Managing the Transfer Pricing Function in an MNE 1. MNEs face challenges in managing their transfer

pricing-function. While transfer pricing may be used in some MNEs for man-agement control, MNEs nevertheless are required to comply with the transfer pricing rules for tax purposes in the countries in which they operate. Th e determination of the transfer price aff ects the allocation of taxable income among the associated enterprises of an MNE group.

2.4.2. Entities in an MNE group conduct global business that gives rise to opportunities to optimise the value chain of goods or ser-vices and therefore look for synergies. A challenge facing an MNE con-ducting a global business with associated enterprises is whether the transfer pricing method used for internal transactions is acceptable to the tax authorities in the countries in which the MNE operates. Th e transfer pricing challenge becomes even greater when the MNE has multiple global businesses with diff erent business models and multiple cost centres. Th e size of the MNE adds to the complexity.

2.4.3. Financial reporting for MNEs are informed by two deci-sion trees. On the one hand, corporate and tax law require an associ-ated enterprise to determine its taxable income derived from a specifi c jurisdiction. On the other hand, an MNE will usually need to deter-mine for management purposes the income and costs of its businesses lines, which, as the previous discussion shows, can operate across sev-eral jurisdictions. In other words, while tax authorities focus on an associated enterprise’s taxable income, an MNE’s managers focus on income from their business lines. MNEs, particularly those where the parent is listed on a stock exchange, are more likely to aim to meet their tax obligations in the countries in which they operate provided that

29Contractual arrangements are not simply taken at face value by tax authorities. For example, each of these diff erent possible contexts of MNE Group A’s value chain would be subject to evaluation to ensure that the eco-nomic substance of the arrangements is consistent with the legal form of the arrangements, and the terms of the arrangements are at arm’s length.

they are not subject to double taxation. Consequently, MNEs should develop and publicise within the enterprise a global transfer pricing policy to help minimise the risk of transfer pricing adjustments which may result in double taxation.

2.4.4. Th e following is an illustrative example of the two diff erent decision trees within an MNE:

2.4.5. Th e allocation of profi ts and costs to the various legal struc-tures is based on the functions performed, risks assumed and assets employed. Since MNEs consist of numerous associated enterprises it is very diffi cult to allocate the profi ts and costs to all the separate legal entities due to the absence of market forces. It is a complex exercise to come up with a consistent global policy for allocating results to the legal structures.

2.4.6. Th e arm’s length principle allows national tax authorities to make an adjustment to the profi ts of one enterprise where the terms of transactions between associated enterprises diff er from terms that would be agreed between unrelated enterprises in similar circum-stances. A tax authority should only disregard a controlled transaction in exceptional circumstances. If the terms of a transaction between associated enterprises diff er from those between unrelated parties and Figure 2: MNE Decision Trees

comparisons are diffi cult to make, an MNE bears the risk of transfer pricing adjustments. If the income of an associated enterprise within Country A is increased as a result of a transfer pricing adjustment, it would be reasonable to expect that there would be a corresponding transfer pricing adjustment resulting in a proportionate reduction in the income of the other associated enterprise in Country B, provided a consistent transfer pricing method is used by both countries.

2.4.7. But Country B may use diff erent transfer pricing methods.

Consequently, if transfer prices are adjusted by a tax authority in one country, double taxation will occur if the tax authority in the other country does not use the same transfer pricing method and allows a corresponding transfer pricing adjustment. It is the task of the transfer pricing function within an MNE to limit the risk of transfer pricing adjustments and the risk of double taxation.

2.4.8. Illustration of double taxation below.

Global Business 3 Global Business 1

Global Business 2

t Country challenges amount of profit reported by legal entity t Consequence: total global profit increases

t End result: Some profit taxed twice (double taxation—(DT))

Figure 3: Th e Global Eff ects Transfer Pricing Adjustments (Before Adjustment)

2.4.9. In principle, designing, implementing and documenting an appropriate transfer pricing policy should not be viewed solely as a compliance issue for MNEs. Th e main goal should be to develop a consistent global policy which cannot be altered to exploit tax laws. A well-developed and consistently applied transfer pricing policy should reduce an MNE’s risk of transfer pricing adjustments and the poten-tial for double taxation, thereby increasing profi tability by minimising transfer pricing costs. Moreover, a global transfer pricing policy may be used as evidence in negotiations with tax authorities when transfer pricing disputes occur.

2.4.10. An MNE’s transfer pricing policy should ideally reduce the risk of transfer pricing adjustments and the risks of double taxation of cross-border transactions. A comprehensive transfer pricing policy should cover four key areas as shown in Figure 4:

 Advisory;

 Reporting;

 Documentation; and

 Audit support/Dispute resolution.

2.4.11. Advising requires a thorough knowledge of an MNE’s busi-ness operations. It is a misconception that the tax department makes the key business decisions within an MNE. In practice, the business units of an MNE will identify business opportunities and a decision may be taken to exploit the opportunity if it fi ts into the MNE’s global business strategy. Advice can be provided to minimise the risk of trans-fer pricing adjustments and therefore optimize the business opportu-nity if the tax department is involved in an MNE’s decision-making.

2.4.12. In today’s environment there is an increasing level of detail required to meet each country’s transfer pricing documentation requirements. Most MNEs therefore prepare global and regional docu-mentation (masterfi les) of the various global businesses. Subsequently, global and regional reports are prepared for local purposes based on the identifi ed risks for each country in which the MNE operates.

2.4.13. Tax authorities around the world are increasingly focussed on transfer pricing and on expanding their transfer pricing capa-bilities. MNEs have to fi nd a way to deal with the increasingly

Figure 4: Aspects of MNEs Transfer Pricing Policy t Cohesive documents, both Global/regional and local t Customised policy t Optimised defence t Knowledge of tax authorities t Managing tax audits t Technical expertise t Litigation t MAP t APA t Business restructuring t Cross-border movement of goods, services t Structuring activities

t Global risk assessment Reporting DocumentationAudit support/ Dispute resolution

Advising

detailed, complex and oft en confl icting domestic transfer pricing legislation in the countries where they operate. Some countries follow guidance from international bodies, others only implement part of the guidance while some develop transfer pricing rules independently.

2.4.14. Tax authorities should not start from the assumption that MNEs are manipulating their results in order to obtain tax ben-efi ts. Many MNEs and certainly those with shares quoted on a stock exchange (listed MNEs) have published codes of conduct or a set of business principles or both. Th ese codes or principles require that an MNE must comply with the tax rules of the countries in which they operate. Violations of these codes may result in severe consequences for a listed MNE.

2.4.15. As transfer pricing is oft en referred to as “an art, not a sci-ence”, the resulting uncertainty creates the potential for transfer pric-ing disputes with tax authorities, even if the MNE is seekpric-ing to comply with domestic transfer price rules. Despite the eff orts MNEs invest in setting the appropriate transfer prices and preparing comprehensive documentation, there is always the risk that tax authorities disagree with the approach taken and there is thus the risk of a transfer pricing adjustment. Th is creates uncertainty for MNEs including the potential associated costs of preparing additional documentation, managing tax audits and conducting litigation. Notwithstanding this, there are cases where transfer prices are manipulated to shift profi ts from one jurisdiction to another to gain tax benefi ts including low-taxation or no-taxation.

2.4.16. Transfer pricing rules are considered very useful by MNEs if they are able to achieve a globally consistent approach and elimi-nate the risk of transfer pricing disputes. If in one country an MNE’s transfer prices are adjusted, resulting in a higher taxable income, the associated enterprise in the other country should in principle³⁰ receive a “corresponding adjustment”, reducing its taxable income. If there is no corresponding adjustment, the MNE will suff er double taxation. In this situation, the dispute is between two tax authorities with the MNE seeking to have consistent transfer prices accepted by both countries.

30UN and OECD Model Double Tax Conventions, Article 9 (Associated Enterprises).

2.4.17. Countries should try to avoid such double taxation, though in some cases there may be legitimate reasons why a corresponding adjustment is not given, or is less than the original adjustment. In such a case, it is important that the two countries enter into discussions to resolve the double taxation issue under the mutual agreement proce-dure mechanism in a tax treaty.

2.4.18. Th e following diagram illustrates a transfer pricing adjust-ment to relieve double taxation:

Figure 5: Global Eff ects Transfer Pricing Adjustments (Aft er Adjustment)

t Adjustment (A) is basically a profit allocation issue between countries

t Increase of profit in Country A must result in corresponding adjustment in Country B

Global Business 3 Global Business 1

Global Business 2

Chapter 3

THE GENERAL LEGAL ENVIRONMENT