Implementing Transfer Pricing into Everyday Operations

HOST: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters. Today's topic is operational transfer pricing.

HOST: Companies are almost through another tax filing season for 2021. 2020 and 2021 have been unique for multinational companies with COVID-19 lockdowns and supply chain disruptions, and everything has had a huge impact on global commerce.

HOST: One of the more esoteric and interesting areas of tax, and international tax specifically, is transfer pricing. There's been a lot of impact on that with the economic downturns over the last year or two, and it's an interesting discussion about what we've learned in transfer pricing and specifically operational transfer pricing during these last two years.

HOST: Joining us today is Kirk Hesser. He is the leader of our Transfer Pricing Analysis and Consulting team. Hello, Kirk. How are you doing today?

KIRK HESSER: Hello everyone. Happy to be part of the Tax Beat podcast. I'm coming to you from Atlanta.

HOST: How hot is it today in Atlanta, Kirk?

KIRK HESSER: It's actually a little cooler today. We were very warm yesterday, in the 90s, and today we're in the 70s.

HOST: I'm sitting in Richmond and likewise we had a real cool down. It's very pleasant.

HOST: As always, joining me is my co-host Sarah McGregor, live from Greenville, South Carolina. How's life treating you, Sarah?

SARAH MCGREGOR: Life is good, Brooks. It's good to be here. We had a fall-like cool down yesterday, which is excellent. I'm ready for fall, pumpkin spice, and all of that.

HOST: The end of the 2021 filing season for tax returns is upon us. I echo that, though we still have a few deadlines ahead of us.

HOST: Transfer pricing is one of the more fascinating topics in tax law. It can be easy to lose sight of it, but when you look at the total amount of money involved in tax controversies and court decisions, transfer pricing is by far the number one issue involving the highest levels of dollars.

HOST: It affects large multinationals—drug and tech companies—and these issues trickle down to the middle-market clients our firm serves. It's very important if you have related parties in different jurisdictions or different countries.

HOST: We often talk about the additional tax, interest, and penalties that can be applied when companies shift taxable income between related parties in different tax jurisdictions. Penalties can be assessed for failure to maintain proper documentation on intercompany transactions.

HOST: Most countries have implemented transfer pricing documentation requirements fairly similar to the United States, although there are nuances and differences. To the layperson, they feel very much the same.

HOST: It's becoming more common to see different countries engage in this space because they all want their tax dollars and revenue. We're also seeing the OECD's influence in this area, and we'll have Kirk talk more about the OECD and BEPS later.

HOST: While there is a lot of negative framing, transfer pricing is also a good way to be proactive and do planning—legally, legitimately, and effectively to implement smart tax planning.

HOST: From my perspective, that's enough on the topic. Kirk, from a 20,000-foot view, how do you approach transfer pricing when you meet with a client?

KIRK HESSER: It's an interesting question and has evolved over the last several years. When we think about the transfer pricing life cycle, it typically involves planning, implementing, and documenting transfer pricing from a compliance perspective.

KIRK HESSER: When I meet with clients, often with the international tax specialist, we talk about effective tax planning and getting clients into a proper international structure to meet their business and tax objectives. From a transfer pricing perspective, we typically talk about outcomes.

KIRK HESSER: For example, if a client sets up limited-risk distributors in Europe in several locations, transfer pricing discussions focus on what the outcome should be for those distributors. They should be earning an operating margin of X% in each country.

KIRK HESSER: When we prepare transfer pricing documentation, many of the methods in the U.S. regulations and the OECD guidelines are outcome-focused. We look at the least complex entities—limited-risk distributors, for example—and justify transfer pricing by benchmarking the outcomes, such as operating margins, against a range of comparables. If they are within range, we conclude the transfer pricing is reasonable and meets the arm's-length standard.

HOST: You mentioned COVID-19 at the outset of the podcast. During downturns and recessions, multinationals often miss those expected outcomes. What we've discovered is many clients miss their outcomes because they never implemented their transfer pricing studies or policies in their financial records.

HOST: Operational transfer pricing means getting transfer pricing into financial records and recording the appropriate journal entries. Some companies only do the transfer pricing study once a year and shelve it for compliance, rather than operationalizing it.

HOST: We've shifted how we speak to clients, focusing on operational transfer pricing. Kirk, when you talk about the operational side not meeting outcomes, in 2022 with high inflation and supply constraints, many plans may need to be revisited before year end to ensure operational transfer pricing is properly implemented.

KIRK HESSER: Absolutely. What we emphasize to clients now is monitoring transfer pricing during the fiscal year. At year end, you need to know whether you're in or out of the benchmark range to have the opportunity to make an adjustment and book it. Waiting until tax return time often means you have to make a tax return adjustment or invent non-transfer-pricing reasons, which can be a stretch and a headache if those reasons don't truly exist.

KIRK HESSER: Even prior to the last two years, many clients were not in the habit of monitoring their transfer pricing within the fiscal year to make adjustments before closing the books.

HOST: At the practical level, operational transfer pricing often leads to intercompany agreements. They seem to be the end result of operational transfer pricing exercises. Talk about the necessity of intercompany agreements and what you look for in them, particularly in the context of COVID-19, inflation, and supply chain issues.

KIRK HESSER: We have always advocated that clients have intercompany agreements. From a U.S. standpoint, there is no legal requirement to have intercompany agreements, but many foreign jurisdictions expect to see them and to see that you're following them to the letter. Germany is an example.

KIRK HESSER: Intercompany agreements also help demonstrate that you are treating related parties at arm's length. If a third party would have an agreement, treating related parties the same way supports an arm's-length position.

KIRK HESSER: COVID-19 highlighted the need for specific clauses. Many multinationals experienced losses due to supply chain disruptions and shutdowns. One standard clause that helps is a force majeure clause, which says that in an unplanned event you will share the risk.

KIRK HESSER: Limited-risk entities, such as distributors or cost-plus entities, typically are not expected to make losses, and many foreign tax authorities will not allow adjustments down to cost or a loss unless you have a clause in the intercompany agreement addressing such events.

KIRK HESSER: Many foreign tax authorities also dislike year-end adjustments made after the fact unless your intercompany agreements commit you to make those adjustments. Intercompany agreements become particularly important during unplanned events and for enabling year-end adjustments to get entities into the benchmark range.

HOST: Which comes first: operational transfer pricing or getting all your documentation in order?

KIRK HESSER: That has changed over the years. Initially, transfer pricing discussions were outcome-based. Over time, we've emphasized operational transfer pricing first. You plan transfer pricing to reach certain outcomes, but you must explain how to get there and what transfer pricing looks like day to day.

KIRK HESSER: We've carved operational transfer pricing into the services we offer in conjunction with designing policies. Historically, we were good at planning and compliance but not focused enough on implementation. If possible, operational transfer pricing should come first, because if it's in place and monitored, the documentation piece becomes much easier.

HOST: I've never heard anyone refer to transfer pricing documentation as easy.

KIRK HESSER: It can be easier when operational processes are in place and data flows into the documentation.

HOST: Speaking of documentation, let's talk about the OECD and BEPS. Explain OECD and BEPS and the current status of their initiative and how it's impacting U.S. companies.

KIRK HESSER: BEPS began as an initiative by the OECD roughly a decade ago. The initiative aimed to put together a documentation platform that many countries would follow. BEPS stands for Base Erosion and Profit Shifting.

KIRK HESSER: The OECD put together a three-tier documentation system: the master file, the local file, and country-by-country (CBC) reporting for very large groups. The master file is a 20,000- to 30,000-foot view of a company, highlighting the overall supply chain, where entities and assets are located, and some financial activities.

KIRK HESSER: The local file documents intercompany transactions for a country-specific entity—for example, a U.K. entity—and includes comparables benchmarking, economic analysis, and the ranges the entity should be within.

KIRK HESSER: The third tier applies to companies with global revenues of €750 million (roughly $850 million at the time). This is filed with the ultimate parent entity return and lists additional information about the global organization, such as where entities are located, where the headquarters are, intercompany loans, intangibles, and other assets.

KIRK HESSER: For large companies, this three-layer documentation was viewed as a significant compliance burden and has been around for a while. Interestingly, while the U.S. says it follows OECD guidelines, U.S. documentation regulations under Section 6662 are still what the IRS expects to see, which creates some compliance confusion for multinationals that must produce master file, local file, and CBC reporting globally while also satisfying U.S. Section 6662 documentation.

KIRK HESSER: Canada has also not fully adopted the master file/local file system. So while much of the world follows OECD BEPS guidance, parts of North America have not fully aligned.

HOST: With the rise in country-by-country reporting and increased documentation requirements, digital data analytics are helpful. Are there digital platforms to manage this work?

KIRK HESSER: There are digital platforms. We have partnered with a group from the Netherlands called TP Tuned, which offers transfer pricing software called RepTune. RepTune is a documentation generator that follows OECD guidelines and the master file/local file framework and helps with CBC reporting.

KIRK HESSER: We've partnered with them to put together global documentation for our clients. To address the U.S. piece, we bridge the master file/local file information to U.S. documentation requirements with an appendix that maps where the master file/local file content aligns with Section 6662 documentation.

KIRK HESSER: A key difference between U.S. regulations and OECD guidelines is transfer pricing method selection. In the U.S., you must select the best method and explain why you didn't select other methods; that's not required by the OECD. We bolt that requirement onto the software.

KIRK HESSER: Digital solutions make generating documentation much easier. Once information is in the software, you can generate master files and local files with the push of a button.

HOST: Sarah, any final thoughts on operational transfer pricing?

SARAH MCGREGOR: Over the last two to three years and into 2022, flexibility and constant attention to transfer pricing activity are critical. The operational side is important, and end-of-year planning should include transfer pricing to get things buttoned up before filing returns next spring and summer.

HOST: Kirk, any final words?

KIRK HESSER: My message to advisers and clients is to ask how you are utilizing your transfer pricing study. Are you using it as a tool to help planning and to get into benchmark ranges? The plans and outcomes are designed to help achieve tax and business objectives; if operational transfer pricing isn't working, you're not achieving those objectives.

KIRK HESSER: Additionally, there are supply chain opportunities. The information in a master file, local file, or transfer pricing study is rich with details that advisers can use to discover opportunities in the supply chain and identify other tax-friendly services advisers can offer.

HOST: Transfer pricing is not only intricate but also a launching point for numerous value-added services.

HOST: Quick disclaimer about this podcast: we are not providing specific tax advice. Please consult with your tax advisor, hopefully at Cherry Bekaert, for your specific tax issues or to discuss information from today's podcast. Check the firm's website at cb.com for the latest guidance and materials on this and other tax and business topics.

HOST: This concludes today's podcast. Please like, share, and subscribe. Thank you, Kirk, and thank you to our listeners for spending time with us.