An Educational Study -- II - Geoff Hopkins and Anton Hume offer a case study on transfer pricing.

An Educational Study – II

Geoff Hopkins and Anton Hume offer a case study on transfer pricing.

Our practical approach to compliance with the transfer pricing régime was the subject of Part I of this article published in last week's issue of Taxation at pages 295 to 298. This concluding Part comprises a case study which we hope readers will find helpful in advising clients on this area.

Case study
A United States technology company recently acquired a United Kingdom company which it was to use as a launchpad for its products into the wider European market. Technology development activities take place in both the United Kingdom and United States, but primarily in the United States. Work done in the United Kingdom constitutes assistance for the United States developers and all products developed are patented in the United States, the United Kingdom does not take any ownership of any intangibles. The technology was to be used by the other group companies all over the world. The United Kingdom operations had been financed by means of loans from the United States company. The United Kingdom company, having licensed the software, incorporates the software into products manufactured for it by contract manufacturers in the Far East and sells the resulting products to unconnected buyers in the United Kingdom. Finally, it was anticipated that the United States company would render management services to its various subsidiaries all over the world. The client's transfer pricing challenges would be dealt with as follows.

First stage
Together with the main board of the company, a group transfer pricing policy was drawn up committing the group to charging arm's length prices. The policy was then distributed to the other companies.

A group structure was then drawn up and assistance provided in drawing up a functional and risk analysis for the various companies in the group. In addition, research (on the Internet, using various libraries and other sources) was carried out, and an industry analysis drafted showing how the company fitted in to the overall industry in which it operated.

Thus after the first stage, the following had been drafted:
a group policy;
a group structure;
a functions and risk analysis for each group company (also showing the intangibles they owned); and
an industry analysis showing how the group fitted in to the overall industry.

Second stage
The tax advisers, company personnel and legal advisers analysed the various intra-group transactions. Each transaction had to be documented by means of a contract and also had to be shown to be arm's length. They were tackled as follows.

Use of trademarks
A royalty agreement was drafted to document this transaction.
The most appropriate way to show the transactions were arm's length was to examine comparable uncontrolled transactions.

The comparable royalty rates on Edgar (electronic data gathering and retrieval – a search engine set up by the Securities and Exchange Commission in the United States) were looked up to show that the royalties were arm's length and established a range of acceptable royalty rates.

Intra-group loans
A loan agreement documented the loans.
The most appropriate way to show the transactions were arm's length was to examine comparable uncontrolled transactions.

This was done by contacting the group's bankers and obtaining from them in writing a range of interest rates that the bank's credit department said would be demanded from the company had it approached the bank and not its head office for the loan.

The interest charged on the loan was in line with that suggested by the bank. In addition, the interest charged was also determined to be in line with 'safe harbour' rules for the purposes of United States transfer pricing regulations (see below).

Development services
A contract services agreement was drafted to document the development services.
The most appropriate way to show the transactions were arm's length was the cost-plus method.

Comparable mark-ups were looked for on the tax adviser's databases to show that the mark-ups were arm's length and established a range of acceptable mark-ups.

Management services
A management agreement was drafted to document the management services.
The most appropriate way to show the transactions were arm's length was the cost-plus method.

Comparable mark-ups were looked for on the tax adviser's databases to show that the mark-ups were arm's length and established a range of acceptable mark-ups.

Invoices
The individual invoices that needed to be drawn up followed the descriptions on the contracts and the amounts were calculated in line with the comparables.

Result
The amount of work involved in documenting this project was significant. Nevertheless, group policies, structures, functions and risk analyses - as well as agreements governing the terms under which goods are sold or services are performed - would (or should) be drawn up as a matter of course. This needs to be assembled for the purposes of the transfer pricing review but the only original portion of this exercise is the determination of the manner in which the prices charged would be justified (in other words, the appropriate transfer pricing methodology to be used) and finding the necessary third party comparables to use as a benchmark.

Because this was a relatively small company, the review was kept as simple as possible. Only one method and a small selection of comparables was selected for each type of transaction where in some circumstances other methods would be used to corroborate the initial results.

In addition, some research was avoided in the case of the less significant transactions. For instance, the interest rates on the inter-company loans were benchmarked by reference to a letter from the company's bank specifying the terms on which it would be prepared to advance funds to the group. In normal circumstances, this would not be an acceptable means of supporting the particular terms applied to an intra-group loan as it does not address the particular risk profile existing between the entities concerned, but in this case the amount of the loan was not large and it was felt that a bank letter would at least serve to demonstrate that the company had made an attempt to ascertain an arm's length interest rate.

Even if a detailed Revenue audit determined that a different rate should be used, penalties should at least be mitigated. In the case of a larger loan or a larger company, a notional credit rating of the company would have to be established, and an arm's length rate calculated with reference to the risk-free rate plus the rate applicable to the company's particular risk profile, which is a much more lengthy and expensive process.

In addition, the loan was made by the United States company and was denominated in United States dollars and it was established that the rate fell within a safe harbour as set out in the United States transfer pricing regulations for the purposes of ensuring compliance with the United States transfer pricing provisions.

Regardless of the efforts that were made to simplify and streamline the process, developing and implementing a transfer pricing policy requires a fair amount of work. Much of can it can be done internally, but certain areas, particularly the selection of transfer pricing method and comparables search, are often best left to the experts.

Geoff Hopkins and Anton Hume are a supervisor and partner, respectively, with Grant Thornton at the London office.
 

Issue: 3788 / Categories: