An Educational Study - I GEOFF HOPKINS and ANTON HUME enlighten readers as to the practical mysteries of transfer pricing.

An Educational Study – I
GEOFF HOPKINS and ANTON HUME enlighten readers as to the practical mysteries of transfer pricing.

MUCH HAS BEEN written about both the complexity of the new transfer pricing legislation and the associated documentation requirements under self assessment, and the fire and brimstone that will rain down upon the heads of taxpayers who do not comply. Not so much has been written about how taxpayers can take practical steps to avoid prospective penalties for non-compliance.

Part I of this article sets out the steps a company or partnership transacting with overseas affiliates (and particularly the small or medium-sized enterprise which has done little, if anything, to document those transactions) might take to ensure that, even if the Inland Revenue is able to show that its transfer pricing is not at arm's length, appropriate documentation is in place to mitigate the penalty threat of non-compliance.

Part II will comprise a case study illustrating some of the practical issues with which we are typically faced when addressing the transfer pricing of transactions undertaken by clients. However, just as there is no such thing as a single arm's length price, so there is not only one way to collate transfer pricing documentation or draft a transfer pricing report, but we believe that our approach is a practical one which achieves the desired result.

We believe that a number of practical differences between how small and medium-sized enterprises, as opposed to larger companies, will be expected to meet the documentary requirements of self assessment will become increasingly apparent. Self assessment is still in its infancy and it will take a number of years to establish a consensus with the Revenue as to exactly where those differences lie. The differences we have experienced are examined below.

The legislation

The 1998 Finance Act radically changed the transfer pricing playing field in the United Kingdom. The scope of the provisions is contained within Schedule 28AA to the Taxes Act 1988. Briefly, paragraph 1 specifies that where two 'affected persons' enter into a transaction or series of transactions whose terms differ from what would have been the case if the transactions were made between independent parties and a tax advantage results, the actual terms of the transaction are replaced by arm's length terms and the taxable profits of each party are adjusted accordingly.

Paragraph 1 relates to transactions between 'affected persons'. That means any two persons where one is 'directly or indirectly participating in the management, control or capital of the other' or where two persons are similarly under the same 'management, control or capital' (whether directly or indirectly). The term 'transactions' is extremely widely defined as including 'arrangements, understandings and mutual practices' regardless of whether they are, or are intended to be, mutually enforceable. For the purposes of this article, we will use the term 'connected persons transactions' to describe transactions that fall within the scope of the provisions.

The documentation requirement is imposed by the self-assessment provisions governing tax returns and assessments in Schedule 18 to the Finance Act 1998. Under paragraph 21, a company submitting a self-assessment tax return is required to 'keep such records as may be needed to enable it to deliver a correct and complete return for the period'. The Revenue provided guidance as to how it will interpret the record keeping requirements of self assessment in Tax Bulletin 37. This specifies that taxpayers should identify:

(i) Details of all relevant commercial and financial relations between the parties.
(ii) The nature and terms (including prices) of all relevant transactions.
(iii) Details of pricing methods used including any supporting study of comparables and functional analyses undertaken.
(iv) An explanation of how that method complies with the arm's length standard or, where it does not, what computational adjustment has been made to ensure it does.
(v) The terms of relevant commercial arrangements with both third parties and group customers.

The Revenue has also published guidance in Tax Bulletin 38 as to how it will apply the penalty provisions for non-compliance with paragraph 21 of Schedule 18 to the Finance Act 1998.
Documentation requirements

It is not clear from the above that there is a requirement as such to prepare a functional analysis – all Tax Bulletin 37 specifies is that there is a requirement to maintain 'functional analyses undertaken'. What if no functional analysis has been performed? In fact, it is difficult to envisage that a taxpayer could feasibly support the arm's length nature of any particular transaction against third party benchmarks in most situations without performing some form of analysis of the functions performed and risks borne by each affiliate. Indeed, the Revenue has since let it be known that it would require a clear statement of functions and risks (as well as product flows and the transfer pricing policy adopted) where it carries out a transfer pricing audit, and that all transfer pricing policies must have a proper analysis to defend the arm's length position with appropriate documentation.

The Revenue has sought to be helpful by specifying in Tax Bulletin 37 that it '[does] not want taxpayers to suffer disproportionate costs, nor to be required to prepare and retain documentation which is out of keeping with the nature, size and complexity of their business, or with the transaction (or series of transactions) in question'.

Nonetheless, it is still difficult in the context of this statement to ascertain with any degree of certainty what level of documentation would be acceptable in any particular case. Inevitably it will be a matter of fact and degree, and the judge of this will be the Revenue itself (and ultimately the courts).

Small, medium or large?

A myth has however grown, which needs to be dispelled, that the Inland Revenue tacitly accepts in practice less documentation compliance the smaller the taxpayer. Some smaller taxpayers have taken this to mean that they do not need to look at their transfer pricing at all, otherwise what difference is there between them and larger taxpayers?

There may be a difference between the amount of work that has to be done by a large multinational and a smaller or medium sized firm to support the arm's length nature of its connected persons transactions. For instance, a large firm is likely to have to investigate every (at least class of) transaction while a smaller firm may get away with only looking at the larger transactions and extending the results and methodologies to smaller, albeit similar, transactions. A larger firm may be expected to use one transfer pricing method to establish a range of acceptable prices and then to use other methods to back these prices up, where only using one method may be acceptable for a smaller company.

Finally, it may be acceptable for a smaller company to use less precise benchmarking than that which would be required for a larger one. A smaller company may even be justified in using an 'off the shelf' benchmark that has been prepared for companies carrying out a similar function in a broadly similar industry. For larger companies, individual, tailored benchmarks are usually required for each class of transaction.

The fact of the matter is that self assessment is exactly that and all relevant taxpayers, no matter how small, have to be able to show that they have at least made an effort to establish the arm's length nature of their transfer prices (and have suitable documentary support for that) before submitting their self assessment returns. In any implication they may have made that they would expect less from smaller taxpayers, the Revenue certainly does not mean it expects nothing.

None of this means to say, however, that the Revenue will not challenge the basis of the transfer price – merely that it is unlikely to contend that penalties should apply for lack of appropriate documentation.

Documentary requirements

A company's transfer pricing documentation might be developed as a two-stage process. The first stage involves a review of the overall group, the companies that make it up and what they do. The second stage involves an examination of the transactions these companies enter into, the development of appropriate contracts and agreements relating to those transactions, and support for how the transactions should be priced. Each of these stages also incorporates a two-stage process of its own. Later we illustrate by means of a case study how we have approached this process and developed briefer documentation for smaller organisations which should still be sufficient to satisfy the requirements of the Revenue.

The group

First stage

First, in a comprehensive exercise, a group policy document would be drawn up. This would say that the group as a whole has committed itself to making its connected persons transactions at arm's length prices. The group structure would be shown on this policy and this policy would also be sent to every company in the group that would be affected.

The document would show that all relevant departments of the organisation, not just the finance department, have bought in to the policy. It is important to remember in this context that transfer pricing is more than just a tax issue. Because a transfer pricing policy often involves setting profit margins or mark-ups, it may affect the basis on which bonus or other performance calculations for employees are made. This is becoming an increasingly common issue.

Second stage

Once the senior management of the group as a whole has committed itself to the policy, even if a very brief one has been drawn up, each company that engages in connected persons transactions needs to do likewise. Each company in the group should first explicitly endorse the group policy. Then the companies should add a description of their business to the policy. This must be written up - whether or not the first stage takes place and should include a description of the functions the relevant companies perform, the risks they assume and the intangibles they own.

Specifically, particular attention should be paid to the functions, risks and assets associated with the connected persons transactions as these may differ from unconnected transactions. This will give group and company personnel, their advisers and the Revenue a clear picture of the nature of the business each individual company carries on as well as a lens through which to view the transfer pricing implications of the transactions they enter into.

Finally, each company should be able to provide a list of the connected persons transactions it enters into. Having the necessary background documentation should enable these companies to identify their connected persons transactions before they take place and thus easily be able to prepare such a list. In addition, a list of any unconnected transactions that are similar to the connected transactions should also be set out in order to show points of similarity and difference. If a company can show that it has the same or very similar transactions with unconnected as well as with connected persons, it is in a very strong position to be able to claim that the prices it charges are arms' length. However, it is not often that companies have sufficiently similar transactions with connected and unconnected persons.

Transactions

Preparing the documentation may appear to be onerous, but most of it (group structures, company descriptions) should be readily to hand. In addition, once they have been prepared, they should only need fairly minor periodic updating. What does change is the documentation that relates to the transactions, rather than the companies, and these should also be prepared in a two-stage process.

First stage

The companies have already prepared documents showing their overall functions and the risks they bear. In almost all cases some form of contract or agreement should be drawn up between the companies reflecting their transactions. Too many companies do not do this on the grounds that contracts are not felt to be necessary between friendly parties.

A separate contract or agreement should be drawn up for each type of transfer of goods or rendering of service. Thus, two connected companies may have drawn up a royalty agreement for the patents that are being used, a loan agreement for intra-group loans, a distribution agreement for the distribution of goods and a service agreement for head office management services. These contracts will both set out what services will be supplied or goods sold as well as the terms and conditions of the transactions and how the price will be calculated.

An exception is where a group transfer pricing policy has been drawn up that identifies the broad types of connected persons transactions within the group and specifies a general formal agreement and transfer pricing policy for each one. Clearly, this approach is more tenable where the transactions are simple and homogenous.

Second stage

The drafting of contracts will set out the terms under which the connected persons transactions will take place, but not why they are arm's length. The second stage involves collecting supporting evidence to show why the prices charged should be considered to be arm's length. This usually involves comparing the connected transactions to unconnected transactions in a benchmarking exercise and showing that the prices charged are substantially the same.

Occasionally, where benchmarking is not possible or not appropriate, a 'profit split' may be used. This involves looking at the total profit achieved by all the transactions relating to the ultimate sale of a particular product or service and assigning an appropriate profit to each party based on its contribution to the profit. However the prices or profits are supported, this is the most difficult and risky section of the overall transfer pricing process.

Transfer pricing methods

The first part of this stage requires making a determination of which transfer pricing method to use. The Organisation for Economic Co-operation and Development Guidelines set out various methods of calculating comparable transfer prices.

The three preferred (or traditional) methods are the comparable uncontrolled price method, the cost-plus method and the resale minus method. Other methods are also mentioned by the Guidelines.

Comparable companies

As mentioned above, the best way of showing that prices charged are arm's length is to show that the same or very similar transactions are carried out with unconnected as well as connected persons and that the same prices are charged - providing for the adoption of the comparable uncontrolled price method.

However, it is unusual for companies to have this kind of information and so most transfer pricing exercises involve searching databases for similarly-sized companies that are in similar businesses and undertake similar transactions, but only with unconnected persons. The object of the comparables search is to try to determine what an arm's length transaction would look like and compare it with the prices of the connected transactions – normally in practice by way of a comparison of the margins achieved by unrelated parties.

Arm's length range

A search for comparable companies or transactions will normally produce a range of results. For instance, a review of comparable contract manufacturing companies may give a range of mark-ups that they achieve. Searches of this nature will often produce outliers that it may be inadvisable to use for the purposes of constructing an arm's length range in that they deviate from the general cluster of data to such an extent that this would raise questions as to their true comparability.

The Organisation for Economic Co-operation and Development Guidelines for Multinational Companies and Tax Administrations refer to a range without specifying how this range should be constructed although under United States transfer pricing regulations it is specified that an inter-quartile range should be used. The inter-quartile range is the range that includes the middle 50 per cent of the total list of observations. To be prudent, we often suggest that our clients use an inter-quartile range. Once the outliers have been eliminated, one can say that an arm's length range of prices can be generated and, if the connected transaction's price falls within this range, it can legitimately be said to be arm's length.

Invoice

Once all the hard work has been done, the drawing up of the invoices that relate to the individual connected transactions is relatively simple. The description on the invoice is taken from the contract or agreement and the price is calculated with reference to the arm's length range.
Conclusion

The process of preparing adequate supporting documentation for the transfer pricing policy of a group of companies may seem to be an onerous one, but it should be borne in mind that much of the documentation will (it is to be hoped) be prepared as a matter of course. Preparing and distributing policy documents should not be new to the main board of a multinational group (even a small one) and group structures, descriptions of the companies' businesses and the drawing up of contracts and agreements are also not out of the ordinary.

The difficult part of the process is the selection of an appropriate transfer pricing method and the identification of suitable comparables. Both are usually best left to transfer pricing professionals who have both the experience to select the method and access to the necessary data. The data is usually generated from databases (including Fame, Amadeus and Compustat, among others) which comprise vast amounts of financial and other information on tens of thousands of companies and are a powerful tool in providing comparables.

As to what level of documentation a smaller enterprise might require if it is to meet the Revenue's expectations vis à vis documentation, this is very subjective. However, we have identified an approach to documentation which smaller multinationals with simpler transactions can adopt with a good degree of comfort that they will achieve penalty protection. This is shown by Figure 1.

Figure 1: An alternative documentation approach for the smaller company
Large, complex company approach

Smaller, simpler company approach

The Group

The Group

Policy statement

Policy statement

Comprehensive description of the group

Summary description of the group (more limited description of functions and risks)

Transactions

Transactions

Comprehensive matrix of inter-company agreements

Set of standard agreements for each broad type of transaction

Benchmarking analysis and conclusions

More generic benchmarking analysis and conclusions


The second part of this article will appear in Taxation in the near future.
 

Issue: 3787 / Categories: