Documentation

Best practice process

Transfer pricing documentation is central to the process of justifying and explaining pricing of cross-border transactions. A company's main purpose in preparing and maintaining documentation should be to place itself in the position where it can readily demonstrate to Inland Revenue that its transfer prices are consistent with the arm's length principle.

There is no explicit statutory requirement in New Zealand to prepare and maintain transfer pricing documentation. However, if a company's documentation inadequately explains why its transfer prices are considered to be consistent with the arm's length principle, we are more likely to audit those transfer prices in detail. The lack of adequate documentation may also make it difficult for the company to rebut an alternative arm's length transfer price proposed by us and is likely to result in significant levels of penalties in the event of an adjustment to taxable income.

Practical transfer pricing compliance generally involves following a process to determine arm's length transfer prices. The four-step process developed by the Australian Tax Office is one such process that may be followed.We have has endorsed the four-step process as a useful tool for taxpayers to develop their reasoning and documentation needed to support their evaluation of transfer prices. In short the process is as follows:

1. Understand the cross-border dealings between the associated enterprises in the context of the taxpayer's business
2. Select the methodology or methodologies
3. Apply the methodology or methodologies, and
4. Determine the arm's length outcome and implement support processes. Install a review process to ensure adjustment for material changes.

Fundamentals first

Understanding your business, including its legal structure and the terms of its contracts, is fundamental to any transfer pricing analysis. Unfortunately we have seen several cases where these building blocks have been absent. Examples include:

• confusion as to whether the entity in focus was a subsidiary or a branch
• contracts either not being read or simply misunderstood, and
• poor analysis of the nature of agency (in particular, the actions and contractual obligations of agent and principal).

Any issue with a cross-border component, must start with a basic analysis of who does what and in what legal capacity. Before getting started into the routine functional analysis, it is critical to:

• identify the parties to cross-border transactions
• determine the parties’ legal status (subsidiary or branch) and
• whether the relationship is as agent or principal.

In support of this initial position it is important to identify the senior executives and to establish their responsibilities and authority for carrying out their duties, not just in the local operation but also in the overseas associate. By way of reinforcement, the salary levels would be expected to reflect the level of responsibility.

It is also necessary to be absolutely clear about the contractual relationships. When an entity enters into a contract it may be as principal or as agent. If it is the latter how has that authority been granted and what restrictions apply?

Along similar lines, when an entity claims to carry the risk on a transaction, how is that achieved and is the party on the other side of the transaction aware of the transfer? In particular:

• Is there an ownership chain that gives rise to the transfer?
• Is there a sale or return policy?
• Is there demonstrable support for defective goods?
• Is there a service or a financial guarantee?
• Is there an in-substance defeasance?
• Is there some other non-contractual way in which risk may be transferred?
• Does the entity assuming the risk have the financial capacity to carry that risk and the personnel to manage that risk?

It is also useful to be able to identify what the entities involved in any cross-border transactions actually do by way of a business, and to have a complete picture of the overall business activities.

It might be claimed that this information is contained in the functional analysis, but we have seen these issues overlooked or simply not considered. This information is the foundation for everything that follows, and anything which crops up later and does not match the starting position will ring warning bells for the taxpayer and the practitioner. A rush to an analysis of potential comparables in reliance only on a familiar business description (such as “wholesale distributor”) without attending to the fundamentals, is inviting disaster.

Good documentation packages

The quality of documentation prepared by MNEs can vary considerably. In our opinion, good documentation packages should include the following:

• a detailed discussion of the facts (analysis of functions, risks and assets - especially intangibles)
• industry analysis (to put the taxpayer's facts in the context of its industry), especially identifying the key profit drivers, performance of major competitors, and where the value added arises for the company
• careful consideration of associated party transactions (each category should be examined separately)
• a discussion as to the efforts made to find internal comparables (are there no sales or purchases whatsoever involving unrelated parties?)
• reasoning as to the selection of the best pricing method available
• full details as to the comparables search undertaken (database utilised, criteria employed, accept/reject list including reasons for rejection)
• an analysis of why the companies selected are indeed comparables
• an unadjusted income statement for each comparable with adjustments explained in detail
• a cross-check using at least a second profit level indicator (for example, if an EBIT : sales yardstick has been applied, then a Berry ratio cross-check should be carried out for a distributor or a return on assets calculated for a manufacturer) - if one methodology produces a result that is significantly different to another it is not sufficient to simply assert that one method is preferable without exploring why those results are different
• conclusions, including sanity checks to demonstrate commercial realism, and
• copies of all inter-company agreements as well as the local and global corporate structures.

Many of the documentation packages prepared by consultants could be streamlined – much less on our law, guidelines and overseas rulings and far more analysis of profit drivers and economic value added. For more routine business models, extensive analysis of method selection (where only one method could ever be used in the circumstances) and lengthy comparable search exclusion matrices (where four companies are selected and 404 rejected) generally do not enhance the output and can distract from the key issues.

Risks

Risks are especially easy to list, describe and acclaim - but do they exist and what are they really worth? On the other hand, we consider more weighting should be given to foreign exchange risk when it is assumed by controlled distributors - do these operations have adequate financial capacity to absorb currency risks or manage an effective hedging strategy? The more volatile the currency, the greater should be the compensation received in the long run.

Don't rely on earlier documentation

Companies should also not rely solely on transfer pricing documentation compiled some years ago. Regular re-evaluation of both the facts and transfer prices to determine that they are, and remain, arm's length is advisable. Has any restructuring taken place? Is the company now performing different functions or assuming new risks? Has there been a change in the group's business strategy impacting on transfer prices? Have any long term supply contracts been concluded or amended recently? Is the bottom-line profit result still commercially realistic? Has there been a major change in the line of business that impacts significantly on prices or profitability? Indeed, are the comparables used three years ago still truly comparables?

Parent company documentation

One other issue that crops up from time to time is the use of transfer pricing documentation that has been prepared by a parent company on a worldwide basis. Frequently no account is taken of the reality of the market place in which a subsidiary may be operating. For example, there may be a tendency to charge royalties at a uniform global rate. Thus a New Zealand company which may have low market share is charged the same royalty rate as a US associate which is a market leader. No consideration is given to the size of the market or the development of the brand with the result that the royalty may not represent an arm's-length price.

There is no suggestion that this level of detail is required for every business that has cross-border associated party transactions. Clearly the compliance costs for such an exercise would be excessive and inappropriate for a business with $100k of cross-border transactions. For a small business it may be quite satisfactory to simply complete a transfer pricing questionnaire, evaluate the results and make notes to explain why the pricing is considered appropriate. This represents a small amount of time to identify any potential risk and provide an adequate explanation. It is infinitely better than having no documentation.

Remember, it is the responsibility of local management to ensure a company's transfer prices are in accordance with the arm's length standard. If we make transfer pricing adjustments, the quality of supporting documentation will be a key factor in determining the extent to which penalties might apply. A failure to prepare adequate transfer pricing documentation or acceptance of pricing that is clearly inappropriate could result in a 40% shortfall penalty for gross carelessness if apparent problems involving material associated party transactions are simply brushed over lightly or even ignored.

 

Date published: 02 Dec 2010

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