Transfer pricing controversy: how to respond
The third installment in our analysis of the 2016–17 Transfer Pricing Survey examines what respondents said about controversy avoidance and dispute resolution.
Sweeping new initiatives targeting base erosion and profit shifting (BEPS), coupled with the number of taxing jurisdictions facing budget shortfalls, increase the likelihood of transfer pricing controversy worldwide. Our survey respondents expect the heightened controversy to center on the thorny areas of intangible property (IP) and permanent establishment (PE), where disputes are longer and costlier.
Respondents are reacting to a perfect storm of:
- Better-resourced tax authorities
- The additional information that will flow to authorities from the BEPS Action 13 documents on the master file and local file and country-by-country reporting
- A rise in countries with transfer pricing rules and information-sharing protocols
In Part 3, Controversy avoidance and resolution, we examine the trends and offer guidance on negotiating a changed landscape.
Encountering more complex controversy
As countries move to implement anti-BEPS recommendations by the Organization for Economic Co-operation and Development (OECD), 79% of survey respondents believe dispute resolution is becoming more difficult.
EY Global Transfer Pricing Leader Peter Griffin says companies will experience not only more challenging controversies but also a significant shortening of the transfer pricing life cycle — the period between transfer pricing design and the emergence or resolution of controversy. “Thanks to BEPS and other trends leading to greater transparency, tax authorities now have more access to more information than ever before,” says Griffin.
The sources of the largest increases in expected tax controversy take three key forms:
- Transfer pricing of intangible property
- Transfer pricing of intragroup financial arrangements
- The tax impacts surrounding expanding definitions of the rules for determining permanent establishment
EY Global and Americas Transfer Pricing Controversy Leader David Canale says: “What’s particularly troubling is that in each of these cases, the issues are rife with technical complexity and subjectivity. Controversy in any of these areas is likely to be more difficult to avoid or resolve.”
Examining the trouble spots
(1) Intangible property
A key focus of BEPS Action 8 is to require greater substance behind cross-border charges for royalties and other intangibles. In the 2013 survey, only 32% of executives pointed to such charges as a key source of controversy. In the latest survey, the figure surges to 49%.
This is unsurprising, says EY EMEIA Transfer Pricing Leader Oliver Wehnert. “Regardless of prior justifications for cross-border IP charges, BEPS now requires a focus on the location of DEMPE functions: develop, enhance, maintain, protect and exploit.”
Going forward, “IP will likely be a key focus of examinations, which will be taking place using what for many will be a new methodology.”
(2) Permanent establishment
BEPS Action 7 substantially lowers the threshold for creating a PE. Three years prior, only 27% of respondents cited PE as a significant driver of controversy. But over the next two years, the figure climbs to 44%.
“Challenges as to whether or not in-country operations constitute a taxable presence — or PE — usually arise along the multinational’s ‘plan/design/manufacture/store/market/sell/service’ value chain,” says Zurich-based Ai-Leen Tan, EY Global PE Project Leader.
In the past, a company could operate in two or more of these areas (e.g., warehousing and sales) and still avoid creating a PE. But BEPS, says Tan, “introduces rules which will allow tax authorities to view the various operations in the same or different locations on a combined basis, such that these will now create a PE.”
(3) Intragroup financing
The means by which companies share intragroup interest charges — another focus of BEPS — are also expected to become a more frequent source of controversy. Specifically, the percentage of respondents expecting such controversy rises to 48% for the next two to three years, from 39% in the 2013 survey.
Largely as a product of this heightened visibility, tax authorities are under pressure to implement greater and unprecedented demands for transparency about multinationals’ operations, tax profiles and effective tax rates, and show tangible outcomes from this.
As of October 2016, 44 countries have implemented all or some of the BEPS recommendations, creating the potential for some conflicting interpretations. In all, more than 80 countries globally are committed to implementation. This compels more disclosure about a business’s transfer pricing activities in the aggregate, and how this aligns to the operating model.
But it also necessitates a shift from a reactive stance to a proactive review of policies, procedures and operations so that any inevitable disclosures contain nothing untoward. Companies today must increasingly demonstrate that they are following not only the letter but also the spirit of the tax and transfer pricing rules — as should any responsible corporate citizen.
Responding to the challenges
The best way to address disputes “is to avoid them in the first place,” says Canale. We recommend that taxpayers assess their structure and risk profile, as well as take other proactive measures.
Get your documentation in order. Having your case ready to go, says Canale, “can improve your stance with authorities, leading to a quicker and, more likely, positive resolution.”
Consider adding a “head” of controversy. As controversies increase, companies may find benefit in creating a centralized team for handling disputes. “This can be an effective means of developing expertise, optimizing resources and using that knowledge consistently across jurisdictions,” says Canale.
Pursue advance pricing arrangements (APAs). Where risks are significant or material, “companies should absolutely seek to mitigate their downside with unilateral, bilateral or even multilateral APAs,” says Canale.
Move now! As Canale explains, “tax authorities … are already hard at work prioritizing what from their perspectives will be the most effective audits.” Prepare now, because “this is no longer a question of will you be audited, but when.”