Transfer Pricing Survival Guide (eBook)

4. Mitigation for the 1st TP Risk Zone: Do Not Be There

Critics of the arm’s length principle tend to lament that MNEs systematically abuse transfer pricing by setting transfer prices that favor subsidiaries located in low-tax countries. From the above, it should be clear that such criticism is misguided, especially when we talk about the 1st TP Risk Zone. Setting transfer prices within a range of appropriate net profit ranges for routine entities hardly offers an enticing “lever” to shift profits. While there may be opportunities to profit shifting in the case of subsidiary 1 in our example if it would only be subject to a 20% tax rate, the incentive to purposefully engage in profit shifting is low9. Also, tax auditors will check and easily detect when there is a misalignment between the profit allocation to routine entities and the BASIC TP RATIONALE. To them, such adjustments are low-hanging fruits in the sense that they do not require a detailed assessment and are comparatively easy to enforce and uphold during audit negotiations. In other words, it is not worth your while to be creative around the 1st TP Risk Zone. Consequently, the best mitigation strategy for these cases can be summarized as: “Do Not Be There”, which coincidentally, is the advice on how to best avoid being hit in the face that is dispensed by the Karate Sensei (Mr. Miyagi) from the Karate Kid Movie. Applied to the transfer pricing context, you should strive to avoid fights that are easy to avoid and rather dedicate your resources to the more pressing (high-risk) issues discussed in the subsequent Chapters.

Remember, in the current Chapter we work on the assumption that the routine classification of the relevant entities can be determined with a high degree of certainty (in our case this is assumed to apply to subsidiary 1 and subsidiary 2, but clearly NOT to HQ which is classified as an entrepreneur). The in-between cases for which you are not sure about the routine classification, will be addressed later. On a related note, we did not address the “economic substance” issue thus far – all the fun stuff must wait.

How do you operationalize the “Do Not Be There” strategy? The answer really should be evident, as it was provided at the end of Section 3: Namely, regularly review the net profit margins of your routine entities and adjust the transfer prices in case the margin falls outside of the arm’s length range (in the above figure the arm’s length range was assumed to be 1% to 8%). In more sophisticated terms, you should apply a “target-margin system”. Again, this approach is viable irrespective of whether your pricing is based on a cost-plus method, a resale price method, the TNMM a master price lists, commission fees or lump-sum payments.

A target-margin system starts with the target. In this context, we continue to solely talk about net margins. In Section 2 and Section 3 reference was made to the EBIT margin as well as the EBT margin. The EBIT margin can be conceived as the main focal point for transfer pricing purposes. Specifically, the EBIT margin is often utilized as the basis (so-called “Profit Level Indicator”, “PLI”10) when determining the typical level of profitability realized by independent companies engaging in business activities that are comparable to that performed by the related entities classified as “routine”. In this context the related routine entities are called “tested parties” because their EBIT margins (or another PLI) are “tested” against the profitability realized by comparable independent companies – the entire process is called “comparability analysis”. While the comparability analysis will focus on the EBIT, you should ascertain that the interest payments do not cannibalize the profits of the tested party. Adhering to the BASIC TP RATIONALE, it would not be commensurate with arm’s length consideration if a contract manufacturer borrowed substantial funds (take out a loan) the interest payments on which cannibalize all profits it realizes from providing contract manufacturing services (often to the entity lending the funds). In such a case, it would be questioned whether the contract manufacturer is sufficiently endowed with equity11 [for details see Chapter 9 below].

Where do we find net margins realized by comparable (routine) entities? One answer would be: In commercial database, which can be utilized to conduct a comprehensive benchmark analysis. Such benchmark analyses have been the “working horse” (backbone) of transfer pricing for decades. Some practitioners tend to smirk when talking about benchmarking, while tax auditors frequently frown. The perception of “will the outcome be whatever you want it to be” is widespread. But it is wrong12. While benchmarks have been “commoditized” in recent years they remain highly relevant in day-to-day practice and provide a reliable indication for an arm’s length range. You need to be aware that some tax authorities expect you to prepare a benchmark analysis by default, and that others conduct their own benchmark studies to challenge your result. From a risk and management perspective, you must recognize, however, that when commissioning a benchmark study (as with everything) you get what you pay for. Consequently, you should think carefully about whether it is sensible to commission a benchmark. In case your tested party does have a “moderate” level of revenues (take the 20 Mio. € from our example), a difference of 1% in the EBIT margin implies 200.000 € while a difference of 5% corresponds to 1.000.000 €. In benchmarking, the level of “accuracy” you can attain is limited. You (and the tax authorities) will always calculate an arm’s length range (not a single value) to establish the appropriate target range13. While you would thus not necessarily fight for each percentage point, risk of 1.000.000 € is nothing to sneeze at – at least within the 1st TP Risk Zone - and should be avoided. In other words, you want to be at least reasonably accurate to stay out of the Risk Zone.

The most straightforward approach is to focus on the median of an arm’s length range when defining your target range. When determining a target range for routine services you can start by looking at publicly available data from (generic) benchmarks. One example is a comprehensive study published by the EU that contains arm’s length ranges for about 30 individual routine services categories (corresponding NACE codes)14. For services relating to “Computer/IT Services” (NACE: 62) the study provides an arm’s length (interquartile) range of 2.5% to 12.8%, with a median of 6.1%. If your related party is an internal service provider of IT services a good starting point would be to aim your pricing (typically either cost plus or an hourly fee) to result in an EBIT margin for the service provider that is close to the median – here 6%. Considering that you are looking at generic data for a large (unscreened) sample of potentially comparable companies, you need to anticipate that a customized (manual) benchmark would result in a smaller (more condensed) range. Thus, venturing too close to the edges of the range, risks that the margin of your service provider falls outside of the customized benchmark (e.g., one conducted by the tax authorities) and put you into the 1st TP Risk Zone. Sticking close to the median, however, provides you with a sort of “buffer”, as it is more likely that the margin could be validated / defended by a manual benchmark. In such a scenario a reasonable approach would be to define your target range by applying the margin + / - 2%, which would yield a range of 4.1% to 8.1% for your IT Service provider. Applying such a range ensures that you will – with a reasonable degree of certainty – be kept out of the TP Risk Zone.

Especially for support services, you can also look at “safe harbor” provisions. For so-called low-valueadding services you can apply a mark-up on full costs of 5% (but the qualification criteria for applying safe harbors tend to be quite restrictive15). In case your service qualifies, it makes a lot of sense to apply the 5% - again, there is virtually no incentive to get creative on these issues.

Some tax administrations, Australia (ATO) being a positive example, are quite transparent regarding their internal risk assessment criteria. For inbound distributors ATO publishes net margins it considers “high”, “medium” or “low” risk (applying a red-yellow-green coloring scheme)16. In case you apply a margin for your Australian routine distributor in the “low” (green) category, you will (likely) not be audited, which obviously mitigates risks and safes compliance costs (you do not have to bother with benchmarks). To qualify for the “low” risk category, however, ATO wants to see healthy margins of >5.3% for general distributors. For specific industries, such as life science, the ATO differentiates between categories of distributors. For example, whereas for simple distributors the “low” risk starts at 5.5%, distributors that perform more complex/additional technical functions (while still being considered routine) are expected to earn >8.9% before ATO qualifies these as “low risk”. Naturally, such comparatively high thresholds might potentially be scrutinized by the “other” tax authorities. The great benefit of...