Subscribers Login  

Transfer pricing¹ documentation, which is normally prepared to meet local regulatory requirements or to provide penalty protection, generally gives tax authorities their first impression of a multinational corporation's (MNC's) transfer pricing policy. It must, therefore, be prepared with extreme care, and with consideration as to how the MNC wishes to be perceived. The factual, economic, and empirical presentation must be company-, product-, and market-specific, and all specific internal and external events that impact the MNC's business, financial performance, and transfer pricing must be detailed. This documentation sets the tone for how the MNC, its culture, and market will be perceived, as well as for all issues to be raised in the ensuing tax audit. The more precise and focused the documentation, the less likely a controversy will occur; the more flimsy and scattered, the more likely the MNC will be inviting controversy.

MNCs must also prepare this documentation with the view that it will be reviewed by other taxing jurisdictions where the MNCs have affiliates along the transactional flow because we live in an environment where Competent Authority requests and exchanges of information specifically for this type of documentation are commonplace. Inconsistencies in methods, data, and factual representations can undermine the veracity of the documentation and trigger unnecessary disputes. What constitutes appropriate documentation can be generally determined by reviewing the regulations under §6662 of the Internal Revenue Code, transfer pricing guidelines published by the Organisation for Economic Co-operation and Development (OECD) (the “OECD Guidelines”), the guidelines proposed by the Pacific Association of Tax Administrators (PATA), or individual country statutes and administrative guidance.

In preparing documentation, MNCs are faced with certain significant strategic decisions. First, the MNC must identify for what regions or local countries must documentation be prepared or will one global analysis suffice for each of these regions or localities. Second, the MNC must decide how much documentation and information should be provided to the tax authorities to meet these various documentation requirements and avoid any proposed tax adjustments and penalties, while at the same time avoiding added burdens and obstacles if a tax controversy arises. Merely preparing documentation, whatever the format or scope, may allow an MNC to avoid penalties, but it must be observed that it is by no means an assurance that tax deficiencies will not be assessed. The point, simply stated, is that, from any documentation perspective, sometimes too much can be as problematic as too little.

For example, it has been frequently observed that MNCs' functional analyses and industry descriptions all too often closely parallel the overly optimistic and marketing-oriented company statements of anticipated financial performance, market-level position, and market share, typically contained in annual reports, websites, or in other “marketing” documents. This may not be a problem for an MNC whose financial performance has matched or exceeded these expectations, but these MNCs are infrequently audit targets. For MNCs with low or varied earnings levels, with recurring net operating losses, engaged in market penetration or the launching of new products, or attempting to rebound from recession or market impediments, these optimistic marketing statements are at odds with the use of a set of comparable firms geared to support the lower, or below normal, performance mandated by these conditions. This marketing-type information can, therefore, only assist a taxing authority with its challenges and places the MNC on the defense in a tax audit or controversy.

This concern is magnified when the documentation being prepared is part of a single global or regional documentation study. Here, the facts and economic analysis presented have a direct impact on more than one legal entity and in more than one tax jurisdiction. Further, the global view of the MNC may not accurately depict the present local market functions, risks, and assets of a particular legal entity under review. Therefore, the requirement for accuracy and consistency in this type of documentation can only be achieved by starting with the basic and bare minimal facts, and building from there. Superlatives, gratuitous facts, and industry anecdotes can only be useful if supportive of the ultimate transfer pricing policy and economic benchmarking. A good factor to keep in mind is that factual representations and economic analysis should directly relate to an entity's profits and loss (P&L) statements. Why? For two basic reasons: one is that the P&L statement gives tax authorities their first glance at the tested party's financial performance and, two, a functional and risk analysis can most easily be depicted by understanding how the tested party spends its money, as evidenced by the P&L statement.

While documentation, whether global, regional, or local, is required as a compliance tool, it is also both an asset to, and a planning vehicle for, an MNC, as well as a guide for tax authorities in various jurisdictions in reviewing the MNC's financial performance. If prepared in a cavalier way, without care and factual precision and judgment, it can very much have the opposite of the intended effect, with truly unintended and untoward results. Properly prepared, it can save the MNC significant tax dollars, internal headaches, and compliance costs. MNCs should, therefore, not treat their documentation routinely or as standardized documentation products, but rather as a protective tool requiring careful analysis and judgment.

In considering the preparation of transfer pricing documentation, we observe that the trend appears to be moving from an art form, as seemed to be the case years ago, to a more precise science. This has been seen since §482 was amended in 1986 to adopt the commensurate-with-income standard and can be illustrated by two sets of regulations issued in the last few years. The first involves the treatment of stock-based compensation as a cost to be shared by the participants in a cost sharing arrangement; the second involves arm's-length pricing for related party services. While both sets of regulations are fraught with their own criticisms, the trend to a more scientific approach to transfer pricing is evident.

Despite strong criticisms, and the lack of international consensus on this issue, the IRS has made clear that stock-based compensation is an expense item that must be considered in the cost base of a qualified cost sharing arrangement. The final regulations offer precise rules for measuring these costs and provide elective measures for certain companies that prepare their financial statements using principles other than GAAP. While some may argue that this is simply a method to discourage the use of cost sharing arrangements, this is clearly an effort to give taxpayers little “wiggle” room or flexibility in transactions involving intangibles.

The regulations on services fully add to this trend. These regulations were not anticipated to be contentious as most taxpayers viewed these rules as principally providing compliance guidance. Instead, the IRS threw a wrinkle in the sail by: (1) creating the new Services Cost Method to take the place of the 35-year-old cost safe haven rule; (2) replacing the generally accepted benefits rule with a recipient approach that requires a test of whether a third party would pay for the service; and (3) revising the embedded intangible rules to add a presumption that if non-routine intangibles exist, the residual profit split approach may be most suitable to benchmark the transactions.

The point here is not to debate the veracity or appropriateness of these recent promulgations, but to take a step back and analyze and cope with the trend. Accordingly, appreciating and analyzing the trends makes the documentation preparation and production more focused, thoughtful, and precise. It often carries a presumption of correctness rather than its intended reasonableness standard.

The trend in transfer pricing truly appears to be towards a more scientific approach. When the IRS issued its §482 regulations in 1994 which sought to revise the 1968 rules in light of the 1986 amendments to §482, the overriding concept was that of an arm's-length range. This was in large part in recognition of the fact that there was no one correct transfer price. Constructing that range was therefore believed by many to be an art form and only minimal economic or financial adjustments were needed to the comparable samples. In fact, even eliminating the outlying companies under the 25/75% regulatory rule was an effort to implement this understanding and to allow for the construction of a range of possible profits.

Over time, the practice of requiring more adjustments in the spirit of economic modeling with a focus on sophisticated adjustments, such as for foreign currency, country and market risks, comparisons of operating expenses to gross receipts, payment terms, and more, made the necessity of the range less important and the search for the true transfer price more evident. Even the standard functional analysis keyed on the minute details of the market and its risks, precise success drivers in the company supply chain, and the underlying nuances of brand development and spending, just to mention a few areas. Transfer pricing studies were becoming a treatise on how a company became successful and the details of its business plans and an effort to tie cost budgets, marketing and business plans, and management compensation arrangements to the transfer pricing documentation. The net result has been the presumption of correctness carried by these studies when MNCs evaluate their tax risks and exposures for financial statement purposes in accordance with FIN 48.

The new detail that is apparently required will make comparability a noble yet likely impossible goal for benchmarking purposes. If true, this will open up a panoply of compliance and legal issues regarding access to, and the production of, relevant underlying documentation. It will also put a great tension on what will constitute appropriate documentation for compliance and penalty purposes. Probably, and correctly so, it will highlight the greater need for a multitude of intercompany agreements to establish the varied legal relationships between related parties.

This commentary also will appear in the June 13, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Levey, Miesel, Garofalo, Patton, Levi, and Krupsky, 890 T.M., Transfer Pricing: Alternative Practical Strategies (Chapter 7, Practical Applications of Transfer Pricing: A Case Study Approach, and in Tax Practice Series, see ¶3600, Transfer Pricing. For more information on Transfer Pricing, see the Tax Management Transfer Pricing Report.