.pwc.comRichard WantanabePartner, PwC Taiwan+886 2 2729 6666 26704richard.watanabe@tw.pwc.comMohamed SerokhDirector, PwC China+41 58 792 4516mohamed.serokh@ch.pwc.com

Case law developments:transfer pricing meetsbusiness reality72

Let’s talk business realities!While TP regulations were envisionedto be an anti‐tax avoidance tool to curbshifting of profits, they have also causeduncertainty due to the evolving nature ofthe subject. As a result, TP has become oneof the biggest tax issues being discussed inthe boardrooms of MNCs.The situation today is perhaps not just dueto the tax authorities’ approach to TP, butalso due to complex business realities andinnovative structures being adopted byMNCs to generate operational efficienciesin this competitive global market. ManyMNCs now have a network of independentunits that utilise their strategic attributesin a complementary fashion, which makesit imperative for MNCs to have a robust TPstrategy that is grounded in commercialreality and economic substance.While TP as a subject has been around for awhile, one can say that with the increasingpace of globalisation, it still seems to beevolving, with principles and judicialprecedents emerging in relation to theapproach to be adopted in case of variousbusiness realities.The above scenario is being analysed inlight of some of the recent landmark TPcourt cases around the world.Pharma trend‐setters –holistic approachIn the landmark case of GlaxoSmithKlineInc. (Canada), the taxpayer importedActive Pharmaceutical Ingredients (APIs)from its associated enterprise (AE) andmanufactured Finished Dosage Forms(FDF) of the product Zantac. As part of thearrangement to use the Zantac trademark,it was required to purchase the API fromits AE. In the years in question, Zantac soldat a considerable premium to the genericversions of the product.In the Tax Court of Canada, the Minister ofNational Revenue argued for the use of theexternal Comparable Uncontrolled Price(CUP) method, using prices of generic APIspurchased by generic competitors afterundertaking appropriate adjustments. Itwas contended that business circumstancesallowing Zantac to sell at a premium werenot relevant. The product comparabilitywas exact and the external businesscircumstances were ignored. On the otherhand, the taxpayer adopted the ResalePrice Method (RPM) which was supportedby transactions with unrelated licensees.These licensees obtained the API andthe rights to sell under the Zantac nameand earned gross margins similar to thetaxpayer. The Tax Court preferred theCUP method.On appeal, the taxpayer contended thatbusiness circumstances such as the use ofthe brand name must be considered andonly in a fictitious world could a companybuy the API at low generic prices and sellZantac at a prevailing premium.The Canadian Federal Court of Appealfound favour in the contentions of thetaxpayer and acknowledged that theholistic approach towards the businessenvironment needed to be considered anda single‐dimensional approach was notappropriate. Recognising the intricacies ofthe business arrangement which involved alicensing arrangement for the use of brandname along with purchase of the APIs fromthe related party, the Federal Court ofAppeal supported GSK’s TP strategy.Transfer Pricing Perspectives. October 201173

In a similar case in India involving SerdiaPharmaceuticals, the issue revolvedaround preference for the CUP methodover the Transactional Net Margin Method(TNMM) adopted by the taxpayer.Though the Indian Tribunal deliberatedon the GlaxoSmithKline Canada ruling(as described above), the principles laiddown in that case were not fully embracedprimarily because the relevant argumentswere not put forth by the taxpayer. In thiscase, the court ruled against the taxpayerand mentioned that the focus should bemaintained on the specific internationaltransaction rather than the overall businessenvironment. Further, the Court upheldthe preference for using a traditionaltransaction method, after makingappropriate adjustments in order to accountfor transaction‐related differences, ratherthan routinely relying on a transactionalprofit-based method. However, theTribunal left a silver‐lining in its ruling– while referencing the Canadian case,it mentioned that the business realitiesneeded to be considered on a holistic basisand the future cases must be evaluatedkeeping in mind the commercial aspectsand facts of those cases.74 Transfer Pricing Perspectives. October 2011The lesson was well learnt and reflectedin a subsequent ruling of the sameTribunal in another case, Fulford India,involving closely similar facts and issues.The principle of considering the macropicture and the economic characterisationof the transacting entity was favourablyconsidered. This ruling merits significancebecause it appreciates that the CUPmethod could not be blindly applied forany and every import of generic APIs.One must consider the functional, assetand risk (FAR) profile or characterisationof the secondary manufacturer, whichthe Tribunal found to be a value-addeddistributor in this case. It was thus entitledto profits commensurate to its FAR profile,instead of premium or entrepreneurialprofits, which the tax authorities sought toattribute by applying the CUP method.Substance is the essenceThe experience from the United Kingdomfurther emphasises the fundamentals oftransfer pricing as it underscores the needfor looking at the larger picture ratherthan adopting a myopic approach. In thecase of DSG Retail, the taxpayer adopteda structure that interposed transactionswith an unrelated entity in between its AEs,attempting to avoid triggering the transferpricing regulations. However, the taxpayerfailed to demonstrate the uncontrollednature of the transaction in substance,despite an unrelated party being involved.A key element in the dispute waswhether an aggregated approachtowards transactions undertaken bymultiple entities, as argued by the UK taxauthorities, or an isolated approach lookingat individual transactions, as employedby the taxpayer, would be appropriate.The case was settled in favour of thetax authorities, with the tribunal rulingagainst attempts to arrange operationsartificially; instead one must consider thecommercial and economic substance in theoperational structure.There is an evolving consensus acrossthe globe that the TP audits shouldacknowledge broader business dynamicsand market realities faced by the MNEs, atthe same time considering the principle ofsubstance and significant people functions.Direct methods most likely to standtest of timeMNCs are effectively compelled to respondto the challenging business environment byusing intricate business strategies including(amongst others):• market positioning throughbrand names• adopting penetrative pricing for gainingentry into a new geographical market• importing goods instead of localisationin initial years• incurring start‐up losses.In today’s global scenario, a substantialcomponent of this response would involvedeveloping an effective TP policy thatwould address the position adoptedthrough the business strategy. The TPpolicy would be based on, amongstother things, the characterisation of thetransacting entities, objectives of thetaxpayer and the contractual relationshipof the taxpayer with its AEs.Let’s look at the recent Court case ofSNF Australia, where the taxpayer wasprimarily a distributor of unbrandedchemicals, which were sourced from its AElocated in France. The taxpayer adopted apenetrative pricing strategy to gain marketentry and presence in the Australianregion. It could purchase the products fromits AE at a relatively lower cost as comparedto third parties. SNF Australia establishedthe arm’s-length principle by adopting aninternal CUP based on the fact that the AEin France sold similar products to thirdparty distributors situated in differentcountries at higher prices as comparedto the supplies made to the taxpayerin Australia.Since SNF Australia had consistentlyincurred losses over an extendedperiod (over 10 years), the AustralianTaxation Office (ATO) challenged thetaxpayer’s contention that the internalCUP was an arm’s-length price in thesecircumstances. The ATO adopted theTNMM arguing the losses incurred werethe result of non‐arm’s length pricing.The Australian Federal Court held thatthe taxpayer had appropriately identifiedan arm’s-length price as required byAustralia’s transfer pricing legislationand interestingly, commented that thestandard of comparability the ATO expectsfrom taxpayers was unrealistic andbeyond that set out in OECD guidance.This result brings into question theefficacy of Australia’s transfer pricingrules and the ATO’s approach to transferpricing generally. It is likely the ATOwill seek to rewrite Australia’s transferpricing legislation.

The appropriateness of using a traditionaltransaction method over a transactionalprofit method was also supported by theAmerican Tax Court in the case of Veritas(USA). This case involved a transfer oftechnology intangibles from the US‐basedtaxpayer to its AE in Ireland. The InternalRevenue Service (IRS) argued that thetechnology intangibles had a perpetuallife and, hence, valued them using aDiscounted Cash Flow (DCF) method basedon all the residual profit expected to begenerated by the Irish AE in the future. TheIRS rejected the taxpayer’s ComparableUncontrolled Transaction (CUT) method,which compared the amount charged tothe Irish AE with the royalties charged inthe taxpayer’s agreements with third partylicensees. However, the American TaxCourt found the IRS to be unreasonablein attributing all future residual profit tothe transferred technology. The Courtrecognised the business reality that futureprofits were attributable in large part to thedevelopment efforts funded by the AE afterthe transfer. The Court allowed the plea ofthe taxpayer and accepted the CUT methodof establishing arm’s-length price.Staying AheadThe emerging premise from the casesdiscussed above is that of incorporatingbusiness realities into the transfer pricingstrategy and approach adopted by both thetaxpayers and the revenue authorities. Thebusiness environment surrounding an MNEand its response of using specific strategiesto adapt cannot be isolated from the overallprofitability and pricing of transactionsbetween group entities.Whether it is robust documentation ofoperations, or the choice of the mostappropriate method, the taxpayer would dowell to understand and proactively outlinearguments that align with the businessrealities in which it operates.There is a growing acceptance as wellamong the revenue authorities across theglobe that TP principles must reflect thebusiness circumstances faced by MNCs.By emulating the fundamental principlesand best practices in TP, one can happilymarry the overall global tax strategy withbusiness realities in this uncertain world oftransfer pricing.AuthorsLyndon JamesPartner, PwC Australia+612 8266 3278lyndon.james@au.pwc.comAndrew McCrodanPartner, PwC Canada+1 (416) 869-8726andrew.f.mccrodan@ca.pwc.comRahul MitraPartner, PwC India+91 124 3306501rahul.k.mitra@in.pwc.comGregory OssiPartner, PwC US+1 (202) 414 1409greg.ossi@us.pwc.comDiane HayDirector, PwC UK+44 (0) 20 721 25157diane.hay@uk.pwc.comKunj VaidyaAssociate director, PwC India+91 80 4079 6252kunj.vaidya@in.pwc.comOnce again, the key take away from thiscase is to document the use and basis of atraditional transaction method robustly,especially the CUP method, if it is availablegiven the facts of the case.Transfer Pricing Perspectives. October 201175

OECD: where to from now?76

Following the completion of the revisions of ChaptersI‐III and the new Chapter IX, the OECD has decided toembark on two new transfer pricing projects: a reviewof administrative aspects of transfer pricing, and anambitious project on transfer pricing and intangibles.The transfer pricing and intangibles project hasalready generated a significant amount of interestfrom the business community. Furthermore, otherorganisations, such as the United Nations, are alsoundertaking transfer pricing-related initiatives, whichthe OECD will certainly keep track of in the comingyears. There is no doubt that exciting times lie aheadfor the OECD.Transfer Pricing Perspectives. October 201177

Administrative aspects oftransfer pricingOn March 9, 2011 the OECD releasedan invitation for comments associatedwith the administrative aspects oftransfer pricing. The work is regardedas important in order to strike a balancebetween the development of sophisticatedguidance for complex transactions, andthe cost‐effective use of taxpayer and taxadministration resources.The OECD is currently being encouragedto consider a variety of tools to helpfacilitate the administrative aspects oftransfer pricing, including for example,safe harbours, risk assessment, operationalguidance, and the use of APAs, to namea few.Also note that in April 2011, the UK HMRevenue & Customs announced it hadagreed to take the lead on preparinga survey into the practicality of globaltransfer pricing guidelines (relating tothe OECD Forum on Tax Administration),which will also consider issues connected tothe OECD’s project.The OECD did not encourage the useof safe harbours in the past, out of fearthat such rules could negatively impactthe subsequent mutual agreementprocess, and increase the risk of doubletaxation. However, implementation ofcertain safe harbour rules for low valueservices could potentially help relievesome administration costs (both for taxadministrations and taxpayers), withoutnecessarily having a material impact on ajurisdiction’s taxable income. The OECD’sconcerns associated with the resultingmutual agreement process could also bealleviated by making it explicit that themutual agreement procedures take priorityof safe harbour rules.The OECD is also being encouraged totake a closer look at risk assessments, anddevelop guidance on risk assessments formember states. This is to avoid situationswhere both tax administration andtaxpayer engage in lengthy and costlyaudits for what should be considered to below risk or immaterial transactions. Greateropenness and transparency associatedwith the triggers of an audit, as well asthe scoping of the agenda, could also leadto improvements. It could, for example,be helpful to see the fact-finding processbeing elaborated in advance and includingan analysis on which documents will needto be requested. Subsequent treatment bytrained transfer pricing officials is thenalso a key success factor, as it would ensurethat tax administration resources becomefocused on the important issues.Operational guidance as an effective toolwill also hopefully be considered by theOECD. Transparency, effectively achievedby the publication of operational guidancecan drive cooperation. Annual APA reports,training materials and announcement oftransfer pricing enforcement plans, such asthose including an outline of the industriesthat are likely to receive increasedattention, are welcomed.Additional operational guidancewould be particularly welcome in thearea of comparables and data used forbenchmarking purposes, especially in theabsence of local comparables. Guidance –with respect to the use of multiple-year data– may also be helpful.Another tool that can help alleviate someadministrative aspects associated withtransfer pricing is the greater use ofAPAs. Although several OECD countriesdo have APA programmes, many areunder‐staffed, making the processextremely lengthy. Dedicating moreresources to APA programmes would allowtax administrations to deal with potentiallycomplex transactions in a more open andcooperative environment, in the long runfreeing up resources that can be dedicatedto less-cooperative taxpayers.Similarly, the OECD is also encouragedto think about a broadening of thecombination of APAs with rollbacks aswell as an effective use of mandatoryarbitration (Art 25(5) OECD Model TaxConvention, with an ever-growing group ofcountries including this possibility in theirbilateral treaties.Operationalguidance asan effectivetool will alsohopefully beconsidered bythe OECD78 Transfer Pricing Perspectives. October 2011

Finally, another concern raised relatesto delays and maintaining momentumthroughout audits. Some of the informationrequested is not readily available orcannot be obtained, or if obtained, needsto be translated from English into a locallanguage. These challenges could beovercome by scoping the audit intelligentlyso that both tax administrations andtaxpayers know ‘what’s on and what’s offthe table’.It is not clear at this stage how far the OECDis willing to go in providing guidance onadministrative aspects of transfer pricing.However it is no doubt a positive signthat the OECD, through the initiationof this project, appears to acknowledgethat there is room for improvement in theadministrative aspects of transfer pricing.Transfer pricing and intangiblesThe OECD announced in July 2010 that itsnext ambitious project would be a review ofthe guidance on the transfer pricing aspectsof intangibles, and in particular Chapters VIand VIII. Working Party 6 (WP6) is workinghard on this project, and has already beenvery active in seeking input from businessesat an early stage.The OECD’s work in transfer pricingaspects of intangibles can, to a largeextent, be broken down to the followingthree questions:• What is an intangible?• Who owns the intangible?• How should the value of the intangiblebe determined?Some particular challenges associated withthe first two questions are discussed below.Definition of intangiblesDefinitional issues relating to intangiblesare nothing new to the OECD. Recall(during revisions to Chapters I‐III) thestruggle encountered when trying to findthe right terminology to describe that“special” thing that should give rise to aprofit-split method (non‐benchmarkable,unique, non‐routine, etc). Chapter IX alsomakes reference to “something of value”which is not explained in great detail in therevised OECD Guidelines.In a scoping document released in January2011, the OECD indicated that relevantfactors to consider when determiningwhether or not an intangible is used ortransferred includes, amongst otherthings, the ability to produce futureeconomic benefits to a business activity, theavailability of legal protection and whethera specific intangible can carry value if itcannot be transferred in isolation.Transfer Pricing Perspectives. October 201179

Of particular interest is the last factor –whether a specific intangible can carryvalue if it cannot be transferred in isolation.This, to a large extent, introduces thechallenges associated with so-called “softintangibles”. Typical “soft intangible”examples include workforce in place,network intangibles, goodwill and businessopportunities (to name a few).What will be particularly interestingis whether WP6 will be able to avoidrevisiting some of the difficult challengesencountered during Chap I‐III and ChapIX. Suppose the OECD concludes that a“soft intangible” has been transferred anddoes constitute an intangible that shouldbe compensated for tax purposes. Does thisimply that sufficiently detailed comparabledata will need to be available to distinguishbetween returns when “soft intangibles”are present and when they are not? Andwould this imply that a profit split methodshould have been applied before the “softintangible” was actually transferred?Bearing in mind the challenges posed bytrying to find a consensual definition ofintangibles, in recent communications theOECD has made clear that although thedefinitional issues regarding intangiblesare still an important part of the project,the focus of the OECD is shifting towardsproviding guidance on whether a transferhas occurred and the corresponding pricingor valuation of those intangibles that havebeen transferred.Who owns the intangible?Another equally challenging issue isdetermining who should, in fact, own theintangible. Despite the fact that a legallyprotected intangible is, according to theOECD, also considered an intangible fortransfer pricing purposes, the January2011 scoping document specificallymentions that, in the context of transferpricing concepts, “economic ownership”,“beneficial ownership” and “functionalownership” are also relevant.There is currently no guidance in the OECDGuidelines on the role of legal ownershipor on determining ownership of intangiblesthat are not legally protected. Moreover, theOECD currently does not clearly advocateeither legal or economic ownership asthe basis for determining the appropriateowner of the asset.A strict reading of the current version ofChapter IX of the OECD Guidelines aswell as recent discussions by the OECDabout this matter seems to indicate thatlegal ownership is just the starting point.The owner, for transfer pricing purposes,could be considered to be the party thathas incurred the costs of developing theintangible and that will be able to sharein the potential benefits from thoseinvestments. A typical example where thisissue arises is in the context of marketingintangibles, where determining which levelof licensee’s marketing costs would renderan intangible fully or partially owned bythe licensee is far from certain.However, as mentioned above, the OECDseems more focused on issues surroundingthe valuation and whether intangibles havebeen transferred.One can hope that the OECD will be ableto establish some factors that can be usedwhen determining which entity or entitiesare the owners of the intangibles, eventhough this will be no easy task.One of the particularly interestingownership issues relates to unique andhigh-value services. The WP6 provide agood example of this issue in the January2011 scoping document when they raisethe question of whether it is appropriate tocompensate a service provider with a costplusfee, if the service provider is providingservices that are unique and carry highaddedvalue.This really hits the heart of the matter– specifically whether incurring thefinancial risk of developing the intangibleis sufficient to be the sole owner ofthe intangible, or whether in somecircumstances it is also necessary to have afunctional role in developing the asset.The above are simply examples associatedwith some of the challenges WP6 will needto deal with in the future, and there areby all means countless other examplesof difficult issues that WP6 will need toattempt to deal with over the course of thisambitious project. It will be interestingto see how far WP6 is willing to go, andwhether it will be ultimately forced torevisit some of the issues discussed inprevious projects.80 Transfer Pricing Perspectives. October 2011

Transfer Pricing developments in theUnited NationsThe United Nations recently began draftinga practical manual on transfer pricingfor developing countries, and releasedfive draft chapters during the autumn of2010. This project is starting to draw asignificant amount of interest, as it is thefirst time that non‐OECD member statesare engaged in developing some form ofguidance relating to transfer pricing (andnot merely observers).This subcommittee on transfer pricingwas established in 2009, and iscomprised of both OECD and non‐OECDmember states. As implied by the titleof the project, it is intended to providetransfer pricing guidance specifically fordeveloping countries.Although the current draft chapters seemto address a range of different aspects inconnection with transfer pricing, thereare what can be interpreted as somesubtle contradictions to some of the textin the OECD’s Transfer Pricing Guidelines,and this gives rise to some concern. Forexample, a number of remarks in theexisting draft chapters of the manualappear to imply a broader use of the profitsplit method than what can be interpretedin the existing OECD Guidelines.The OECD is, in all likelihood, monitoringthe United Nations developments closely,as any explicit or direct contradictionsbetween the existing OECD Guidelinesand the manual will give rise to someserious concerns for OECD member states.However, given that the manual is stillfar from complete, it is too early to tellwhat impact the United Nations’ transferpricing work will have on the OECD.ConclusionAs a result of the various OECD initiatives,and the current United Nations work, itwill be interesting to monitor the OECDdevelopments in the coming years, bothin terms of how much detailed guidancethe OECD can provide relating to theintangibles project, but also the OECD’sreaction to the manual prepared by theUnited Nations once complete. Thesedevelopments could have a materialimpact on the way we do transfer pricingin future years.It will be interesting to monitorthe OECD developments in thecoming yearsAuthorsJustin BreauPartner, PwC Denmark+45 3945 3383justin.breau@dk.pwc.comIsabel VerlindenPartner, PwC Belgium+32 2 710 4422isabel.verlinden@be.pwc.comRita Tavares de PinaDirector, PwC US+ 1 646 471 3066rita.tavares.de.pina@us.pwc.com

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