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Resolving transfer pricing controversies, handling audits and queries, and “best

practices” in TP documentation:A practical guide

Douglas FoneGlobal Partner, Transfer Pricing Associates

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Content

1. Introduction to transfer pricing Slide 32. Key trends in Asia Pacific Slide 63. Practical approach to transfer pricing system design Slide 114. Transfer pricing risk assessment Slide 175. Mastering multiple demands for transfer pricing documentation Slide 226. Dispute resolution process Slide 267. Examples of key TP transactions - case studies Slide 308. Key recommendations Slide 359. Questions & answers Slide 37

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Introduction to Transfer Pricing

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• Supply of raw materials

• Purchase of finished goods

• Supply of right to use group IP

• Supply of know-how

• Supply of services

• Supply of bank and credit guarantees

• Supply of loan finance

Overseas MNE

Subsidiary in Singapore

• Payment for raw materials

• Charge for sale of finished goods

• Payment of royalties

• Payment for know-how

• Payment of service fees

• Payment of guarantee fees

• Payment of interest

What is transfer pricing and why is it important?

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• Pricing of all inter-company transactions• Necessary in every multinational• Determines profit allocation within multinational• Regulations required to ensure fair and reasonable for all stakeholders:

Tax authorities – fair share of profit to levy taxCFO, FD, CEO, Heads of Tax etc – shareholder valueCurrent shareholders – return on investmentPotential investors – future return on investment, corporate governance, proper valuation of the businessLending institutions – corporate governanceEmployees – performance measurementBoards of Directors – corporate governance, shareholder valueCompetitors – relative shareholder value

What is transfer pricing and why is it important?

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Key Trends in Asia Pacific

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Key trends in Asia Pacific- Overview

• Growing importance of transfer pricing in AsiaTax authorities sharing knowledge and best practiceDouble tax treaties, APAs and MAP casesLess reliance on customs duties for fiscal revenueIncreased competition as more countries introduce audit programsDevelopments in China

New EIT law introduced wef 1 January 2008Documentation requirements to be effective from 1 January 2008

Other countries forced to protect their tax basesHong Kong (next DIPN will be re TP)Taiwan (documentation now compulsory)Singapore (guidelines and review program introduced)Vietnam (guidelines and audit program recently introduced)

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Key trends in Asia Pacific- Singapore’s new Transfer Pricing Consultation programme

• Issued 6 August 2008• Notice of IRAS questionnaires to be sent for fact gathering• Selected taxpayers for a TPC will need to be able to show:

– Business structure– Local activities and mode of operations, – Explain how certain factors in its business or industry affect its operating results– Nature, pricing and benchmarking of the related party transactions– Documentation prepared.

• Outcome (1) IRAS’ opinion on level of taxpayer’s transfer pricing risk, based on quality of documentation and “commercial realism” of results.

• Outcome (2) IRAS’ recommendations on how the documentation or methodology may be improved.

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Key trends in Asia Pacific- Practical issues faced by multinationals

• Satisfying the increasing documentation compliance burden• Managing the overall effective tax rate in face of increases in tax rates and greater

enforcement of transfer pricing regulations• Finding reasonable comparable data to support the arm’s length nature of inter-

company pricing• Countering the use of secret comparables by certain tax authorities• Dealing with the risk of aggressive and unpredictable audits in multiple countries• Addressing the rapid development of transfer pricing in China and intra-China

variations in approach• Dealing with varied level of experience in different jurisdictions• Is the existing transfer pricing system in Asia likely to withstand serious scrutiny?

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• To counter evasion or money laundering• FIN 48 implications – corporate governance• Increased interaction between tax authorities

Emerging trends in Asia Pacific

Greater exchange of information between tax authorities

• Need for transparency and fairness in application• Increased resources required and more training• Conflict with need to attract FDI – reducing in importance

Increased enforcement –more audits/APAs/MAPs

• Need for certainty and consistency in application• Agreement on transaction or profit approach – to prevent anomalies

Integration of customs and transfer pricing

• Emerging global issue – more MAPs likely but double taxation in the meantime• Common approach required from tax authorities•Business restructuring

• Domestic transactions as well?• Alleviate through Masterfile approach• Acceptance of economic indicators/safe harbours?• Exemptions for small and medium sized companies?

Compliance burden for MNCs increasing

• Thin cap and transfer pricing interaction?• Availability and definition of the thin cap safe harbour• Guarantee fees – GE case – approach of tax authorities?

•Financial Transactions

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Practical Approach to Transfer Pricing System Design

- Get it right from the start

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Practical approach to system design- TPA’s Transfer Pricing Process

TPA’s Transfer Pricing Process:

Transfer Pricing Process:

COMPANY’SBUSINESS

OPERATIONS

How to get from a business model to a manageable transfer pricing system?

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- Investigate industry and business context

- Identify key business objectives of management e.g. market penetration

- Analyse key functions/ activities performed

- Identify assets and risks associated with activities

- Analyse the nature of the current value chain and plans for the future

- Identify responsibility centres- Determine appropriate TP

methodology- Consider opportunities to

minimize overall tax rate- Establish appropriate

performance measurement / incentives

- Legalise inter-company transactions – agreements

- Conduct comparability search to support result

- Prepare Masterfile/local documentation

- Prepare transfer pricing policy paper

- Identify key risk countries –country risk matrix

- Introduce maintenance and disclosure manual

- Ensure legal agreements in place and consistent

- Prepare transfer pricing defence file

- Tax risk assessment – e.g. FIN 48

- Investigate possibility of APAs?

- Risk ranking/screening for transfer pricing audit

- Manage transfer pricing audits effectively

- Explore avenues for arbitration

- Consider availability of MAP

Practical approach to system design- TPA’s Transfer Pricing Process

IDENTIFICATIONOF BUSINESS

CONTEXT

DESIGN &IMPLEMENTATION DOCUMENTATION RISK ASSESSMENT/

MANAGEMENT

INPUT: COMPANY’SBUSINESS OPERATION

OUTPUT: DEFENSIBLE/WORKABLE TRANSFER

PRICING SYSTEM

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• Identify and analyse business context• Determine existing responsibility centre profile• Consider whether existing pricing model is arm’s length

If not, changes can be made to overall profit allocation by amending pricing to ensure it is arm’s length

• If changes are made to the pricing model:Identify functions, assets and/or risks that can be moved/centralisedCarry out financial and risk management scenario analysesAvoid business restructuring issues - ensure substance over formPrepare business case for change – anti-avoidance rulesPerform thorough economic analysis – documentationEnsure legal agreements are consistent and in placeInvolve all parts of the business to ensure changes are practical eg are changes required to IT systems?

Practical approach to system design- Planning process

DESIGN &IMPLEMENTATION

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• Remunerate companies based on responsibilities:Expense centre e.g. core research, strategic marketing

actual costs (inc. variances) plus arm’s length mark-upCost centre - e.g. contract manufacturing, support services

standard costs x actual volumes (maybe non-controllable variances as well) plus arm’s length mark-up

Revenue centre - e.g. limited risk distribution, commissionaireallocation of margin by way of commission on sales revenue

Profit centre - e.g. full risk distribution, speculative treasury operationsmarket price x actual volumes (net margin should provide adequate return)

Investment centre - e.g. intellectual property owner and developer effectively residual profit split

• Economic substance and commercial reality drives the setting of inter-company prices

Practical approach to system design- Introduction to responsibility centres

DESIGN &IMPLEMENTATION

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Investment Center

IP owner/ parent company

Revenue Center

Sales/distribution subsidiaries

Cost Center

Contract manufacturer

Expense Center

Contract R&D activities

Profit Center

Entrepreneur (principal)

R&D services

manufacturing services

sale of products

license

Practical approach to system design- Typical centralised business model

DESIGN &IMPLEMENTATION

17Your bridge to world-wide transfer pricing services

Transfer Pricing Risk Assessment- Know what to look out for

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Transfer pricing risk assessment- Likely weak spots

IDENTIFICATIONOF BUSINESS

CONTEXT

DESIGN &IMPLEMENTATION DOCUMENTATION RISK ASSESSMENT/

MANAGEMENT

INPUT: COMPANY’SBUSINESS OPERATION

OUTPUT: DEFENSIBLE/WORKABLE TRANSFER

PRICING SYSTEM

A B C D

Industry and business model

not clear

Legal, economic and accounting realities

do not match

Non-compliance or insufficient

compliance

Transfer pricing audit and conversion

risks

RISK ASSESSMENT/MANAGEMENT

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• OECD note in October 2006 re audit case selection• ATO methodology

Quality of documentationCommercial realism of results

• Common audit trigger factors, including:High risk transactions - royalties, service fees, financial transactionsAggressive tax planning structures eg transactions with tax havensDisclosure of unusual methodologies in Sch 25A or equivalentLower profitability than the industry norm, varying levels of profitabilityLack of responsiveness to queries – poor corporate governance standardsPoor compliance and tax payment record – inadequate TP documentationPoor relationships/Guanxi with tax officials

Transfer pricing risk assessment- Tax authority approaches

RISK ASSESSMENT/MANAGEMENT

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• Subsidiary of overseas parent companySingle country risk assessmenteg ATO approach

• Global MNC in respect of single transaction typeSingle transaction risk assessment – e.g. HO service feesBased on specific risk factors for specific transaction

• Global MNC in respect of all transaction types – FIN 48 approachRecognition of all transactionsAre they ‘more likely than not’ to withstand tax authority audit?Adopt objective measurement methodology

Audit/APA history?Documentation/benchmarking available?Treaty/MAP protection? Tax rate differential?

Transfer pricing risk assessment- Multinational approaches

RISK ASSESSMENT/MANAGEMENT

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Transfer pricing risk assessment- A practical tool

Type of Transaction Recharge of Costs

Management/ Support Services

Management/ Support Services

Royalty Sale of Goods

Sale of Goods to

Loss-makerNumber of countries involved 2 2 20 20 30 10Transaction amount US$1m US$10m US$50m US$50m US$500m US$100mRisk rating

Documentation recommended:InvoiceLegal agreementSummary TP reportMasterfilecountry risk analysismaintenance & disclosure

manualLocalisation of MFAdditional analysisother methodologiesin depth industry analysisloss justification paper

RISK ASSESSMENT/MANAGEMENT

22Your bridge to world-wide transfer pricing services

Mastering Multiple Demands forTransfer Pricing Documentation

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• Preparation of core set of documents per best practice• Maintained at head office for efficient updating• Comprises OECD-compliant documentation in modular format, easy to leverage:

Business context and industry analysisFunctional analysis for each type of entityClassification of each type of entity - responsibility centre profilesInter-company transactionsTransfer pricing system designGlobal or regional benchmarking

• Also supporting documentation:Transfer pricing policy paperCountry risk analysisMaintenance and disclosure manual

Transfer pricing documentation- Masterfile documentation: What is it?

DOCUMENTATION

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• Basic outline of Masterfile transfer pricing report:Executive SummaryIntroduction and purpose of reportCompany and industry analysis – global/regionalFunctional analysis – regionalClassification of companies – responsibility centresOutline of transfer pricing policy for price settingSelection of methods per OECD for price checkingApplication of methods – for each classification of companyConclusionsAppendices, including OECD Guidelines, support for economic analysis, inter-company agreements etc.

• Satisfies 70-80% of local country requirements

Transfer pricing documentation- Outline of Masterfile transfer pricing report

DOCUMENTATION

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• Benefits of Masterfile documentationSatisfies around 70%-80% of local requirements Reduces compliance costs - prevents duplication of effortMoves away from costly country by country approachConsistent classification of companiesConsistent economic analysis – selection, definition of PLIs etcMNCs take ownership of monitoring their TP issues

• Is it possible in Asia? Definitely!Convergence of acceptable methodologiesAvailability of regional financial data improving

• Useful risk management tool for MNCsWhere are the exposures?Where are the opportunities?

Transfer pricing documentation- Masterfile documentation: Benefits

DOCUMENTATION

26Your bridge to world-wide transfer pricing services

Dispute Resolution Process - Tips for handling tax authority enquiries

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• Before notification of review/auditEnsure all legal agreements are in placeDesign your transfer pricing system in accordance with arm’s length principleEnsure transfer pricing documentation is prepared in advance – contemporaneousCarry out regular reviews of returns vs benchmarksCollect other relevant documentation – eg Board minutes, evidence of negotiationEnsure documentation is up-to-dateBe aware of risk areasPrepare additional documentation to cover significant exposures

Dispute resolution processRISK ASSESSMENT/

MANAGEMENT

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• After notification of review/auditAppoint team to handle the queries, including technical advisersRespond promptly and fully to requests for information Assume tax office has full knowledge – do not rely on non-disclosure!Keep full and accurate record of information providedAssume from the start that the dispute will go to CourtAnticipate direction of tax office queries – be one step aheadKnow your strengths and weaknessesConsider availability of MAP and APACarry out detailed scenario analyses – what would it mean to you?

Dispute resolution processRISK ASSESSMENT/

MANAGEMENT

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• During conduct of review/auditSuggest appropriate people for tax office interviewCarry out test interviews to ensure clear communicationRecord the interviews – tape or by note-takingShare file notes with tax officials to arrive at agreed version of discussionsCo-operate with and show respect at all times to the tax officialsEnsure everyone in the office is aware of the visitAccompany the tax officials at all times while on company premisesBe clear of your facts and your preferred direction of enquiry

Dispute resolution processRISK ASSESSMENT/

MANAGEMENT

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Examples of TP transactions- Case studies of key challenges

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ItalyHeadquarters

Distributors

Legal ownership and developmentof brands/ trade names and design

Case study I- Key transactions

Luxury goods

Principal /Manufacturer

HKProcurement

Local operation in 5 years of consecutive losses

Company manufacture and determine global marketing strategy

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Key considerations- International tax and TP issues

• Consecutive losses – all TP related?• Key reasons from industry and business challenges

Practical solution• Loss justification paper to draw out anomalies in the industry, key business

challenges (potential argument may exist if problems specific to market or business)

• Ensure Transfer Pricing policy reflect functions, assets and risk. It will be difficult for principal entity to argue that it needs to be making profits when it drives all key decisions and assumes most risk

• Any start- up considerations? -Review pattern of losses and gains and conduct an average of profitability

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Local and overseas third partysuppliers

Third partyCustomers

Raw materials – prices negotiated by HQ

Sale of finished goods (price set by negotiation with Distributors based on forecast resale minus methodology)

Cost recharge (based on unitsproduced)

USHeadquartersHQ cost (inc brand

development costs) recharge (based on relative EBIT)

Marketer/DistributorsSingapore

ManufacturerChina – producingon orders by HQ

R&D Company – under direction from HQ

Legal ownership and developmentof brands/ trade names (no royalties)

Sale to third party customers at market price

Case study II - Key transactions

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Case study- Issues and consequences

Current State China manufacturer Distributors R&D companies US headquarters

Responsibility centre profile

Cost centre Revenue/Profit centre Expense centre Profit and Investment centre

Current profitability High and variable, fluctuating

Low and variable, some losses

Break even Break even at best, or losses

Issues arising Increase in overall ETR

Potential trapped losses causing high overall ETR

No profit - lack of commercial reality

Losses - lack of commercial reality

Local economic ownership of IP

Local economic ownership of IP

Diverse ownership of group IP

Consequences Loss of shareholder value

Loss of shareholder value Loss of shareholder value

Loss of shareholder value

Inability to pay dividends by HQ

Increase in transfer pricing audit risk

Increase in transfer pricing audit risk

Increase in transfer pricing audit risk throughout group

Future business restructuring issues and transfer pricing

audit risk

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Key Recommendations

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• Apply best practice transfer pricing system designProactive approach – price-setting should be on an arm’s length basisUse the responsibility centre concept for system designLet the business model drive the transfer pricing systemMaintain contemporaneous TP documentation

• Adopt Masterfile approach to satisfy compliance burdenEnsures higher quality documentation for good corporate governancePuts MNCs in control of their transfer pricing documentationProvides flexible framework for ongoing management of TP risks

• Risk management should be the trigger for tax planningWhere are the exposures – to avoid double taxation?Where are the opportunities – to reduce overall effective tax?

Key recommendations

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Questions & Answers