New Zealand’s transfer pricing rules are to be applied consistently with the OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations - July 2017, including the guidance on documentation contained in Chapter V.
Master file and local file content
Annexes I and II to Chapter V provide detailed guidance on the required content of the master file and local file. We recognise that there are considerable compliance cost benefits for taxpayers in aligning our practice with international standards. We accept documentation prepared in accordance with the guidelines and have not imposed additional requirements.
Obligation to maintain and provide documentation
Whilst there is no statutory obligation to maintain documentation, New Zealand’s tax system operates on a self-assessment basis, where the taxpayer is expected to keep sufficient records to support its tax position.
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. As the burden of proof for transfer pricing matters rests with the taxpayer, a lack of adequate documentation may make it difficult for the company to rebut an alternative arm's length transfer price proposed by us. In the event of a transfer pricing adjustment being imposed, a lack of adequate documentation is also likely to result in penalties.
Taxpayers are required to provide documentation on request. This may occur as part of a risk review or audit. Typically, taxpayers will be given a period of two months from the receipt of the request to provide documentation.
Local management responsibility
It remains the responsibility of local management to ensure a company's transfer prices are in accordance with the arm's length standard. In our experience, local management are best placed to review and confirm the factual accuracy of the local file. This step is essential where the file has been initially prepared by an overseas entity.
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.
Good documentation packages
The quality of documentation prepared by multinationals can vary considerably. In our opinion, good documentation packages should include:
- 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
- copies of all inter-company agreements as well as the local and global corporate structures.
Preparation of good transfer pricing documentation requires judgement as to the critical elements for inclusion relevant to the specific facts and circumstances of the case. Unfortunately, we have seen several cases where the documentation has not adequately reflected the facts and circumstances. Some of the common issues we have seen include:
Absence of basic building blocks
Understanding your business, including its legal structure and the terms of its contracts, is fundamental to any transfer pricing analysis. 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
- failure to identify all parties to cross-border transactions
- contracts either not being read or simply misunderstood
- poor analysis of the nature of agency (in particular, the actions and contractual obligations of agent and principal).
Reliance on familiar descriptions
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. Anything which crops up later and does not match the starting position should ring warning bells for the taxpayer and the practitioner.
Documentation often states which entity bears risk without a clear rationale supporting the statement. During a review or audit, compliance costs associated with such an approach are likely to be higher as more follow-up questions may be required.
When an entity claims to assume risk, it is necessary to explain how that is achieved. For example:
- Is there a sale or return policy?
- In which currency is the transaction undertaken?
- Is there demonstrable support for defective goods?
- Is there a service or a financial guarantee?
- Is there an in-substance defeasance?
- Which personnel are making decisions regarding the risk?
- What is the nature of those decisions?
- 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 control that risk?
A common issue we encounter is a failure to account for foreign exchange risk when it is assumed by controlled distributors in New Zealand - do these operations have adequate financial capacity to absorb currency risks or manage an effective hedging strategy? The more volatile the currency, the greater the compensation received should be in the long run.
We have also encountered the argument that where a New Zealand subsidiary's transfer pricing policy guarantees the subsidiary a specific return, that the New Zealand subsidiary is by default a no or minimal risk entity, irrespective of any other facts and circumstances. We do not accept this argument. At the heart of transfer pricing is the requirement to test whether or not intercompany prices are arm's length. The application of an approach, such as the argument above, that relies solely on the very intercompany price that is being tested, is circular. For this reason, the functional analysis and the risk profile of an enterprise should be determined by an appropriate analysis of the facts and circumstances in each case.
Further guidance on the analysis of risk is contained in the OECD guidelines, Chapter I, D.1.2.1.
Reconcile to financial statements
The tax manager needs to partner with the company’s finance function to ensure associated party transactions are identified and accurate disclosures are made (including notes to the annual financial statements). Financial ratios calculated in the transfer pricing documentation should also reconcile to the financial statements and the reconciliation should be included in the documentation.
Don't rely on earlier documentation
Transfer pricing is an ongoing process, not a one-time documentation exercise. Companies should 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. Issues to consider include:
- 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?
- 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 $100,000 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.
Opportunity to streamline
Many of the documentation packages prepared by consultants could be streamlined by providing 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.