Transfer Pricing Perspectives/October 2013: A series of articles taking a broad look at the different transfer pricing requirements and unique challenges companies are facing all over the world. Managing multiple stakeholders in the new economy

www.pwc.com/transferpricingperspectives Transfer pricing perspectives: Managing multiple stakeholders in the new economy Foreword

In the current economic the number of interested The articles in this October environment, the continuing stakeholders is expanding. We now 2013 edition of Transfer Pricing priority for governments worldwide have to be prepared to manage Perspectives are designed to help you – and Western governments multiple stakeholders in this get the insights you need on transfer in particular – is for their new economy. pricing issues to equip yourself for systems to generate the level of the changes we’re sure to see. Garry Stone revenues they expect. Against this Add to this the impact on transfer background, the media, politicians pricing of OECD’s recently released Don’t forget our app, TP to Go to and NGOs worldwide have engaged Coordinated Action Plan on keep you up to date with the latest in a sometimes heated debate Base Erosion and Profit Shifting transfer pricing developments. about the ethics and legality of (BEPS), and it’s clear: The need for It’s available to download on most various multinationals’ tax policies, defensible transfer pricing policies devices. Search for it in your app often with significant impacts on is more important than ever. But store today. You can also sign up to the reputations of the companies it doesn’t end there. Not only do our PKN alerts and receive emails concerned. Our client conversations we need to ensure we are legally on the latest transfer pricing news. and 16th Annual Global CEO compliant, it is critically necessary Survey both confirm that tax has that we be perceived as doing I hope you enjoy this edition of moved up the agenda of business the right thing. The recent “tax Transfer Pricing Perspectives. leaders around the world. morality” debates taking place with respect to large US corporations Undoubtedly, the tax world will brought before government bodies continue to see a lot of change in are prime examples. No doubt, the next year – and for years after all these factors combine to make that. And as transfer pricing tops one thing clear: There will be Garry Stone more and more media headlines continuing changes in the transfer PwC (US) – and internationally coordinated pricing world for a time Global Leader, Transfer Pricing efforts to aggressively collect to come. [email protected] escalate even further – +1 312 298 2464 Transfer pricing perspectives: Managing multiple stakeholders in the new economy Contents

Double jeopardy… Leading practices for South America: Dealing with local complexity managing risk in the oil and when applying global transfer pricing policies gas industry The impact of transfer pricing on real estate Global tax audits and disputes: New forces are funding – Mezzanine financing converging to form second wave The intersection of ERP systems and Industrial products transfer pricing

Progress, but no guarantees for the consistent The politics of taxation treatment of intercompany financing transactions Transfer pricing symptoms of chronic Regulatory reform in the financial industry industry challenges and end-to-end transfer pricing execution Value chain transformation globalisation Russia’s new rules: Overview and maturity framework practical aspects Our transfer pricing territory contacts Transfer pricing perspectives: Managing multiple stakeholders in the new economy

Leading practices for managing double taxation risk in the oil and gas industry

Double jeopardy… Transfer pricing perspectives: Managing multiple stakeholders in the new economy Double jeopardy…

Industry expansion leading direct benefit received by the local to greater costs Global oil and gas affiliate or disallow the deduction The significant expansion of expansion increases of the service fee for tax purposes oil and gas (O&G) companies need for industry player at the local level completely. In globally makes the need for alignment many cases, these decisions are industry players to align and made by the foreign tax authority coordinate local operations with unilaterally, not considering that corporate strategy greater than The OECD Guidelines provide for there may be potential implications ever. As a result, the majority of – and many countries, including under an existing treaty. multinational energy companies the United States, require under incur significant general and their local transfer pricing rules – When this situation arises, a administrative expenses related charges for intercompany services company potentially could be to headquarters services rendered that provide or are intended required to pay tax twice on the on behalf of foreign affiliates. In to provide a benefit to related same income for the same period – addition to general management parties. Although specific rules in the local country which disallows and administrative activities in a jurisdiction may allow for the deduction and in the host including accounting, human certain expenses to be allocated country where the counterparty resources (HR), and information at cost, in some cases the services to the transaction must report the technology (IT) services, O&G are required to be charged with a income on its tax return and pay companies may also charge their mark-up. tax on that income. related parties for centralised quality, health, safety, and Tax authorities’ response to It is critical that corporate environmental (QHSE) support OECD charges personnel recognise that services, engineering and technical Many tax authorities are sceptical a disallowance of an otherwise services, and procurement of these charges – particularly those appropriate expense allocation or and logistics services – among including a mark-up – and impose charge has potentially far-reaching other functions – performed by local requirements mandating tax consequences and take action to corporate departments. documentation showing the remedy the situation. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Double jeopardy…

Certain disallowances can have significant tax consequences

Many of the developing countries administrative, management, and • Sales and marketing, in which multinational O&G back office services. These shared including brand development companies operate do not have services may be executed through and management extensive treaty networks. As the parent company’s headquarters • Accounting, finance, and treasury such, remedies such as Competent or in one or more regional administration, including global Authority may not be available. service centres. management • Tax planning, reporting, Intercompany headquarters In addition to strategic compliance, and services management and corporate goal controversy support To capitalise on economies of setting, the services provided at the • Legal and general scale and remain cost competitive head office level may include but counsel functions in the global marketplace, O&G are not limited to: • Management information companies generally centralise systems and IT Transfer pricing perspectives: Managing multiple stakeholders in the new economy Double jeopardy…

• HR, including expatriate activity. As a threshold matter, Issues raised by foreign personnel management, payroll, headquarters services must not tax authorities and benefits administration duplicate the activities performed Due to their heightened visibility, • Engineering and technical at the local level and be seen as O&G companies are on the radar support services providing a recognisable benefit to of tax authorities around the • QHSE programme development the recipient in order for a charge world. Increasingly, multinational and management to be made in most jurisdictions. enterprises are facing tax • Corporate structuring and authorities in many jurisdictions planning, including merger, – including member states of the divestiture and acquisition Services providing indirect OECD – taking aggressive positions planning and execution benefits to more than on audit to disallow the deduction • Purchasing, logistics, and one member often most of allocated headquarters services procurement, including asset and contentious charges. In the case of more materials management sophisticated tax authorities, the • Stakeholder relations, disallowance may be explained in a including investor, public and Services providing indirect well-reasoned manner. Conversely, media relations benefits to more than one in less advanced economies, no • Intellectual property member of a controlled group – justification may be offered at all. administration, including patent such as QHSE programmes and and trademark registrations company-wide asset management Historically, foreign tax authorities and defence activities – are often the most have challenged headquarters contentious as local tax authorities services charges on the basis of Broadly, headquarters activities are typically reluctant to accept lack of direct benefit received in can be bifurcated between those charges for activities which do not the local country, misallocation activities that provide a benefit appear to have a direct impact on of charges between affiliates, and to related parties and those the recipient. inappropriate mark-up applied. that are performed on behalf Absent planning and proper of the company performing the documentation that meets local Transfer pricing perspectives: Managing multiple stakeholders in the new economy Double jeopardy…

country requirements, these met. Invoicing and cash settlement the operation. While seemingly a disputes can be difficult to address is another common reason given third party relationship, a JV could in the foreign jurisdiction. If these for disallowance of headquarters face a near “perfect storm” where issues are raised in a treaty country, services charges, particularly in CIS investors in the JV refuse to accept then relief may be available countries. These jurisdictions do mark-ups on the operator’s service through Competent Authority not accept offsetting journal entries charges – seemingly an example of under the Mutual Agreement or accounting cross charges, instead third party negotiations – while a Procedure (MAP) of the treaty. demanding that intercompany tax authority asserts a mark-up on a invoices be rendered and payments perceived related party transaction. be made in cash. Disallowance: Tax authorities see some Specific challenges for Critical matter: Oil and gas troubling trends O&G companies Due to the contractual nature companies need holistic of deals in the O&G space, there approach to structuring However, a troubling trend has are particular issues industry joint venture activities emerged over the last several participants face in determining years. Some tax authorities have and charging appropriately asserted that the disallowance of for headquarters and other It is critical that O&G companies the deductibility of headquarters management services. take a holistic approach to services charges is a domestic issue structuring their JV activities – tied to local rules – and insist that Whether for commercial, liability, taking into account the tax Competent Authority has no right to or other reasons – such as local implications of service activities negotiate the issues. For example, content laws – O&G companies performed by one or more Mexico has been observed to often will enter into a joint venture members of the JV and prepare deny inbound expense deductions (JV) relationship with one company the appropriate analysis and claiming domestic substantiation as the operator and others as documentation to support and form requirements are not investors who pay the costs of their positions. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Double jeopardy…

Leading practices • Ensure that intercompany When Competent Authority While the challenges related charges are supported by specific is not available, advisors with to foreign deductibility of invoices designed to meet local experience and a physical headquarters services charges requirements for invoicing presence in the foreign allocated by multinational and payment. jurisdiction are even more enterprises will likely continue, critical. This local presence is corporate personnel can take • Understand and follow imperative as court actions, proactive steps to better defend local transfer pricing bond applications, and other these deductions. Companies documentation requirements. necessary events and processes should consider taking the have deadlines and procedures following actions: • Develop and maintain unique to each country. The specific evidence substantiating ability to navigate these local the benefits received by requirements is vital to achieving What are the proactive steps the local entities from the a successful outcome for corporations can take to head office, where possible. the company. defend deductions? This documentation could include executive travel logs, Ultimately, advance planning meeting notices, training or and documentation prepared • Put in place comprehensive operating manuals, and the in accordance with the relevant intercompany agreements and like, evidencing that important jurisdictional requirements ensure that the duly executed directions and guidance are is essential to multinational agreements are registered with communicated to the local entity O&G companies successfully the appropriate local authority, from the corporate headquarters. defending headquarters services where applicable. charges in both domestic and • Identify and retain local foreign environments. advisors to give timely direction on tangential sourcing issues for withholding purposes and consequences. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Double jeopardy…

Authors

Dale Bond PwC US +1 713 356 4156 [email protected]

Elizabeth A. Sweigart PwC US +1 713 356 4344 [email protected]

Transfer pricing perspectives: Managing multiple stakeholders in the new economy

David Swenson, global leader of PwC’s tax controversy and dispute resolution network, predicts a second wave of tax audits and disputes is on the horizon around the world.

Global tax audits and disputes: New forces are converging to form second wave Transfer pricing perspectives: Managing multiple stakeholders in the new economy Global tax audits and disputes: New forces are converging to form second wave

Predictions of a ‘perfect “Today’s multinational storm’ materialise OECD stats corporations are facing These predictions of a growing show high surge the most challenging tax perfect storm in the global tax in tax disputes environment in history controversy arena, accompanied worldwide in past because of a combination by an unprecedented rise in five years of four global forces tax audits and disputes, have in fact materialized. Independent converging to create a empirical evidence now confirms perfect storm. The unstable that we are in the eye of the storm. environment created by these forces is resulting OECD statistics released in April in a substantial increase show a dramatic surge in tax in the number and size of disputes worldwide over the past tax audits, adjustments, five years. For the most recent reporting year (2011), the OECD The on-going OECD base erosion and disputes. This surge statistics reflect a substantial and profit shifting (BEPS) . . . is placing significant increase in new (and pending) initiative, as well as the related strain on the traditional mutual agreement procedure tax planning debate, is adding methods of resolving (MAP) cases, providing clear to this turbulent environment. It tax controversies.” evidence of a significant rise in appears clear that these forces and international tax controversies a confluence of other factors will Excerpt from an article coauthored around the world. As a result, the trigger a second wave of aggressive by David Swenson and Garry Stone global system for resolving cross- enforcement actions by countries in 2008 border tax disputes continues worldwide, leading to a further under pressure, with few prospects surge in international tax audits for immediate relief. and disputes. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Global tax audits and disputes: New forces are converging to form second wave

The first wave of the storm According to the most recent OECD Most new MAP cases filed in 2011 Most pending MAP cases in 2011 statistics, 1,624 new MAP cases were initiated among OECD member Germany Germany 306 702 countries during the 2011 reporting United States United States period, representing a 21% increase 279 686 over 2010. The countries with the France France most new MAP cases filed in 2011 173 539 are shown opposite. Belgium Belgium 120 241 The total number of new cases Switzerland Canada filed in 2011 represents a 112 225 substantial 57% increase over Sweden Switzerland the new cases filed in the 2006 111 187 reporting period, and is the largest Canada Sweden number of MAP cases ever filed in 94 163 a single year. Luxembourg United Kingdom 75 133 The OECD statistics also show that Austria the number of open (pending) MAP 110 cases reported by OECD member Luxembourg countries at the end of 2011 totaled 109 3,838 – a 15% increase over 2010 The Netherlands – and the total caseload continues 99 to grow each year. The countries Spain with the highest total of pending 87 MAP cases at the end of 2011 are shown opposite. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Global tax audits and disputes: New forces are converging to form second wave

Significantly, the existing competent authority office indicate cases worldwide, and it has placed overall inventory of open MAP that US- initiated MAP cases more substantial strain on the existing cases represents a 63% increase than doubled in 2012 (over 2011). framework for resolving cross- compared with 2006, and is the border tax disputes. Unfortunately, largest number of pending MAP How will increased tax turbulent conditions are on the cases in history. horizon and it appears that new audits/disputes and limited forces will trigger a second wave of The average time for completion resources impact processes? increased audits and examinations, of MAP cases between two OECD presenting additional challenges member countries in 2011 was With limited tax administration for those facing the storm. 25.6 months. Although this resources in many jurisdictions, represents an approximately two- the total MAP caseload likely will Driving factors month reduction in the average continue to grow and the average Nations throughout the world completion time (from 27.3 months completion time may lengthen have an acute need to raise large in 2010), it remains well above in the near future. Although the amounts of revenue to fund a the recent four-year average of concept of mandatory binding variety of and long-term approximately 21.6 months. arbitration holds promise as a obligations, from infrastructure release valve in the storm, those projects and defense initiatives to These OECD statistics provide provisions are included in a limited social programmes. dramatic evidence of the surge number of double tax treaties, and in tax audits and disputes among any widespread positive impact Governments must encourage OECD member countries over the may be years away. voluntary taxpayer compliance last five years. New MAP cases and simultaneously develop tools are increasing at a significant rate The second wave is rolling in to ensure compliance through and the total open inventory of The first wave of the tax cooperative engagements, cross-border disputes is on the rise controversy perfect storm has documentation requirements, and each year. For example, statistics already delivered record numbers enhanced enforcement initiatives. recently released by the US of tax audits, disputes, and MAP The primary enforcement actions Transfer pricing perspectives: Managing multiple stakeholders in the new economy Global tax audits and disputes: New forces are converging to form second wave

include improved methods Unprecedented political pressure for reporting and sharing continues to escalate based on Intense scrutiny taxpayer information, robust populist rhetoric. It has become of multinational risk assessment approaches, and politically acceptable to single corporations aggressive audit and examination out multinational corporations now politically techniques. Governments are for intense scrutiny, even to the acceptable adding resources to audits and extent they have become targets other enforcement initiatives and of a crackdown on aggressive are supporting greater training tax planning and perceived and education of tax auditors and deficiencies in the historical inspectors. These enforcement architecture supporting the global steps will inevitably lead to tax system. further audits and disputes in both developed and emerging Non-governmental organigations international tax planning. In countries worldwide. (NGOs) have raised issues related turn, these developments have led to tax fairness and tax morality, to a focus by the G-20 countries Austerity measures implemented and several governments have on preventing and in many countries in response held public hearings on issues aggressive tax planning. In to the global financial crisis related to the tax planning debate, response, the OECD has initiated have placed a spotlight on tax double non-taxation, and tax its well-publicised BEPS project. obligations and enforcement. As evasion. Some observers believe deficit reduction measures are that concerted action on tax fraud With an eye on the second wave, adopted and government services and tax evasion is a necessary the OECD has taken the lead in are decreased, stakeholders step to ensure that austerity and addressing base erosion and profit are focusing on obligations to deficit reduction measures are shifting in a systematic manner. pay tax and the enforcement of fair and equitable, and attention Following up on its February 2013 those obligations. on these topics has spread to BEPS Report, the OECD released the more traditional areas of in mid-July a Coordinated Action Transfer pricing perspectives: Managing multiple stakeholders in the new economy Global tax audits and disputes: New forces are converging to form second wave

Plan (the Action Plan), which nations, a second wave of audits have formed the foundation of the addresses perceived flaws in the and disputes, resultant global international tax system for many international tax rules and sets chaos, and a potentially higher decades. As a result, because of forth precise action points and a incidence of double taxation. the length of time necessary to suggested time line. achieve mutual understanding Will the BEPS initiative and consensus on changes to This highly anticipated Action Plan result in collective action established technical rules, it may calls for fundamental changes - as by nations? be extremely difficult to reach a opposed to wholesale amendment At present, it is unclear whether holistic agreement on revised rules - to current mechanisms and the the BEPS initiative will result in and common principles of taxing adoption of new consensus-based collective (multilateral) action jurisdiction among developed approaches designed to prevent by nations, or whether unilateral and emerging nations on an and counter base erosion and measures will be adopted in expedited basis. profit shifting activities. Overall, certain areas. Many observers the Action Plan reflects a balance believe that it will be relatively Some countries may believe that in clearly identifying the gaps easier for countries to agree the historical international tax and a roadmap forward, while on coordinated action in some rules are no longer fit for purpose at the same time establishing administrative areas, such as and need to be substantially a responsible tone by setting transparency of information, rewritten, while others may forth principles based on the reporting requirements, exchange believe that vigorous audits and need for clarity, predictability, of taxpayer data, joint audits, and aggressive enforcement of the and administrability for both revisions of procedural rules to existing rules, combined with governments and taxpayers. The make MAP cases more efficient. allocation of additional resources Action Plan cautions, however, that to those efforts, will address the inaction regarding base erosion There is also a view that it will underlying issues raised in the and profit shifting may have more be far more problematic to reach OECD BEPS initiative. deleterious effects, likely including broad agreement on major changes unilateral actions by individual to fundamental taxing rights that Transfer pricing perspectives: Managing multiple stakeholders in the new economy Global tax audits and disputes: New forces are converging to form second wave

Conversely, some observers and uncertainty will emerge, disputes hopper, an inevitable rise believe that and there likely will be renewed in the number of tax controversies among nations must be addressed interest in cooperative compliance will develop, as well as an as a first step, thereby leading to programs among revenue increase in domestic alternative a lack of uniformity on the best authorities and taxpayers, such as dispute resolution (ADR) options, path forward. Based on a number the compliance assurance program including administrative appeals, of competing considerations, it (CAP) in the US, the real-time mediation hearings, MAP cases, appears that a combination of working procedures in the UK, arbitration proceedings, and tax collective and unilateral actions and horizontal monitoring in the litigation. The existing system may be forthcoming, with Netherlands. for resolving cross-border tax some countries and regional disputes will continue under organisations - such as the Greater risk & uncertainty growing pressure, and additional European Commission - adopting resources will be necessary interim measures. Regardless to accompany rising global in these areas to address the of the approach ultimately tax controversy expanding caseload and to avoid adopted, there is little doubt delays and uncertainty in resolving that tax administrations will feel There also may be increased these controversies. emboldened, and even compelled, demand for private rulings in the current environment to and pre-filing agreements to Historically, there has been escalate enforcement activities reduce risk and uncertainty general agreement among OECD leading to a second wave of tax regarding specific transactions countries over the meaning of audits and examinations in the and operations, such as advance the arm’s length standard and years ahead. pricing agreements (APAs) in the the definition of permanent transfer pricing area. establishments, creating taxing What to expect link between a taxpayer and the As the global tax controversy With the anticipated surge in new relevant jurisdiction. area heats up and the second audits and examinations, and as wave approaches, greater risk more cases are thrown into the tax Transfer pricing perspectives: Managing multiple stakeholders in the new economy Global tax audits and disputes: New forces are converging to form second wave

There appear to be growing differences, however, between Will OECD BEPS residence- and source-based initiative justify countries regarding those rules extreme positions and such differences may lead in tax audits and to a divergence of views on basic disputes? taxing rights and fundamental tax principles. As differences emerge over the interpretation of the arm’s-length standard and the concept, the potential for difficult and protracted tax disputes without a uniform global tax lack of congruence on key issues rises and the spectre of double system, which is not realistically may also lead to a further surge in taxation becomes more acute. achievable in the near future. cross-border disputes and a rise in The OECD’s Action Plan calls for the incidence of double taxation. steps to provide clarity into the Further, some countries are likely concept of PEs and for measures to use the OECD BEPS initiative Several countries are considering that are either within or beyond to justify taking extreme positions enacting (or revising) general the arm’s-length principle in in tax audits and disputes. anti-avoidance rules (GAARs) certain circumstances. Major differences are already or specific anti-avoidance rules prevalent and some jurisdictions (SAARs) to address issues raised In the new environment, a lack of are adding local content to their by the BEPS initiative. Many uniformity on critical issues and interpretations of the historical observers believe that unilateral concepts may continue to emerge international tax rules. Such action on GAAR or SAAR without coordinated multilateral unilateral actions risk triggering legislation will lead to a further action. Indeed, differences among multiple claims of taxation over rise in cross-border disputes and national tax regimes are inevitable the same items of income. This a higher probability of double Transfer pricing perspectives: Managing multiple stakeholders in the new economy Global tax audits and disputes: New forces are converging to form second wave

taxation. Others are of the view business judgment undoubtedly will Strategic risk assessments that although multilateral action trigger more difficult and complex (SRAs) are important tools to on GAARs is preferable to separate tax controversies. identify, evaluate, and manage country measures, the most tax risks and exposures around appropriate response is through The business world must be the globe. Proactive use of SRAs the proactive use of limitation on able to rely on the rule of law, involving priority countries, benefits provisions in double tax and it needs legal certainty in operations, and transactions may treaties. These differences of view these areas. A uniform set of identify material tax risks and will make finding common ground principles is critical to managing exposures before an audit even very challenging. global business operations. commences. Implementation of Indeed, the OECD Action Plan SRA recommendations may also There are also differing views on acknowledges that more clarity strengthen reporting positions, other important concepts such as is required around identifying reduce uncertainty, and develop the need to respect the existence of which types of transactions can be responses to anticipated tax separate legal entities, the validity re-characterised. In the interim, authority positions. of binding legal agreements, and however, the current global tax the allocation of risks among environment is creating less In the current environment, related parties. Further, there are certainty and greater tax risks many multinational corporations divergent opinions concerning and exposures. have 100 or more active tax the need to respect transactions audits and disputes underway as structured by taxpayers and Proactive approaches to around the globe. It is critical the limits on the ability of tax anticipated surge in tax audits to proactively coordinate and authorities to re-characterise and disputes manage those examinations, bona fide existing arrangements. With the second wave of the monitor statutes of limitations Expansion of the tax administration perfect storm on the horizon, and treaty requirements, adopt rights to re-characterise transactions taxpayers should adopt proactive consistent positions regarding and the ability to substitute steps to prepare for the anticipated facts and issues, and develop government opinion for a taxpayer’s surge in tax audits and disputes. holistic approaches to resolving the Transfer pricing perspectives: Managing multiple stakeholders in the new economy Global tax audits and disputes: New forces are converging to form second wave

controversies, taking into account lifecycle. Proactive strategies to audit and, if possible, resolve all local as well as multi-country craft contracts, agreements, and issues at the audit level. Early tax attributes. Implementation other documents with a defensive development of the taxpayer’s of global coordination hubs and mind-set will not only strengthen affirmative theory of the case is dispute resolution centers is useful the taxpayer’s on audit, critical to a favourable resolution to achieve these objectives. but also may lead to a more timely of the audit or dispute. Informed and favourable resolution of the strategies for responding to It is also important to build tax dispute. information document requests, defence into entity structures and employee interviews, and facility transactional documents from A pressing juncture arises when tours are also key to successfully the initial steps of establishing a tax audit commences. The resolving the issues at an early an organisational structure taxpayer should develop an overall stage in the controversy process. and throughout the operational strategic plan for managing the

Strategic plan for managing the audit and respective issues is key Transfer pricing perspectives: Managing multiple stakeholders in the new economy Global tax audits and disputes: New forces are converging to form second wave

As the number of audits and level likely will rise in the years A 2011 World Bank study found disputes rise, there will be a ahead. In this environment, that more than 84% of nations premium on gaining certainty it is critical for taxpayers to around the world have an existing early in the process through work cooperatively with the independent administrative pre-filing rulings and APAs. relevant competent authorities appeals function, but almost Consideration of the affirmative to resolve disputes quickly and 63% of the respondents thought use of APAs is part of a well- efficiently. This approach includes those functions did not work developed responsive strategy in transparent actions designed to efficiently. The OECD recognises the current environment. In many assist the governments involved in this conundrum in its Action Plan situations, an APA may act as an a dispute to understand the facts, and supports measures to make insurance policy against future issues, and positions asserted and dispute resolution mechanisms audits, risks, and exposures. to draw the competent authorities more effective – such as resolving There are, however, a number together for a successful resolution disputes where MAP does not work of important considerations in of the issues and the elimination of or is not applied – including use pursuing an APA that should be double taxation. of arbitration. carefully weighed depending on the countries and transactions Demand for effective Alternative involved. The allocation of human Dispute Resolution (ADR) Pending MAP cases capital and financial resources, as mechanisms at highest level well as transparency requirements, As the second wave approaches, in history. How is among the many factors that there are also a number of proactive should taxpayers must be balanced to determine the actions governments should adopt respond? advisability of seeking an APA in a to reduce the unfavourable impact given situation or case. from the next surge of disputes – including the use of effective ADR As noted, the worldwide inventory mechanisms and improvements to of pending MAP cases is at the existing domestic administrative highest level in history and that appeals programs. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Global tax audits and disputes: New forces are converging to form second wave

An effective administrative (winner takes all) may serve as fewer disputes are successfully appeals process should reduce forceful incentives to resolve resolved. Divergent positions by the number of disputes that reach cases early in the MAP process nations worldwide and pressure on the MAP level, arbitration, and (actually, even before arbitration existing dispute resolution options tax litigation. Improvements to begins). For those cases not will lead to greater uncertainty existing administrative appeals resolved before arbitration, and more controversy, and an programs are needed in many these factors may also lead to an unwelcome haze may be cast countries. Governments should objective means of resolving the over the environment for years consider the use of additional underlying differences between to come. These forces will drive a ADR approaches, such as domestic the two governments. second wave in the perfect storm mediation and domestic arbitration of cross-border disputes. Carefully as alternative methods to deal with Which forces could drive coordinated actions and informed the anticipated increase in tax strategies are needed now before disputes. Equally important, tax second wave in perfect storm the next wave rolls in. administrations should ensure that of cross-border disputes? increased resources are devoted to APA and MAP programs in response to the rising inventory in The bottom line these critical areas. New forces are gathering on the horizon of the global tax Finally, in the context of MAP controversy environment. If cases, mandatory binding nations deviate from historical arbitration may offer a reasonable international tax principles, alternative for resolving complex substantial additional resources or difficult cases. The use of will be necessary to address the specified time limitations, flood of new audits and disputes. independent arbitrators, and a Ultimately, double taxation may ‘baseball arbitration’ approach become more widespread as Transfer pricing perspectives: Managing multiple stakeholders in the new economy Global tax audits and disputes: New forces are converging to form second wave

Author

C. David Swenson PwC US +1 202 414 4650 [email protected]

Based on recent developments, this is an updated version of an article previously published in TNI. Transfer pricing perspectives: Managing multiple stakeholders in the new economy

Industrial products companies have witnessed a significant shift in production to emerging markets, including most notably China, , and India.

Industrial products Transfer pricing perspectives: Managing multiple stakeholders in the new economy Industrial products

Globalisation markets to meet overseas demand transfer pricing structures and Industrial products companies growth. There has been a large policies. They must deal with the have witnessed a significant increase in investment in China, growing number of jurisdictions shift in production to emerging with two chemical companies that have adopted rigorous markets, including most notably recently announcing plans to transfer pricing policies that, China, Brazil, and India. Today, increase their research and at times, rely upon inconsistent multinational enterprises in development (R&D) capabilities intercompany transfer pricing laws the sector continue to extend in Shanghai. In industrial and standards. Multinationals also the breadth of their existing manufacturing, foreign must respond to more aggressive international operations while and investment is becoming enforcement by tax authorities expanding into new markets to be increasingly important as demand – a consequence of the attempt closer to their customers. These from emerging markets is growing by many countries to prevent companies are looking to emerging faster than in the United States and perceived abuses by taxpayers and markets as sources of not only low- Europe as a result of higher birth a desire for increased revenues to cost labour for manufacturing, but rates, improving living standards, reduce deficits. also highly skilled labour that will and increasing industrialisation of help drive development activities. their economies. These developments are taking In addition, emerging markets place both in developed and also are expected to propel future The impact of globalisation on emerging countries. Indeed, growth through lucrative new transfer pricing the transfer pricing landscape sales channels. As a result of globalisation, throughout the world is transfer pricing is becoming constantly evolving, as evidenced The chemical and industrial a more important as well as a by the recent focus on base manufacturing sectors are good more complex issue for industrial erosion and profit shifting illustrations of the impact of products and services companies. (BEPS) by the Organisation globalisation. Many US-based As these companies expand their for Economic Cooperation and chemical companies are building global operations, they must Development (OECD). production facilities in emerging develop robust and defensible Transfer pricing perspectives: Managing multiple stakeholders in the new economy Industrial products

Multinationals must comply with inconsistency of transfer pricing of deficit spending during the material differences in transfer rules worldwide, will likely lead downturn. These factors have pricing rules across multiple to a dramatic increase in transfer created an environment that is jurisdictions. In certain countries, pricing controversies. ripe for tax controversy. Indeed, such as Brazil (a major market for multinationals have been industrial products), companies Due in large part to the global confronted by enhanced tax must comply with transfer pricing economic downturn, transfer compliance enforcement activity rules that do not adhere to the pricing in recent years has been throughout the world, including arm’s-length principle. an exercise in the allocation of intense attacks on their in-country losses, rather than income, among “loss operations.” As a result, The Brazilian transfer pricing related entities. Meanwhile, transfer pricing presents unique regime is a formulary-based the governments auditing these challenges to companies seeking system that defines maximum companies are looking for tax to manage multiple stakeholders in price ceilings for deductible revenues to help offset the cost the new economy. expenses on intercompany transactions and minimum gross income floors for intercompany These factors transactions. This regime have created an creates a unique challenge for environment that multinationals operating in is ripe for tax Brazil, since transfer pricing controversy requires analysis under two distinct models that cannot necessarily be reconciled. In such instances, double taxation may be inevitable. This expansion of businesses across national borders, and the proliferation and Transfer pricing perspectives: Managing multiple stakeholders in the new economy Industrial products

The risk of double taxation years as well as to implement new single audit using a single team Many multinationals are transfer pricing policies coinciding comprising representatives looking for ways to protect with a business restructuring. from two or more jurisdictions themselves from the risk of Despite the benefits of achieving – although these joint audits double taxation that could arise certainty, some multinationals have not yet gained widespread in a transfer pricing controversy. have been reluctant to enter into traction. In cases involving tax Traditionally, companies relied on the APA program, believing that disputes between treaty partners, preparing robust transfer pricing APAs can be invasive, costly, and the competent authorities of the documentation to support their tax time consuming. relevant countries may be engaged return filing positions. However, in to resolve the dispute under the today’s more contentious transfer In response to concerns from mutual agreement procedures pricing environment, many multinationals for consistency embodied in the relevant income companies are exploring Advance and efficiency in audit processes . Pricing Agreements (APAs) and in different countries and other forms of dispute resolution, minimising the risk of double Intangibles in a global economy such as joint audit examinations or taxation, there appears to be a Globalisation also has resulted in a the competent authority process, gradual shift from adversarial wide array of issues involving the to avoid or resolve transfer to collaborative approaches to ownership and use of intangible pricing controversies. resolving tax disputes. Indeed, property. As companies expand collaboration is also increasing internationally, they often seek The APA – an agreement between between tax authorities, including to align the ownership and the taxpayer and tax authority an increased willingness on the use of intangible property in a that sets out the method for part of tax authorities to share regional headquarters through determining the transfer pricing information in order to reach cost sharing, licensing, or contract for the subject transactions over an mutually agreed upon outcomes service arrangements. agreed time period – can be used with taxpayers. Some countries to help gain a level of certainty are beginning to offer joint audit on existing structures for future examinations – a coordinated Transfer pricing perspectives: Managing multiple stakeholders in the new economy Industrial products

Recent US regulations regarding cost sharing arrangements have made these structures administratively burdensome

Under a cost sharing arrangement, upon the formation of a cost can prove challenging in certain each participant in the sharing arrangement potentially jurisdictions, where foreign arrangement is a co-owner of could give rise to a significant currency exchange or other intangibles with certain rights tax expense. limitations hamper the ability to to their use. However, recent make royalty payments or subject US regulations regarding cost As an alternative to cost sharing, such payments to significant sharing arrangements have made many industrial products withholding taxes. these structures administratively companies have adopted licensing burdensome. In addition, for models, under which ownership Supply chain management many companies in the industrial of the group’s intangibles are Many US-based customers of products sector with valuable, self- retained by the owner and industrial products companies are developed intangibles, the buy- licensed to affiliates within the moving their operations to regions in payment by a new participant group. Licensing models also with faster growth or lower costs, Transfer pricing perspectives: Managing multiple stakeholders in the new economy Industrial products

forcing suppliers to move with development, and sourcing, which Another important element in them. To meet these global shifts, makes them more responsive managing a global supply chain industrial products companies are to local demands and less of an is the workforce, including the re-examining their supply chain outsider to their customers. recruitment of skilled employees management strategies. in multiple locations. The Global placement of R&D and industrial products Lean manufacturing, which human resources revolves around concepts of As demand for products increases sector as a whole faces a growing continuous improvement and in emerging markets, the need shortage of talent in many innovation, waste elimination, for local distribution channels disciplines, including design and the reduction of total costs, to satisfy local demand is also engineers, project managers, continues to gain traction as increasing. Meeting local demand superintendents, and middle companies struggle to maintain often requires knowledge of local and senior management, leading margins in a highly competitive consumer preferences, which, to intense competition among in turn, may necessitate a build- companies to hire qualified business environment. Companies up of local R&D capabilities to people. While this trend has been are standardizing and simplifying ensure that product innovations somewhat offset recently by lower their product mixes and aligning are aligned with consumer demand due to the recession, it their products and services with preferences. This change in R&D remains relevant for the longer global macroeconomic trends, investment brings with it the term as knowledge and age gaps such as increasing needs for need to consider carefully how to within the workforce continue global infrastructure, clean structure the ownership of any to grow. To be successful in and renewable energy and intangible property, especially tight labour markets, all global energy efficiency, and a more since some countries have weak companies have to provide mobile, networked society. laws in regard to intangible additional incentives to potential Manufacturing companies also are property protection. employees by offering global developing a regional approach training, rapid promotions, and to manufacturing, product attractive remuneration packages. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Industrial products

Increased controversy around Organisation for Economic Co- restructured supply chains operation and Development The restructured supply In reaction to supply chain Transfer Pricing Guidelines for chain must carefully reorganisations by multinationals Multinational Enterprises and Tax reflect the intended shift in in pursuit of growth opportunities Administrations (OECD Transfer functions, assets, and risks in emerging markets, some Pricing Guidelines). While the among the parties tax authorities in developed OECD Transfer Pricing Guidelines countries have sought to protect suggest that such restructurings their tax base by challenging will be disregarded or re- stock or business assets of other the movement of operations to characterized only in exceptional companies at competitive prices. emerging markets that offer more circumstances, companies For some companies seeking to attractive growth opportunities. should expect challenges relating streamline operations and remove These tax authorities argue that to the economic substance non-core assets, reorganization constitutes a and business purpose of such has been an attractive option. “transfer” that should give rise restructurings. Accordingly, when During the economic recession, to an exit charge. It is important, considering an internal business deal volume and value declined therefore, for companies restructuring, multinationals are in most industrial products to consider the operational advised to clearly demonstrate sectors, including chemicals, changes that must accompany a the business purposes and metals, industrial manufacturing, business restructuring. economic advantages relating to transportation and logistics, and the restructuring. engineering and construction. As More specifically, the restructured the economy continues to recover, supply chain must carefully Mergers and acquisitions with improved balance sheets reflect the intended shift in (M&A) indicating more internal financing functions, assets, and risks among Due to recent challenges in capability, and healthier capital the parties. The significance creating organic growth, industrial markets providing more external of this tax issue is highlighted products companies with strong financing, there is an expectation by the release of Chapter IX on balance sheets have taken the that M&A activity will continue Business Restructurings in the opportunity to acquire the to increase. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Industrial products

as well as the status of any rulings for the acquiring company, such Some of the largest business or APAs that may remain in effect as centralising operations or focused transfer pricing subsequent to the acquisition. The intangible property, as well as opportunities that arise acquiring company also has to evaluating the current supply in connection with M&A consider how the transfer pricing chain structure. The post- deals occur during the post- policies of both companies can be acquisition period presents acquisition phase. unified going forward. an excellent opportunity for a company to structure its Some of the largest business intercompany pricing for the More robust M&A activity focused transfer pricing future in a way that is consistent brings with it several pre- opportunities that arise in with its operational and and post-acquisition transfer connection with M&A deals occur financial objectives. pricing considerations. Prior to during the post-acquisition phase. an acquisition, a detailed due During this time, companies diligence review is needed to evaluate the transfer pricing ensure the target company does policies of both the target company not have any material transfer and the acquiring company and pricing exposures that could have look for ways to harmonise the a significant negative impact on structures. When determining the the acquiring company going optimal transfer pricing structure forward. In particular, during going forward, companies the due diligence phase, the should consider any historical acquiring company should look audit exposures, existing APAs, for exposures arising from non cost sharing arrangements, arm’s-length pricing, lack of and tax authority rulings. The transfer pricing documentation, post-acquisition phase also inconsistent transfer pricing may be an appropriate time to policies or application of policies, consider operational changes Transfer pricing perspectives: Managing multiple stakeholders in the new economy Industrial products

Authors

Geoffrey K. Armstrong PwC US +1 267 330 5374 [email protected] Transfer pricing perspectives: Managing multiple stakeholders in the new economy

As the severity of the global financial crisis fades and the Euro zone shows signs of stabilising, governments continue to seek a cure for the economic stimulus hangover.

Progress, but no guarantees for the consistent treatment of intercompany financing transactions Transfer pricing perspectives: Managing multiple stakeholders in the new economy Progress, but no guarantees for the consistent treatment of intercompany financing transactions

Current tax regimes in a Not surprisingly, intercompany post-crisis world financing transactions are Post-crisis: Expect more As the severity of the global highlighted both in the BEPS focus on arm’s length financial crisis fades and the Euro initiative and in three documents pricing & tax treatment zone shows signs of stabilising, published by the OECD in July governments continue to seek a 2013, namely, the Action Plan on cure for the economic stimulus Base Erosion and Profit Shifting, length pricing and tax treatment hangover. Naturally, this remedy the White Paper on Transfer Pricing of these transactions from both consists of a cocktail made of Documentation, and the Revised tax authorities and financial politically sensitive spending cuts Discussion Draft on Transfer Pricing statement auditors. mixed with the comparatively Aspects of Intangibles. sweeter taste of changes in tax This guidance should be welcomed regulations and treaties. Consistent Collectively, these documents because it attempts to establish with this theme, the OECD, in its recognise the transfer pricing and at least some consistency among review of base erosion and profit tax treatment of intercompany global members of multinationals. shifting (BEPS), has been proactive financing transactions in a level For example, in the White Paper on in recognising the pressures that of detail not seen before. This is Transfer Pricing Documentation, the new economy has imposed on not to say they provide guidance the OECD proposes a masterfile the wealth of nations. In short, the to the transfer pricing community portion to documentation review aims to determine whether on how to price these transactions that gives information on a current tax regimes allow for the (this guidance is anticipated with multinational’s intercompany allocation of taxable profits to the release of the revised transfer financial activities accompanied by locations other than where the pricing guidelines in December a local country file demonstrating actual business activity occurs, 2015); rather, they provide a clear that the MNE has complied with and to provide strategies for those indication that we can expect the arm’s length principle in that countries concerned about BEPS. more attention paid to the arm’s country. Clearly the objective is

1 At stake for Tyco is $883.3 million in additional taxes plus penalties of $154 million related to an IRS challenge of intercompany financing with certain international subsidiaries related to acquisitions and restructurings in the late 1990s. At stake for Ingersoll-Rand is a potential levy of $400 million and $700 million of additional withholding and income taxes with respect to a portion of the interest payments on intercompany to a Bermudan affiliate. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Progress, but no guarantees for the consistent treatment of intercompany financing transactions

to improve the ability of a tax Based on the responses, it is clear authority to evaluate transfer that transfer pricing legislation pricing risk specific to individual and general practice with respect financial transactions and to these issues is inconsistent verify the consistent application across territories and, in many of a transfer pricing policy to cases, still evolving. Nevertheless, these transactions. some key themes have emerged from the survey in relation to (i) For financial transactions, whether transfer pricing and thin the proposed approach to capitalisation rules are embedded documentation is superficially in ; (ii) generally accepted simple and yet fundamentally methods to evaluate arm’s length complex, as evidenced by our interest rates on intercompany PwC survey of 40 countries ; (iii) the preferred method that addresses these issues. The to evaluate the arm’s length survey focuses on country-specific nature of guarantee fees; and legislative requirements for pricing (iv) whether passive association of intercompany loans as well (i.e. where the creditworthiness as staff’s experience with tax of the subsidiary is evaluated authorities’ positions on various based on its membership in a aspects of the transfer pricing of multinational group and assumes financial transactions.1 that the parent will intervene if the subsidiary encounters financial difficulty) should be accounted for in analysing arm’s length interest rates and guarantee fees.

1 http://www.pwc.com/managingthecomplexity Transfer pricing perspectives: Managing multiple stakeholders in the new economy Progress, but no guarantees for the consistent treatment of intercompany financing transactions

Transfer pricing and thin comparable uncontrolled price take into account the terms and capitalisation rules (CUP) method; over 80% of conditions of the and the While transfer pricing rules respondents indicated that the creditworthiness of the related and thin capitalisation rules CUP method is accepted, with the party debtor based on a are embedded in the tax law of remaining respondents reporting scoring analysis as a distinct and most responding countries, the no clear guidelines on accepted separate enterprise. Bank quotes transfer pricing rules are often not methods or very specific rules in are accepted in approximately one- specific to financial transactions the transfer pricing regulations. third of the responding countries, (such rules that explicitly but typically only as secondary address financial transactions Application of the external evidence of the arm’s length nature primarily address intercompany CUP method should typically of the applied. loans, in particular in terms of volume and interest rate, with only limited rules addressing Survey: CUP intercompany guarantees and Generally accepted methods to evaluate arm’s length method most cash pooling). To the extent that a interest rates on intercompany loans country lacks specific guidelines commonly used for evaluating transfer pricing External CUP for evaluating applied to intercompany financial 84% arm’s length transactions, the broader guidance Bank quotes interest rates provided in the OECD Transfer 24% Pricing Guidelines is typically Unclear/no preference referred to. 16% The most commonly accepted method to evaluate arm’s length interest rates on intercompany loans is the internal or external Transfer pricing perspectives: Managing multiple stakeholders in the new economy Progress, but no guarantees for the consistent treatment of intercompany financing transactions

The CUP method and the benefit and (ii) the multiplication of method are the most commonly the expected frequency, Generally accepted methods to evaluate the accepted methods to evaluate the underlying asset valuation, arm’s length nature of guarantee fees arm’s length guarantee fees for and the loss given default of the intercompany guarantees. The guaranteed asset. Benefit approach benefit approach analyses the 61% interest rate benefit obtained as a As the results show, there is no Cost of capital approach result of the guarantee and splits common approach for accounting 53% this between the guarantor and for passive association in Internal/external CUP the guaranteed. substantiating the arm’s length 69% nature of interest rates and Credit default swaps Other methods often accepted are guarantee fees. Nonetheless, the 36% the cost of capital approach, where OECD embraces the concept of Other approach the guarantee fee is determined implicit support in the Revised 25% based on the cost of the guarantee Discussion Draft on Transfer Unclear to the guarantor (typically Pricing Aspects of Intangibles, 28% determined by analysing expected which includes an example that loss on the guarantee and the recognises that implicit support cost of capital to be maintained is a synergistic benefit and not a Passive association/implicit support in relation to the guarantee), and compensable benefit. analysing the fees paid on credit Yes Unclear/ No preference default swaps on bonds with 17% characteristics comparable to 47% the guaranteed transaction (i.e. primarily the credit rating of the No guaranteed). Other approaches 36% include calculating the guarantee fee as (i) the value of a put option; Transfer pricing perspectives: Managing multiple stakeholders in the new economy Progress, but no guarantees for the consistent treatment of intercompany financing transactions

Conclusion: Challenges OECD should be welcomed from presented by inconsistency a compliance perspective. In the and unclear guidance interim, common practices can The PwC survey highlights the be identified to help ease some current inconsistency and lack of of the compliance burden. These clear guidance in global transfer practices can also be used as a pricing rules and in the planning basis for the master file and local and management of intercompany country documentation discussed financial transactions from a in the White Paper for Transfer transfer pricing perspective. This Pricing Documentation when collectively presents challenges in addressing an organisation’s main the global context, and the 2015 financial transactions. guidance anticipated from the Transfer pricing perspectives: Managing multiple stakeholders in the new economy Progress, but no guarantees for the consistent treatment of intercompany financing transactions

Authors

Krishnan Chandrasekhar PwC US +1 312 298 2567 [email protected]

Wout Moelands PwC UK +44 0 20 7213 8168 [email protected]

Jeff Rogers PwC US +1 416 815 5271 [email protected]

Michel van der Breggen PwC Netherlands +31 0 88 792 75 23 [email protected] Transfer pricing perspectives: Managing multiple stakeholders in the new economy

The authors urge financial institutions to integrate their transfer pricing execution and reporting with the implementation of modified financial reporting processes arising from recent regulatory changes, noting the greater need for regulated entities to prove out and consider inter-company transactions from all angles and provide arm’s length support for each participant’s results.

Regulatory reform in the financial industry and end-to-end transfer pricing execution Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

The recent financial crisis made How will regulations affect will be uniformly increasing clear to the world that the current banks’ global capital usage under Basel III and some countries operative regulatory rules and and other operations? will be going beyond Basel III oversight were ill-suited to the way When the Dodd-Frank Wall requirements.1 However, local financial markets have evolved. Street Reform and Consumer regulatory definitions of types of And that reform was long overdue. Protection Act was signed into capital that meet the various tiers Undoubtedly regulatory reform law in 2010, banks as well as or the risk-weighting of assets is a global agenda addressing non-bank financial institutions are still in flux with potential multiple fronts. Countries active in braced themselves and started inconsistencies that banks now the global financial markets have to devote significant resources need to consider in optimising been taking measures to improve to preparing for the significant their global capital usage. the controls governing the capital fundamental changes to their markets, with the immediate compliance, reporting and objective of protecting their own operational structures. The U.S. economy and fiscal health. These was the first to adopt such broad measures include improving regulatory reform into law, but transparency in securities trading other countries are fast on its among market participants and heels, with provisions regarding individual investors as well as capital requirements, ring-fencing tightening legal entity accounting and other measures. Whether and valuation protocols within a these separate country initiatives global institution. The U.S. has will converge into a consistent and certainly been the most assertive common regulatory landscape and prescriptive in pushing in application is undetermined. legislation around these measures. Regulatory capital requirements

1 In addition to risk-based capital requirements, U.S. regulators are proposing a higher leverage ratio for the eight largest U.S. bank holding companies that have been identified as global systemically important banks and their FDIC- insured bank subsidiaries at 5 percent and 6 percent, respectively. See Crittendon, Michael, ‘‘Plan Reins In Biggest Banks: Proposal Requiring Extra Capital Would Force Firms to Be More Conservative or Shrink,’’ Wall Street Journal, July 9, 2013. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

One thing that is evident is that world. But this is an area in which Regulatory institutions need to tighten up on many financial institutions have reform’s impact on controls, process and execution considerable process and system intercompany arrangements of their governance policies, not challenges. Many have seen The clearest manifestation of least of which relates to their acquisitions as a means to achieve regulatory reform’s impact on intercompany arrangements their growth strategies, which have intercompany arrangements and dealings. led to managing different types of originated in the U.S. through legacy systems – whether at source specific provisions of Dodd-Frank. Ability to generate data level or reporting platforms The U.K. has also recently enacted standalone legal entity – without having properly and a rule requiring a nominated fundamentally reconciled these ‘‘senior accounting officer’’ to financial statements key to disparate systems. Global financial verify that financial statements compliance, but challenges institutions have highly integrated reflect appropriate tax accounting are plenty operational structures heavily arrangements. As other countries reliant on shared technology, continue their own local agendas, One of the chief impacts of operations, management and a closer examination of these these measures in the emerging other critical infrastructure across recent laws is mandatory in regulatory environment is the multiple legal entities. Historically, evaluating whether an institution requirement of institutions to they have not always applied the is capable of reporting under these reliably and accurately produce same level of diligence in accurately new standards. separate legal entity reporting processing their intercompany of their financial positions on arrangements as they do for third- This analysis begins with a review an ongoing basis. The ability party transactions, despite the fact of the specific key provisions to generate stand-alone legal that for many overseas subsidiaries under Dodd-Frank for which entity financial statements is the of U.S. financial institutions successful compliance with the cornerstone of an institution’s intercompany transactions new regulatory requirements ability to comply with the various represent the greater part of is acutely affected by the regulatory changes around the their income. institution’s operational execution Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

of intercompany and affiliate Impact of Dodd-Frank For third-party dealings, the transaction pricing policies. Often At the heart of Dodd-Frank is the general accounting rules and transfer pricing policies have been need to ensure that a regulated regulations tend to ensure viewed in isolation as a cross-border institution is adequately capitalised appropriately transparent tax matter with an occasional nod and that it is sufficiently protected accounting and operational to its U.S. regulatory equivalent – from risk that is created or borne by processes as a general matter. the Federal Reserve’s Regulation W affiliates. All roads therefore lead to However, the strict processes, implementing Sections the following fundamental question procedures and discipline around regarding separate-entity reporting external market transaction 23A and 23B of the Federal of the affected regulated entities accounting and disclosures have Reserve Act.2 However, there is and the operational framework: Are often not been carried through to now wider recognition that the the assets, liabilities, revenues and intercompany and affiliate dealings. tax and regulatory governance of expenses reported by the regulated An extreme scenario, which is intercompany arrangements needs entity complete, appropriately not uncommon among some of to be reconciled, both from a policy valued and appropriately classified? the largest and most complex as well as an execution perspective. institutions, is one in which all

2 These provisions govern transactions by a U.S. bank with its affiliates. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

intercompany transactions are that is legal-entity neutral captured and accounted for Strict discipline around (that is, based on a region or on a net basis through a single external market transaction a business segment) than on below-the-line intercompany accounting and disclosures separate legal entity results. settlement account irrespective has often not been carried This has deemphasised the of the nature of the intercompany through to intercompany need to understand legal entity arrangement – often with poor and affiliate dealings relationships and to ensure audit trails back to the source. Not that transactions are fully least of the distortions created recognissed and recorded at the by this simplified accounting between the costs incurred local statutory levels. is that on a gross basis, a firm’s by the firm and the ultimate assets, liabilities, revenues or end-user business unit or legal • To date, statutory audit and costs are understated. This has entity that might rely either accounting governance has immediate implications on the directly or indirectly on these focused on controversial same inputs that drive capital centralised resources. In turn, accounting methods such requirement calculations. there has been a vast increase in as Repo 1053 rather than on cost centers that require active intercompany transactions with A few factors have created mapping and profit or revenue the proviso that they should the more lax operational center allocations. Further, completely eliminate at top-level environment around intercompany various entities might serve as consolidations, notwithstanding transactions as compared to this operational or management that local statutory financial external transactions: hub, and therefore an end-user statements would reflect their of one service is a provider side of the offsetting accounts. • The increasing centralisation of another. of operations within most As a result, as firms try to align multinationals has created • Many firms are measured more their operational, governance and a less direct accounting link on management reporting control infrastructure to comply

3 Under Repo 105, a short-term deposit is classified as a sale, and the resulting cash is used to pay down debt. This allows the company to appear to reduce its leverage for purposes balance sheet reporting. After the reports are published, the company borrows cash and repurchases its original assets. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

with Dodd-Frank and other For a regulated entity that relies disposals or bankruptcy. In any regulatory requirements, the status significantly on its affiliates for of these scenarios, being able to of an institution’s intercompany revenue, services and balance provide accurate separate-entity and transfer pricing policy sheet usage, the accurate financial positions is critical to execution framework has become execution of the intercompany the efficacy of the plan. Given one of the primary areas of focus. dealings is essential to the that most regulated entities question of the required level of generally rely heavily on resources There are a few key initiatives and capital for that entity if valued on not directly within the control provisions within Dodd-Frank a pure, stand-alone arm’s-length or sponsorship of that entity, in particular for which the level basis in which all the support a significant element of their of intercompany and transfer provided by its affiliates (or that financial position is driven by its pricing operational framework is it is providing to other affiliates) intercompany dealings – including most visible. The initiatives to be are appropriately measured and the need to capture service discussed in this article are: reported on the balance sheet and fees and cost allocations due to income statement. services being provided by an • capital requirements, affiliate. Therefore, it is essential • resolution and recovery Resolution and that the intercompany policies plans and recovery planning in place are implemented and • swaps and derivatives push- Resolution planning requires that executed correctly. out rules. large U.S. banking organisations and certain designated The execution includes ensuring Bank capital requirements systemically important non-bank not only that the correct costs Adequate capitalisation of a legal financial companies submit to the and revenues are included in the entity is based on the riskiness of regulators on an annual basis a calculations, but that the legal the assets and liabilities on – and resolution plan for their market- agreements are explicit about in some cases, off – its balance facing regulated entities under the nature of the services or sheet and the stability of the a hypothetical failure scenario. goods being made available along revenues it derives and costs it Usually the plans include courses with the risks. The exercise of bears to drive its profitability. of action for recapitalisation, preparing a resolution plan starts Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

with a hypothetical scenario of should naturally already be priced to non-bank affiliates subject to being cut off completely from the and settled at arm’s length and Regulation W requirements. support of affiliates. What are properly reflected on a stand-alone the operational, financial and basis today. This raises two scenarios regarding management support functions intercompany arrangements: that must now be provided Swaps and derivatives push by an external party – and at out rule • a one-time intercompany what price would the regulated Under the swaps push-out rule transfer of the associated entity be charged? Once these of Dodd-Frank, U.S. banks are business or assets and dependencies are identified, the required to push out certain • potentially new or revised existing intercompany transactions swaps and activities intercompany arrangements.

The question of a one-time intercompany transfer of a business or assets requires appropriate valuation of the related business or assets. As most assets, especially financial instruments, are generally accounted for on a mark-to- market basis, this should not be a significant issue. However, if there is a transfer of a broader business, then one must consider a more holistic valuation of the business itself, which includes identifying

5 Net interest is calculated as interest expense to related parties less corresponding interest income. Adjusted income is defined as , adding back interest expense, depreciation expense and exempted dividend income, but excluding extraordinary income or loss. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

the projected cash flows that account for prospective inter- company services expected to be performed. Generally, projections rely on past and current actual levels of costs and revenues, and therefore it is important to ensure that current execution of transfer pricing policies have resulted in accurate charges and service fees so that the projections built on historic figures are reliable and not distortive to the overall valuation. to ensure that the separate- the U.S. banking regulatory world Similarly, when a segment or entity reporting of the business has Regulation W implementing business is transferred from is accurate and complies with Sections 23A and 23B of the one legal entity to another, new regulatory requirements. Federal Reserve Act. There are a intercompany arrangements few nominal but real differences may be created due to the fact Arm’s-Length Pricing: between the two in their that some of the activities in ‘Reg W,’ Section 482 respective historic applications, support of the swap business There has always been a natural the most notable being that the that formerly were carried out overlap between the regulatory Section 482 regulations generally by the same legal entity will not oversight of bank transactions provide a multi-party evaluation of or cannot migrate with the swap with affiliates and the rules the arm’s-length pricing from the trading activities. Therefore, these governing related-party pricing perspective of all participants to new intercompany services will for tax purposes. The tax world the transaction, whereas Section need to be identified, priced and has regulations under Internal 23B is usually one-sided, from the ultimately executed appropriately Revenue Code Section 482, while perspective of the regulated entity Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

only. That is, the bank transaction service and other transactions with third-party terms and conditions? is on pricing terms that are at affiliates are on market terms and In this context, it is then expected market rates or better, irrespective conditions. The purpose of Section that market prices and terms of results to the non-bank affiliate. 23B is to ensure a bank is not should already be reflected in using service contracts as a way to the prices and terms for all of the A brief background and unfairly shift costs of operations to affiliated service transactions history of each would be the bank, which can be financially and relationships in place today. helpful to understanding why damaging to the bank and a Further, as an entity regulated this coincidence and overlap means for non-bank affiliates to under the one regulatory body has evolved into an outright price more aggressively than their such as the Federal Reserve may convergence of principles and competitors. Much of Sections 23A be transacting with another entity governance across the two regimes and 23B focus on enumerating that is regulated under another since Dodd-Frank. financial and securities dealings agency such as the Financial with affiliates as greater concerns Industry Regulatory Authority Sections 23A and 23B make of the regulators. or the Commodity Futures clear that the primary concern Trading Commission with similar of regulators is to ensure that With Dodd-Frank as the catalyst, expectations of market pricing in an entity is not, by virtue of affiliate service transactions have affiliate transactions, the axiom its dealings with its affiliates, become much more prominent as of ‘‘market price or better’’ is inadvertently exposed to its entities work on provisions such compressed into ‘‘market prices,’’ affiliates’ financial and operational as resolution planning. Resolution with less bandwidth for a onesided risks. Section 23A has a long planning forces regulated entities evaluation. Similarly, other bank history and is basically intended to to imagine being completely cut off regulatory bodies such as the ensure that banks are not unduly from affiliates. What management, Office of the Comptroller of the exposed to credit risks arising from operational, administrative, Currency and the Federal Deposit transactions with affiliates. Section infrastructure and other types of Insurance Corporation have an 23B has a much shorter history and support would they now need to expanded role under Dodd-Frank is intended to ensure that a bank’s contract with third parties under to interpret and apply Sections Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

23A and 23B to arm’s-length How exactly a bank can go about governance process to address transactions between banks and substantiating the market value of cross-border transactions is the non-bank affiliates. its affiliate pricing arrangements natural starting point to see how is not addressed. As a result, these can be extended and applied A bank’s transfer pricing banks’ historic experiences with to affiliate transactions involving compliance process on its cross- regulators on this issue, according regulated entities, whether border related-party transactions to anecdotal evidence, have been domestic or crossborder. And is the obvious and ready platform inconsistent and unpredictable. even more critical to regulatory for regulatory compliance on Banks’ more recent experience compliance is the execution affiliate transactions. For starters, speaks to more proactive scrutiny framework once transfer pricing the Section 482 regulations are of affiliate service transactions policies have been established. vastly more rigorous than Reg W, with a dramatic uptick in requests Section 23B in the requirements for supporting documentation and U.K. senior accounting to substantiate the arm’s- analyses. No longer are regulators officer provisions length nature of related-party satisfied that some charge has In 2009, the U.K. introduced transactions. The Section 482 been made and that the results senior accounting officer (SAO) regulations provide for specific are not unfavorable to the bank. rules that require qualifying methods that can be applied in They want the assertive analysis companies to nominate an SAO evaluating these transactions and that the value of the charge is that is personally responsible for require that the taxpayer consider comparable to what would occur taking ‘‘reasonable steps to ensure the appropriateness of each in a third-party arrangement and the qualifying company establishes method before selecting the best have started to more fully align, and maintains appropriate tax method to apply. intentionally or unintentionally, accounting arrangements.’’ with the provisions and standards Within the rules, tax accounting Section 23B does not elaborate of the Section 482 regulations. arrangements are described as further than the requirement the end-to-end process ‘‘from the that affiliate pricing should be Therefore, a bank’s existing comparable to market prices. transfer pricing policies and Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

initial data input into accounting SAO rules. arm’s-length support for each systems to arriving at the participant. Add to this the lack of numbers which form the basis for Transfer pricing underlying execution groundwork completion of the tax return.’’ execution framework and systems support, and financial It is therefore growing increasingly institutions are faced with an In 2012, following revisions to the important for financial institutions extremely challenging time with original rules, banks were brought to be able to ‘‘prove out’’ the significant constraints. within scope of the SAO rules such implementation or execution of the that today, banks with sizable U.K. policy in their books and records. In some instances the issue may operations are likely to qualify and This step is an integral part of the be even more acute – for example, be required to certify compliance end-to-end processes and data in locations where the majority with the SAO rules each year. flows that take a transfer pricing of the activity is intercompany, strategy all the way through to with little third-party activity. Many banking institutions local financial statements and tax This results in jurisdictions where will have transfer pricing returns. This end-to-end execution the impact of inaccuracies in policies that cover material is even more important for transfer pricing execution for cross-border transaction flows. regulated entities in their reporting one transaction may result in The implementation of these for intercompany transactions. material errors and restatements. transactions may involve tax The difficulty in managing this accounting arrangements that The increasing importance of legal level of vulnerability can affect a span multiple jurisdictions entity governance continues to put company’s effective . and require data from several transfer pricing execution higher information sources. The on the agenda of executives and Execution risks complexity of these arrangements controllers. Where a unilateral Large financial institutions in mean transfer pricing execution is focus was historically allowed, particular have built up constraints becoming increasingly important institutions are now faced with the and obstacles over time due to for banks operating in the U.K. requirement to look at transactions the highly complex nature of that are required to comply with from all angles and provide their operations. These transfer Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

pricing execution challenges often Improper governance around have not reached an audience intercompany flows presents a Risks of improper outside of the tax department. variety of execution risks. To governance The various financial reporting illustrate how this risk can play out around systems used for controllership and potentially snowball, consider intercompany purposes are often not adequately the impact from local affiliate flows or optimally designed to source perspectives. Local profitability in and aggregate the types of data some locations of the firm may be required to identify and process highly or exclusively dependent intercompany transactions. Since on intercompany relationships, most firms are more concerned the proper execution of policies, with accuracy of financial and the appropriate reporting of reporting at the consolidated level, revenue and expenses on local governance on separate legal statutory books and records. Along entity accounting for the various those lines, if transfer pricing intercompany transactions often policies are otherwise designed to is lax or nonexistent, resulting in properly allocate profits and losses journal entities and accounting to affiliates operating in multiple treatment for the resulting flows. countries with different tax Intercompany balances may rates, improper execution leaves or may not be properly settled incorrect local taxable income on a timely basis, which can bases and therefore can affect a distort balance sheets through firm’s global effective tax rate. This semipermanent receivables and can also affect deferred tax assets. payables balances. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

Symptoms of transfer pricing adequately maintain and monitor Where to begin execution challenges the transfer pricing results; Companies can establish a more Transfer pricing execution strategic approach to managing difficulties stem from a number of • undocumented interpretations intercompany processes that sources. When multiple difficulties of ambiguous terms in moves beyond typical ad hoc are present in one instance, the intercompany agreements; activities and manual data uphill battle to execute transfer collection and also aligns all pricing policies can be exhausting • informal process hand-offs relevant control groups to more and frustrating. As outlined relying on goodwill and personal effectively monitor and implement earlier in this article, the picture relationships, which create intercompany policies and is similar for large financial multiple manual processes; procedures. Successful companies institutions trying to ensure their focus on the people, process, and intercompany and affiliate pricing • quarterly or annual close technology aspects to bring their is executed accurately. processes creating frustrations organisations into alignment for tax, controllership and around the relevant transactions Some typical symptoms of information technology; and processes. intercompany execution challenges include: • transfer pricing results For banks and other regulated themselves that are not consistent institutions, this means a renewed • ‘‘hero dependency’’ – the from period to period and cannot focus on developing a transparent overreliance on key individuals be easily explained, which and collaborative team that works – in tax and accounting mean that effective tax rate towards the same goal while or controllership; forecasts are hampered by lack achieving personal goals along of information at the entity or the way. • a patchwork of data sources country level; and and Excel spreadsheets, and The value to be realised concern that enterprise and • ‘‘near misses’’ and concern The more efficient and aligned the resource planning system do not about the SarbanesOxley functions involved in executing provide sufficient functionality to controls position. intercompany pricing that feed Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

into local statutory accounting, and functional groups, and the more value can be realised. ultimately across the branches Get more out of what you Examples of value typically and legal entity subsidiaries in are already doing observed include: which they operate. This has resulted in greater reliance on • statutory and regulatory one another among branches and So what does this mean for requirements that are separate legal entity subsidiaries the financial institutions’ met in a more timely and for capital, infrastructure and current efforts? efficient manner, operational support. Not least of • reduced audit risks, the affects of banking reform is One immediate opportunity • better internal tax controls, the heightened need for end-to- is to get more out of what you • a faster close process, end processes that are complete, are already doing. For starters, • automated and standardised reliable and sustainable to financial institutions have already data collection processes and ensure accurate and complete been doing a lot since the early transfer pricing calculations, execution of intercompany pricing winds of regulatory reforms were • rationalised IT and policies. Therefore, as a financial felt post-2008. These efforts have systems investment, institution navigates through the included, among others: • decreased costs of audit defense, ongoing changes in the regulatory • improved cash tax management, landscape, in developing strategy • legal entity rationalisations, • a completed transfer pricing and planning for regulatory • business unit realignments scenario analysis, and compliance and optimising capital and migration, • reduced indirect tax usage across the globe, all control • diagnostics of systems compliance costs. groups within the institution – capabilities and constraints and legal, regulatory, treasury, finance • modification or new builds of Conclusion and controllership as well as tax – financial systems including Today’s financial institutions require an active seat at the table. revised or new reporting operate in a highly integrated hierarchies and improved manner across multiple regions integrity of source data flows. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

Given how highly dependent • Identifying opportunities to • Expanding, modifying regulatory compliance might improve accuracy and efficiency or designing the overall rest on accurate and efficient in intercompany pricing data policies and processes execution and reporting of sourcing, calculations and governing intercompany intercompany transactions, reporting. This may include pricing calculations, journal proactively considering and transfer pricing input into the postings and reporting. These implementing intercompany as definition of profit and cost should include unambiguous well as third-party transactions in center attributes, mapping or sets of policies, roles and the existing work streams is both hierarchies by legal entities at responsibilities across all necessary and highly beneficial. the source data level. the relevant control groups In addition, such activity such as tax, business unit and might involve only incremental • Expanding, modifying or legal entity controllerships, supplementing of the existing designing reporting capabilities regulatory, treasury and legal resources and expenses relative to to improve transparency of departments. Continued the size of the overall investments. intercompany transactions. governance in the development This may include trying to of segmented legal entity Below are just a few examples of automate as much as possible reporting and implementing how including transfer pricing the aggregation of certain data, appropriate procedures around as an important stakeholder and calculations processed directly this process ensures that the sponsor in aspects of regulatory in the system and providing value of the initial investment reform initiatives can optimise the analytics for more efficient and and control level are realised and results from the large investments flexible sensitivity analyses optimised over the long run. currently being made in the way to monitor intercompany of internal resources, costs in- transactions and impacts on each In this regard, the authors suggest legal entity. that the institution formally curred for infrastructure changes include transfer pricing policy and use of external advisers: execution and accounting as an Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution objective of regulatory reform project plans due to the natural The authors synergies mentioned above. Tax, view the work transfer pricing and intercompany currently being accounting control teams should undertaken on be involved at the appropriate financial reporting stages throughout the life cycle of institution these projects to assist in defining reporting data and reporting requirements, as a natural and ongoing process and and critical governance procedures. opportunity The authors have assisted with to embed the and witnessed the short-term and data, reporting long-term benefits of strategic and control alignment of resources, budgets requirements and objectives on infrastructure around to meet multiple objectives. As intercompany advisers actively working with transactions. institutions in their respective response to regulatory reform and compliance efforts, the authors view the work currently being undertaken on financial reporting institution reporting as a natural and critical opportunity to embed the data, reporting and control requirements around intercompany transactions. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Regulatory reform in the financial industry and end-to-end transfer pricing execution

Authors

Adam Katz PwC US +1 646 471 3215 [email protected]

David Nickson PwC US +1 646 471 6814 [email protected]

Monica Winters PwC US +1 646 471 9064 [email protected]

Reproduced with permission from Bloomberg BNA’s Transfer Pricing Report, Vol. 22, No. 12, 10/17/13, The Bureau of National Affairs, Inc. (800-372-1033) www.bna.com. Transfer pricing perspectives: Managing multiple stakeholders in the new economy

The new Russian transfer pricing rules came into effect on 1 January 2012.

Russia’s new rules: Overview and practical aspects Transfer pricing perspectives: Managing multiple stakeholders in the new economy Russia’s new rules: Overview and practical aspects

The new Russian TP rules came Starting from 2013, the financial and penalties for non- into effect on 1 January 2012. In thresholds for controllable compliance;1 comparison with the old rules, transactions will decrease and • introduction of APA procedures; which were outlined in Article more transactions will potentially • practical hints and 40 of the Russian Tax Code (the fall under control from the Russian recommendations for Code), the new rules are largely TP perspective, thus increasing Russian taxpayers. based on TP Guidelines of the the volume and the complexity of Organisation for Economic Co- the analysis. Overview of tax authorities’ operation and Development structure (OECD), but also contain certain The main changes in the Code Prior to discussing the substance peculiarities that can trigger in relation to TP include, among of the main changes to the TP TP issues for both related and others, introduction of the arm’s rules and relative practical unrelated companies transacting length principle as a fundamental recommendations, we provide a with domestic and cross border principle of the Russian TP rules, brief overview of the structure counterparties. A number of setting the ownership ratio at established to oversee TP matters amendments regarding the which companies are considered by the Russian tax authorities. deadlines for submission of related at 25 percent, etc. In order to monitor compliance the 2012 TP notification on with the newly established rules controllable transactions and TP This article focuses on: and to perform tax control, documentation were recently the Ministry of Finance of the introduced into the rules. Due to • changes in the Russian tax Russian Federation established the fact that the deadlines have authorities’ structure aimed at a new department dedicated been moved, companies now have TP matters and introduction of to TP issues (Department of more time for 2012 TP compliance. special TP audits to be conducted International Relations and However, taxpayers should start by the Federal Tax Service (FTS); Transfer Pricing of the FTS). planning the TP documentation • introduction of reporting and The main functions of this process for 2013 beforehand. TP documentation requirements department include performance

1 No penalties can be assessed for 2012-2013 transitional years in case of TP adjustments Transfer pricing perspectives: Managing multiple stakeholders in the new economy Russia’s new rules: Overview and practical aspects

of TP audits, conclusion of supporting the automatic selection APAs, analytical and tax of taxpayers for TP audits. Russian taxpayers control procedures. could be facing The above changes imply that the audits from the In addition to that, the FTS and the Russian tax authorities intend to Department of Federal Anti-monopoly Service set pay close attention to TP matters. International up a dedicated workgroup dealing Their knowledge of basic principles Relations and with TP matters. Its main objective will gradually grow and they will Transfer Pricing is to propose improvements to tax increasingly apply international in connection and antitrust legislation in the area practice in Russia. with controlled of identifying arm’s length prices. transactions and the This work- group is expected to Russian taxpayers could be facing arm’s length nature focus on common approaches to audits from the Department of the pricing, as well law enforcement practices. of International Relations and as audits from the Transfer Pricing in connection with regular federal tax Further, the Specialised Inter- controlled transactions and the inspector on general regional Inspectorate for TP arm’s length nature of the pricing, tax matters. was created in April 2012 and as well as audits from the regular currently employs approximately federal tax inspector on general 200 specialists. Its main functions tax matters. These audits could include collecting, processing happen at different times and will and analysing information on be independent of each other. intercompany transactions, analysing and evaluating market TP compliance prices, identifying mechanisms for Taxpayers are obliged under tax underpayment, responding to the Russian TP rules to prepare TP inquiries from central and local and submit notifications on government authorities as well as controlled transactions and TP Transfer pricing perspectives: Managing multiple stakeholders in the new economy Russia’s new rules: Overview and practical aspects

documentation which may be • the subject of the controlled trigger more questions. In order requested by the Russian tax transaction, including the to maintain good relationships authorities. The list of transactions relevant contract number, the with local tax authorities, Russian subject to TP control specified by amount, delivery terms and taxpayers should strive to be the Code includes cross border the price; fully compliant with the new and domestic transactions • the legal entity/ individual TP requirements. between related parties, as well which is party to the as a number of other transactions controlled transaction. B. Documentation which may be considered as In the autumn of 2012 the Russian controllable (such as foreign trade The Russian tax authorities tax authorities issued a Letter3 transactions with exchange traded indicate that the notification providing detailed guidance commodities, etc.). should be prepared for each and practical recommendations controlled transaction, therefore on preparing and filing TP A. Controlled filing of notifications may prove documentation, as prescribed by transaction notification to be quite a cost- and time- the Code. Although the Letter Corporate taxpayers conducting consuming process. Although the is non-binding, the guidance business in Russia need to prepare penalty for non-submission of the it provides is useful and it will and file the notification on TP notification is not high,2 the likely be applied by the tax transactions subject to TP control risks for taxpayers could be quite authorities during their reviews of annually in order to comply with significant. As the notifications will taxpayers’ documentation. the reporting requirements. The be used by the tax authorities for notification form should contain conducting a pre-audit review and In addition to the Code, this Letter information on the following: selecting entities to un- dergo tax explained how to classify parties to control measures, non-submission a transaction, which transactions • controlled transactions, of this form or submission of require documentation and how including the amount of income an improperly completed form to select a pricing methodology, derived and expenses incurred; may serve as a ‘‘red flag’’ and the content of the documentation,

2 RUR 5,000, approx. US$150. 3 Letter of the Federal Tax Service dated 30.08.2012 No. OA-4-13/14433 ‘‘On the preparation and submission of documentation for the purposes of tax control’’ Transfer pricing perspectives: Managing multiple stakeholders in the new economy Russia’s new rules: Overview and practical aspects

the level of detail required in the tax authorities may request TP separately and taxpayers should documentation, the filing deadline documentation, namely during a consider the specific features and and the archiving period. TP audit or at any time after June economic circumstances of each 15 of the year following the year in controlled transaction (a group of The Letter indicates that taxpayers which the controlled transaction homogeneous transactions). must file documentation at the took place, irrespective of whether request of the FTS.4 The FTS a TP audit has been commenced. For 2012 – 2017, the Russian reckons that the taxpayer’s tax authorities have set a document filings will be used for When preparing the transitional period during conducting a pre-audit review and documentation, taxpayers which the financial threshold selecting an entity to be subject should consider that Russian for controlled transactions will to a TP audit, as stipulated in tax authorities prefer the gradually decrease. The summary Chapter 14.5 of the Code. There transactional approach. Thus all of documentation requirements is are situations in which the Russian transactions should be analysed presented in Table 1.

Table 1: Documentation requirements Period of audit Requirements on preparation of TP documentation Penalty for non- submission Cross-border transactions Domestic transactions 2012 n/a if> 100 mln RUR (appr. US$ 3,5 mln) if > 3 bln RUR (appr. US$ 107 mln) 2013 n/a if> 80 mln RUR (appr. US$ 2,8 mln) if > 2 bln RUR (appr. US$ 71,4 mln) 2014-2016 20% all transactions if > 1 bln RUR (appr. US$ 35,7 mln) 2017 40% all transactions if > 1 bln RUR (appr. US$ 35,7 mln)

4 Art. 105.15.1 Code 5 For year 2012 this date has been moved to December 1. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Russia’s new rules: Overview and practical aspects

C. Filing deadlines of notification, request of to Federal Law No.39-FZ, the As the rules are fairly new, documentation by tax authorities Russian tax authorities provided the authorities continuously and TP audit are summarised in recommendations in relation to develop them and introduce Table 2. loans only in unofficial discussions necessary changes. One of the and Q&A sessions. The Law most important changes has been The deferral of deadlines is an put an end to this ambiguity recently introduced, including the opportunity for taxpayers to and gave more clarity on new deadlines for submission of increase the quality of their TP financial transactions. TP notifications. documentation –the tax authorities will widen their expertise and According to the recent Federal Law No.39-FZ of April 5, be much more prepared by 30 clarification, the TP rules will not 2013, introduced amendments June 2014. apply to transactions concluded regarding deadlines for before 1 January 2012 which submission of the 2012 notification D. Intercompany financing relate to bank loans, loans granted on controlled transactions The new TP rules did not by non-banking organisations and preparation of 2012 TP provide clear guidance on (including commodity and documentation reports. The TP control for intercompany commercial loans/deferrals of new dead- lines for submission financial arrangements, as prior payments), guarantees, except for

Table 2: Deadlines Document Earlier established deadline New deadline Submission by taxpayers of the notifications on controllable transactions 20 May 2013 20 November 2013

TP documentation may not be requested by the tax authorities earlier than 1 June 2013 1 December 2013

The deadline for the issuance of the decision on the initiation of the 2012 TP 31 December 2013 30 June 2014 audit not later than Transfer pricing perspectives: Managing multiple stakeholders in the new economy Russia’s new rules: Overview and practical aspects

transactions for which the terms a number of different groups of were changed after 1 January controlled transactions. Russian taxpayers should 2012. Therefore, if a taxpayer prepare TP documentation needs to change the terms of Further to the introduction of and submit TP notifications the loan due to certain business actual TP rules, the Russian 6 for controllable reasons, it is recommended that tax authorities issued a Letter transactions those changes are done under the providing more specific guidance frame of a new contract. on how the new rules will be implemented. Among other airline company, Aeroflot. In APA programme availability practical recommendations, the addition to that, up to 70 more The new TP rules introduced Letter introduces a pre-filing stage companies have applied for APAs APA procedures for the ‘‘largest’’ when taxpayers could evaluate the and are in negotiations with the taxpayers. The main aim in cost effectiveness of conducting Russian tax authorities (pre-filing concluding an APA is to facilitate an APA. According to the Code the and filing stages). negotiations between the taxpayer APA period cannot exceed three and the tax authorities in order years and can be renewed for no All four APAs with so far concluded to avoid disputes regarding more than two years. Breaching have been unilateral. While TP issues. It is worth noting the APA’s provisions entails a there is a possibility to conclude that unilateral or bilateral APA penalty of RUR 1,500,000.7 bilateral APAs, we anticipate that procedures are available and it will take some time them to be could be concluded only for one By mid-2013 the Russian tax implemented in practice. specific type of transaction (group authorities had concluded of homogeneous transactions). three APAs with large Russian Practical hints Therefore the conclusion of APAs companies from the energy sector and recommendations could be rather time-consuming (Rosneft, Gazprom and Lukoil) As outlined above, Russian and costly for the taxpayer if it has and one with the largest Russian taxpayers should prepare TP

6 Federal Tax Service Letter OA-4-13/85 of 12 January 2012, ‘‘On Concluding Advanced Pricing Agreements for Tax Purposes’’. 7 Approx. US$45,500. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Russia’s new rules: Overview and practical aspects

documentation and submit TP notifications for controllable There are some transactions. When considering peculiarities the potential impact of TP rules on specific only their business activities (including to Russian TP the obligation to prepare the requirements appropriate documentation) companies should perform the inventory of transactions and the functional analysis, analyse the pricing methodology applied, consider changing through bonuses or credit-notes) • Cost allocation: The Code it (if necessary) and, finally, are allowed at the year-end. does not formally recognise prepare TP documentation for Moreover, certain risks may exist cost allocation arrangements controlled transactions. due to non-refundable extra which can be viewed as a cost duties and uncertain tax recharge, rather than provision There are some peculiarities and foreign currency treatment. of the service. Therefore specific only to Russian TP such arrangements, without requirements, the most significant • Treatment of IP: Unlike OECD proper support evidencing the of those include: countries, certain intangible services provided, are likely to assets (such as a customer list) be challenged by the Russian • True-up/true-down are not recognised as IP objects tax authorities. adjustments: The mechanism under the Russian Civil Code. for TP adjustments is not Therefore, the TP methodology • Obligatory selection criteria provided by the Code, therefore related to these intangible assets for comparability analysis: taxpayers should constantly and applied under the OECD Russian tax authorities monitor the profitability. Only principles requires tailoring for have expressed their strong upward adjustments (available Russian TP purposes. preference for local comparables. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Russia’s new rules: Overview and practical aspects

In addition to that, the rules and taxpayers who fail to submit Conclusion specify certain obligatory criteria properly completed notifications on In order to comply with the new TP which should be used when controllable transactions during the rules, companies doing business performing a benchmarking first year of TP audits. in Russia (both Russian-based study (e.g. independence and companies and MNEs with a net assets screening, necessity to Based on the economic analysis presence in Russia) are required renew the benchmarking study of actual financial results, to analyse and tailor their existing on a yearly basis, etc.). taxpayers may need to think TP policies taking into account the about restructuring their provisions of the Russian rules, As preparation of TP operations and streamlining tax authorities’ clarifications and documentation and alignment of intercompany transactions for existing administrative court the existing policies to the new future periods. Therefore, tailoring practices. Although the Russian TP TP requirements proves to be TP documentation and revising rules are broadly consistent with a time consuming process, it is TP policy for Russia should be OECD Guidelines, there are certain recommended that taxpayers begin considered as a priority for the significant differences which make the process well in advance. next couple of years to ensure it difficult for multinational groups compliance with Russian TP rules to tailor their TP documentation From our experience, good quality from the outset. (e.g. requirement for local documentation would be the best comparables, yearly renewal of defence in case of any challenges Although the Russian TP benchmarking study, absence from the local tax authorities. The rules are broadly consistent of true-down adjustments, etc.). more details taxpayers provide Russian taxpayers who are deeply to justify their approach to the with OECD Guidelines, involved in preparation of local aggregation of transactions and there are certain significant TP documentation have already TP methodology, the less tax risk differences which make it experienced the significant work would exist. It is expected that the difficult for multinational load associated with it, which Russian tax authorities will most groups to tailor their TP resulted in reconsideration of likely focus on large taxpayers with documentation the 2012 filing dead- lines by the significant intercompany flows Russian Ministry of Finance. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Russia’s new rules: Overview and practical aspects

Authors

Kseniya Legostaeva PwC Russia +7 495 967 6000 ext. 2839 [email protected]

Olga Ponomareva PwC US +1 313 394 3334 [email protected]

Nika Slavinskaya PwC Russia +7 495 967 6000 [email protected]

Garry Stone PwC US +1 312 298 2464 [email protected]

Svetlana Stroykova PwC Russia +7 495 9676024 [email protected] Transfer pricing perspectives: Managing multiple stakeholders in the new economy

The regulations in place in South America, as well as the approach adopted by the tax authorities in relation to intercompany transactions, create problems when applying certain OECD compliant structures in the region.

South America: Dealing with local complexity when applying global transfer pricing policies Transfer pricing perspectives: Managing multiple stakeholders in the new economy South America: Dealing with local complexity when applying global transfer pricing policies

The regulations in place in South and services reached 36% of the the tax authorities’ practical America, as well as the approach regional GDP from 28% at the end approach included the creation adopted by the tax authorities of twentieth century. of special and easily auditable in relation to intercompany methods in the case of commodity transactions, create problems With transfer pricing regulations transactions, which in some cases when applying certain OECD now applicable in eight countries, might be at odds with the arm’s compliant structures in the region. whose economies jointly represent length principle, and greater focus In particular, special care must 99% of the regional GDP, and on deductibility requirements be exercised when recurring to more demanding documentation rather than pricing in what relates central marketing or sourcing requirements, transfer pricing to service and royalty fees. entities, or when applying royalties is now a top priority not only or shared services agreements. for tax authorities, but also for As a result, multinational multinational enterprises with corporations have found it The growing relevance of operations in the region. difficult to align some of their intercompany transactions global transfer pricing policies and the administrative In this context, tax authorities with local regulations, many approach in South America have struggled to deal with the times resulting in cases of double Since the first tax laws including increasing quantity and complexity taxation. Next we review the most transfer pricing regulations were of intercompany transactions. common pitfalls encountered by enacted in the region at the end To cope with this situation, corporations when applying global of the 1990’s, South America they have adopted a Pareto TP policies in South America. has experienced significant Principle approach by focusing economic growth and has become on certain types of transactions Commodities – Ad hoc increasingly integrated with the that represent a significant part methods that focus on global rest of the world. In 2012, South of international commerce flows, sourcing or marketing agents America’s GDP was 60% greater such as commodity trade and In 2003, Argentina established than it was in the year 2000, while intercompany service fees received a special method for the the international flow of goods from abroad. Furthermore, analysis of the of goods Transfer pricing perspectives: Managing multiple stakeholders in the new economy South America: Dealing with local complexity when applying global transfer pricing policies

with publicly quoted prices in Given the importance of transparent markets to a related commodity trade for the Can certain ad-hoc company, where an international economies in South America, methods result in intermediary -- who is not the which nowadays represents 67% double taxation? actual receiver of the goods and of the total exports of goods, other does not meet certain substance countries such as Ecuador, Peru parameters contained in the law and Uruguay soon adopted similar -- is involved. In such cases, the rules targeting intermediaries price for tax purposes must be the as well as extended their scope greater of (a) the price negotiated to . In 2012, Brazil with the intermediary and (b) the implemented a similar pricing publicly quoted price at the date method for commodity imports of loading of the goods. This rule, and exports with related parties initially intended to prevent base –regardless of the participation shifting through the manipulation of an intermediary - by which the of transaction dates with related publicly quoted price at the date of purposes generally differs from entities, soon extended to non- transaction – where such can be the actual transaction date that is related intermediaries for which reliably determined - or at the date recommended by OECD Guidelines compliance with the substance of loading of the goods is used for to set the arm’s length price; and, thresholds might not be easily tax purposes. (ii) the publicly quoted price may documented (which happens, in not reflect the characteristics of fact, in most cases). As a result of the application of the controlled transaction in terms these methodologies – which of delivery, quality and quantity, consist in setting a price for tax Thriving South American among other comparability factors. purposes equal to a market quote Hence, the application of these ad- commodity trade gives at the date of the loading of the hoc methods to set the prices for rise to tax/pricing rules goods – two comparability issues these transactions could result in adoption in several countries arise: (i) the pricing date for tax double taxation. Transfer pricing perspectives: Managing multiple stakeholders in the new economy South America: Dealing with local complexity when applying global transfer pricing policies

Furthermore, many offshore Services – Documenting the • The services must have been marketing structures - in the case benefits for the local entity actually rendered; of exports (or central purchasing Most multinational corporations structures in the case of imports) rely on a series of centrally • The services must be related - create significant tax risks, since provided management, research, to the activity performed by their transfer pricing policies finance and IT services, among the company and necessary generally command a discount others. Accordingly, these to generate taxable income in or premium, respectively, on corporations generally apply an the country; the publicly quoted price to OECD compliant cost sharing account for the differences in or cost plus policy to determine • The charges must be quality, opportunity and delivery the transfer prices for such proportional to the activity terms, among others. This risk services, using allocation drivers performed by the subsidiary (i.e. is particularly significant for selected to reflect usage intensity reasonable amount of expenses companies sourcing minerals or of each subsidiary. correlated to the income or agricultural products from South profit generated) and follow America, and for industrial groups In most OECD member nations, an arm’s length compensation providing raw materials for its a great deal of effort is put into structure; and, local operations. analysing the functions developed by the service providers and • In some cases, both the service In short, many corporations have in determining an appropriate fee and the withholding tax, found that customising their global remuneration for them. But South where applicable, must have marketing or sourcing policies American tax authorities have been paid prior to the income tax to align them with local rules is been focusing on the deductibility return due date (e.g. Argentina). the best way to avoid or mitigate of the fees before reviewing the double taxation. pricing policy itself. In this regard, most countries in the region have implemented some of the following deductibility requirements: Transfer pricing perspectives: Managing multiple stakeholders in the new economy South America: Dealing with local complexity when applying global transfer pricing policies

Documenting benefits & relevance of services received from abroad is extremely difficult

Gathering information for Tax Authority may require the or a four-hour assistance from deductibility requirements taxpayer to provide evidence such engineers in the headquarters has its own challenges as flight tickets, correspondence when selecting a new supplier), Even though these requirements and reports by headquarters’ generating a file that extensively are also present in OECD experts to demonstrate the documents the benefits and documents and its discussion provision of the services, as well relevance of the services received may seem trivial from the service as to show clear examples on how from abroad is extremely difficult, provider’s standpoint, actually such advice generated profits for it. especially when such evidence is gathering the information to prove Since in many cases the assistance spread all over the organisation the compliance with deductibility provided by the headquarters is and is gathered extemporaneously requirements can pose quite a of a fragmentary nature (e.g. a during the course of an audit. challenge for South American multiparty conference call with subsidiaries. For example, the an expert in the legal department Transfer pricing perspectives: Managing multiple stakeholders in the new economy South America: Dealing with local complexity when applying global transfer pricing policies

In conclusion, when applying require payments before allowing Hence, when dealing with customs global transfer pricing policies deduction, double taxation and or currency restrictions that for services in South America, thin capitalisation problems. impede the application of the documenting the benefits and regular policies, a comprehensive nature of the services received Under this scenario, many analysis of the pros and cons from foreign related parties from companies have evaluated of each alternative must be the local perspective is a first different alternatives to pay off carried out, so as to avoid threshold that must be passed prior their liabilities with foreign related collateral or unforeseen transfer to documenting the price itself. entities, such as writing-off , pricing consequences. discontinuing the accrual of the Deductibility and currency fees, or paying off debts in local In short – Certain approaches flow restrictions – The trade currency or in kind. Even when and ad hoc rules can off between global policies these alternatives may allow pose troubles and double taxation the deduction of the charges or Even though – with the exception During the last few years, some prevent double taxation in the of Brazil - transfer pricing policies countries like Argentina and short term, they might have side in South America are generally Venezuela have implemented effects that conceal tax risks for consistent with the arm’s length legal or factual restrictions to both the local and foreign entities. principle, the approach adopted currency outflows and foreign For example, if the billing of fees by the tax authorities as well the trade, delaying or precluding is suspended until payments are existence of certain ad hoc rules the payments of goods, services, once again allowed, the local tax – particularly in Brazil - pose royalty fees and loans. In authority may question whether troubles when implementing consequence, local subsidiaries’ the services were actually needed certain policies consistent with the balance sheets show swelling by the subsidiary in the first place, OECD Guidelines. At the very least, intercompany payables and while the foreign tax authority evaluating timely customisations liabilities, giving rise to may question this exception to the to global policies may reduce deductibility challenges. As it was global transfer pricing policy. the likelihood that the company mentioned before, some countries suffers double taxation. Transfer pricing perspectives: Managing multiple stakeholders in the new economy South America: Dealing with local complexity when applying global transfer pricing policies

Authors

Juan Carlos Ferreiro PwC Argentina +5411 4850-4651 [email protected]

Jose Maria Segura PwC Argentina +5411 4850-6718 [email protected]

Cristina Medeiros PwC Brazil +5511 3674 2585 [email protected]

Transfer pricing perspectives: Managing multiple stakeholders in the new economy

Highlighting some recent developments concerning the financing of real estate through mezzanine loans

The impact of transfer pricing on real estate funding – Mezzanine financing Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

Introduction substantially more conservative In this article, we highlight some than those which were prevalent Rising threat of double recent developments concerning in prior years. As such, making taxatation makes correct the financing of real estate optimal use of the funds already transfer pricing of debt through mezzanine loans. With available within real estate groups those developments in mind, is becoming ever more important. funding a higher priority we then describe the relevant transfer pricing landscape in This higher degree of self-funding, three representative jurisdictions: together with budget pressures is in place is becoming a key Japan, the UK and the US. We experienced by governments, has management focus. conclude with some suggestions resulted in an increased focus by on how to increase the robustness tax authorities across the world Recent developments of transfer pricing policies for real on the transfer pricing of debt. Real estate investment estate financing. For example, as of the writing of fnancing trends this article, two high profile audits Foreign investors, from high net Current environment involving intercompany debt have worth individuals to sovereign changing traditional been taking place in the US.1 As wealth funds, are faced with lending dynamics a result, the correct application certain challenges should they The weak economic climate, of transfer pricing legislation has wish to fund their acquisitions the sluggish tenant market and become a higher priority as the with debt. European real estate increasing regulatory requirements potential for incurring double investors are faced not only have changed the dynamics of taxation through adjustments with the paralysing effect of the traditional lending facilities within and penalty payments, as well European sovereign debt crisis, but the real estate sector. The terms as the negative publicity linked also the impact of unprecedented and conditions that third party to tax disputes and litigation, regulatory changes, resulting in providers of credit are willing has increased. Ensuring that a banks facing a stark choice of to accept are, in many cases, robust transfer pricing policy raising new capital or disposing of

1 At stake for Tyco is $883.3 million in additional taxes plus penalties of $154 million related to an IRS challenge of intercompany financing with certain international subsidiaries related to acquisitions and restructurings in the late 1990s. At stake for Ingersoll-Rand is a potential levy of $400 million and $700 million of additional withholding and income taxes with respect to a portion of the interest payments on intercompany debt to a Bermudan affiliate. Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

assets. The US and Japanese real are able to take advantage of estate markets face similar issues the opportunities from bank Importance of as lending institutions exercise deleveraging and new debt mezzanine debt extreme caution as they slowly providers entering the market, funds on the rise recover from the recent financial such as insurance companies and crisis and learn to deal with new specialist debt funds. regulatory restrictions. It is not only the availability of European sovereign debt new debt that is a challenge; underwriting standards are crisis, unprecedented becoming more rigorous; loan-to- regulatory change force value (LTV) ratios are falling and stark choices on lenders the cost of borrowing is rising, reflecting the higher margins and According to the Property Week higher capital charges faced by report, Property Finance 2013, The widespread view within senior lenders. However, these there is a long-term shift in real the real estate sector is that LTVs vary on a case by case base: estate financing. Many senior commercial real estate lending the PwC Real Estate Investment lenders have shut down their will shoulder a disproportionate Survey states that “there is real estate lending businesses share of the burden and, as adequate money out there for because they don’t feel they can be such, debt has been the main deals involving core assets and profitable at their long-term cost story for the real estate sector. core geographies, but debt is of capital. However, new entrants Although this development is a thinner for properties in secondary are coming into the market, such huge challenge for many, it also markets and weaker tenancies. as insurance companies and debt creates opportunities for others, Underwriting is still very strict funds. The Property Week report in particular equity investors for tertiary locations and unstable also highlights the increasing less reliant on debt; those who assets in core markets.”2 importance of mezzanine debt

2 The PwC Real Estate Investor Survey is widely recognised as an authoritative source for capitalisation and discount rates, cash flow assumptions, and actual criteria of active investors, as well as property market information. http://www.pwc.com/us/en/asset-management/real-estate/publications/pwc-real-estate-investor-survey.jhtml Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

funds that have managed to raise to provide the mezzanine product; capital and are now starting i.e. the retreat of the banks could Senior debt & asset to lend. leave mezzanine lenders in an >60% backed lending Risk aversion and exposed position rather than The mezzanine gap tucked into a well protected gap regulation are The most immediate opportunity in the . The other pushing senior in real estate investment appears concern is pricing. lenders down Senior subordinate to be the provision of mezzanine to LTVs of 60% debt debt since the retreat of senior If return expectations for equity or lower, which lenders is opening a gap in the are falling, then the population of creates an opening capital structure. When senior potential mezzanine borrowers for mezzanine debt lenders, generally banks, were will also decline unless mezzanine providers. Convertible providing debt at 80% or even expectations are reduced subordinate debt higher LTV ratios, few borrowers correspondingly. If not, the main needed mezzanine debt. Risk role of mezzanine and preferred aversion and regulation are equity will be in restructuring

Mezzanine gap Mezzanine pushing senior lenders down situations where the borrower has Redeemable to LTVs of 60% or lower, which little alternative. preferred stock creates an opening for mezzanine debt providers. Real estate financing structures However, two major concerns have Overview Equity been identified in Emerging Trends There are various options in Real Estate in Europe 20123. to structure the financing of First, mezzanine lenders need real estate: debt, equity or a active senior lenders behind whom combination of both. In terms of

3 The 2012 report is the 9th edition of the report published by PwC and the Urban Land Institute. It is a survey of sentiment based on 310 face-to-face interviews and 386 online survey responses of representatives of the Real Estate sector consisting of senior executives from across Europe from a broad cross-section of the industry, including institutional investors, fund managers, listed and unlisted property companies, lenders and service providers. http:// www.pwc.com/gx/en/asset-management/emerging-trends-real-estate/emerging-trends-in-real-estate-europe-2012.jhtml Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

debt, various types of financing own a property-owning entity, financial difficulties, the mezzanine are available with a broad range which debt is secured by a first debt is unlikely to be recovered. of criteria including different in the borrower’s It has the characteristics of debt priority levels of repayment in case pledged ownership interests in but it may carry a right to shares of liquidation; i.e. ranging from the property owner”. Mezzanine as a way of providing some form senior debt which must be repaid finance is typically used by of recompense to the holder in the first to junior and mezzanine debt, companies that are already highly event of default. The term originally the latter being structured either leveraged but still have positive referred to debt financing which as debt (typically an unsecured cash flow to support additional gave the lender an equity stake, or and subordinated note) or debt payments. Mezzanine finance had the possibility of conversion preferred stock. is often used to support growth into equity. It has more recently through expansion projects; been used to describe any middle As the main focus of this article is acquisitions; recapitalisations, and layer of debt in leveraged buyouts, the transfer pricing of mezzanine leveraged buyouts. “below” the senior debt and “above” debt in real estate financing the equity, whether or not any structures, the following sections Tax authorities may use a equity rights are attached to the first define mezzanine financing broader definition than Moody’s. debt. Such debt may be fixed rate or from both a tax and a commercial For example, Her Majesty’s floating, secured or unsecured and perspective before going into more Revenue and Customs (HMRC), it is common that the loan is bullet detail on the tax aspects associated describes mezzanine debt in their repayment rather than amortising”. with mezzanine financing. International Tax Manual (INTM) as follows: “Mezzanine debt sits In contrast, the tax authorities of Mezzanine fnancing between senior debt and equity in other countries, such as Japan and Moody’s4 defines mezzanine the capital structure of a business. the US, may refrain from formally financing as: “lending to a Often a high-risk form of finance, it defining mezzanine financing borrowing entity or group of is subordinated to the senior debt, in legislation. entities that directly or indirectly so that if the borrower gets into

4 In its paper “US CMBS and CRE CDO: Moody’s Approach to Rating Commercial Real Estate Mezzanine Loans”, March 2007. Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

Mezzanine financing may be short common features of all mezzanine returns on debt capital are treated term or long term, amortising or instruments are that they offer differently for tax purposes interest only, floating or fixed rate, a risk/return profile that lies and so thin capitalisation poses though the current market sees between debt and equity. an issue for tax authorities as most mezzanine loans as relatively further elaborated below. The short-term, interest-only, floating Intercompany returns to shareholders on equity rate transactions. In contrast to mezzanine fnancing investment are not tax deductible some preferred equity deals that As a result of the recent financial for the paying company, being have debt characteristics, few, if and economic turmoil, the distributions of profit rather any, mezzanine loans destined utilisation and incidence of than expenses of earning profits. for the capital markets have intercompany mezzanine Alternatively, the returns to cumulative returns or equity financing in the real estate sector lenders of debt (typically in the “kickers”; they are straight debt has become more prevalent. It is form of interest) are normally notes, for the most part, albeit at increasingly difficult for companies deductible in arriving at profits higher spreads to reflect the risk to obtain external third party assessable to corporation tax. of being in the transition zone financing and higher current Therefore, there is an incentive between debt and equity. market credit spreads have made to present what is in substance an external financing less attractive. equity investment in the form of Most mezzanine loans are targeted Therefore, considering using funds debt to obtain the favourable tax to be at the bottom of the debt available within the company, treatment. stack and are expected to receive rather than attracting funds below investment-grade shadow externally, has become even more Having said that, many countries, ratings. Isolated mezzanine important for many companies. such as the UK, the US and transactions, however, may reach Japan, place other restrictions low-to-mid investment-grade There are some important tax on the use of debt funding, such levels, often when the real estate is aspects to consider when choosing as thin capitalisation rules or located in jurisdictions with hefty to use mezzanine financing. For earnings stripping rules (which mortgage recording taxes. The example, returns on equity and limit the deductibility of interest Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

expenses on related party debt). Relevant Japanese regulations Nevertheless, debt funding for real Broadly, Japan limits the use of CUP method preferred for estate investment may still provide related party debt through its pricing of intercompany a more attractive alternative than thin capitalisation and earnings debt in Japan equity funding for many real stripping rules. estate groups. In general, the thin capitalisation In addition to the above, from Transfer pricing of debt rules provide a 3:1 debt-to-equity the tax years beginning on or Governments have imposed safe harbour. Article 66-5 (1) after April 1, 2013, an earnings various regulations to curb the of the Act on Special Measures stripping rule has been introduced. misuse of intercompany finance Concerning Taxation (ASMT) Under this rule, the deductible arrangements. Perhaps the most sets out that if the annual average portion of a corporation’s net common regulations across balance of interest-bearing debt interest expense to a related various taxing jurisdictions would owed to a foreign controlling party will be restricted to 50% of be the imposition of the arm’s shareholder exceeds the capital adjusted income.5 Where interest length standard, which states that contributed by that foreign expense is not deductible, it may the price of a related party debt controlling shareholder by a ratio be carried forward for seven years arrangement should be consistent in excess of a 3:1 safe harbour, the and deducted in a fiscal year with the price of comparable third excess interest expense paid or up to the 50% threshold in that party debt arrangement. Below, we payable to the foreign controlling fiscal year. first set out the tax regulations on shareholder is not tax deductible. interest deduction in Japan, the UK In addition, interest paid to a Given these domestic law and US relevant for the purpose of third party may also be subject to limitations on deductibility of this article before describing the Japanese thin capitalisation rules if related party interest expense, basic principles of transfer pricing the loans are guaranteed or bonds the volume of debt has not been a of debt. are provided as collateral by the major issue in Japan. foreign controlling shareholder.

5 Net interest is calculated as interest expense to related parties less corresponding interest income. Adjusted income is defined as taxable income, adding back interest expense, depreciation expense and exempted dividend income, but excluding extraordinary income or loss. Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

Finally, in terms of the arm’s length nature of intercompany debt pricing, the comparable uncontrolled price method (CUP method) is the preferred methodology. According to ASMT Directives 66-4, (7)-4, and 68-88, (7)-4, where the same method as the CUP method is to be applied, the following factors should be taken into account: The currency of the loan; the timing and term of the loan; the manner of setting the interest rate (i.e. setting of sets out the basic pre-conditions For intercompany financing, specific fixed or variable rate, or simple or for transfer pricing legislation to rules around thin capitalisation compound rate); the method of apply: When a provision is made or are included in Part 4 TIOPA 2010. interest payment (i.e. method of imposed between any two persons Following S152, a person is said advanced or deferred payment and by means of a controlled transaction to be thinly capitalised when it so on); the credibility of the debtor; that differs from the provision has excessive debt in relation to its and the conditions of collaterals and which would have been made in an arm’s length borrowing capacity, guarantees as well as other factors uncontrolled transaction (the arm’s which then leads to the possibility affecting the arm’s length rate. length provisio”) and, as a result, a of excessive interest deductions. In UK is conferred on addition to considering the level of Relevant UK regulations one or both persons, then the profits debt, it is also important to consider The UK transfer pricing legislation is or losses of the advantaged person whether the rate of interest applied contained in Part 4 of the Taxation are to be calculated for tax purposes is consistent with arm’s length (International and Other Provisions) as if the arm’s length provision had prices. Act 2010 (TIOPA 2010). S147 been made or imposed instead. Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

HMRC takes a broader view than additional debt from a third that is based on comparable just the amount of debt and the party given the interest rate and uncontrolled transactions under interest rate when looking at thin terms of the available finance is a Treas. Reg. §1.482-2(a)(2)(i). capitalisation. One of the key different question. In looking at However, it should be noted that considerations is whether indeed the transaction from both sides the ability of a taxpayer to deduct the borrower would have chosen to (which is consistent with the OECD interest on debt from a related take on a loan, even if the lending Guidelines and from a UK thin party is contingent on whether were available. HMRC describes capitalisation perspective) it is the indebtedness is considered this approach as looking at the necessary to apply basic transfer bona fide.6 The issue of whether “could” and “would” arguments: pricing of debt principles; on what an intercompany debt obligation terms a third party would be is bona fide debt is not described • The “could” argument – what willing to lend, and on what terms in Treas. Reg. §1.482-2(a) but a lender would have lent and would a third party be willing rather, is described in Section 385 therefore what a borrower could to borrow. of the Internal Revenue Code. As have borrowed; and part of US tax law, the generality Relevant US regulations of IRC §385 serves as guidance • The “would” argument – what In general, Treas. Reg. §1.482- for defining bona fide debt for a borrower acting in the best 2(a), describes the transfer pricing tax purposes, but the resolution interest of their own business rules applicable to intercompany of whether an intercompany would have borrowed. loans in the US. These regulations debt obligation is bona fide debt provide three general approaches has generally been considered For mezzanine financing with a to establishing an intercompany in the context of US Tax Court very high interest rate, it may be interest rate: i) safe harbour decisions as a result of the lack of the case that it could be made approach under Treas. Reg. §1.482- statutory or regulatory guidance. available to a company; however, 2(a)(2)(iii); ii) situs of the borrower The approach taken by the US whether the company in reality approach under Treas. Reg. §1.482- Tax Court can be best described would choose to take on that 2(a)(2)(ii); or iii) an approach as a facts and circumstances

6 Treas. Reg. §1.482-2(a)(1) Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

approach that considers the nature Basic principles for transfer debt transactions in an attempt to of the financial contribution to pricing of debt establish debt on an arm’s length the recipient of the funds and There are three key factors that basis in an intercompany situation the circumstances under which determine interest expenses in by analysing: the contribution has been made. third party scenarios. The first is Ultimately, the economic substance the likelihood of borrower default; • the terms and conditions of the of the transaction governs the tax e.g. how creditworthy is the debt (e.g. the loan tenure, its treatment of the transaction.7 borrower and how able is it to meet seniority and collateral); its liabilities? Another factor is the Other tax rules should also be expected loss in the case of default; • the volume of the debt (i.e. by considered in establishing an e.g. how senior is the debt relative analysing borrowing capacity intercompany debt arrangement to the borrower’s assets; is there through free cash flow analyses in the US. Section 163(j) of any collateral pledged to protect and comparing to financial ratios the US Internal Revenue Code the creditor from realizing a loss? of comparable independent limits interest deductions where Finally, what is the opportunity companies); the corporations debt to equity cost of making the loan for the ratio exceeds 1.5 to 1 or when lender; e.g. what is the lender’s • the credit or default risk of the the corporation has excess cost of capital and/or next best borrower (measured through a interest expense for the tax investment alternative? credit rating process); and year. Additionally, Real Estate Investment Trusts are subject to Taking the above into account, • the interest rates offered by a 100 percent tax to re- in an attempt to comply with other lenders in comparable determined interest deductions for the various transfer pricing circumstances. their Taxable REIT Subsidiaries regulations, taxpayers have under Section 857(d)(7)(A) of the tried to replicate what unrelated US Internal Revenue Code. parties do when entering into

7 Treas. Reg. §1.482-1(f)(2)(ii)(A) Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

Transfer pricing of debt – estate sector where mezzanine mezzanine financing and how mezzanine financing debt is more prevalent. To mitigate they compare with those of As previously mentioned, the risk of a challenge from tax external transactions is one of mezzanine financing is typically authorities, it is important that the most important aspects of the most junior debt with equity- the arm’s length nature of any any transfer pricing analysis. To type characteristics. Furthermore, mezzanine financing has been address this point, and while it the interest rates on mezzanine assessed and documented by does not constitute a comparable financing are typically high given following the four basic principles for transfer pricing purposes this junior character. As such, of transfer pricing of debt. because it does not represent there is an increased likelihood actual transacted data, having of scrutiny on the levels of and Terms and conditions of the a bankability letter typically interest rates on mezzanine mezzanine debt represents good corroborative financing; in particular in the real Accounting for the features of evidence. However, as a result of Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

banks reducing their lending to In contrast, the volume of related capacity to service debt, and are the real estate sector, it may prove party debt will be a critical issue likely to want financial conditions difficult to obtain such a letter for in countries where there are less in the loan agreement (such as the mezzanine financing to fund the restrictive requirements outside of ratios described above) to ensure acquisition of real estate. transfer pricing. that this capability continues.

As such, other sources of data to The arm’s length volume of In terms of quantifying the support related party transactions any mezzanine financing is a borrowing capacity of the debtor, become even more important, determinant of the total borrowing market practice is to look at including referring to third party capacity of the debtor. The arm’s LTV ratios; which consist of the loans (preferably third party length borrowing capacity should debt expressed as a proportion mezzanine loans) with similar ideally be determined based on of the value of a property that a characteristics at the time of the independent comparables; key lender is prepared to lend (most intercompany transaction. financial ratios should be used to often expressed as a percentage). assess the arm’s length nature of However, it should be noted that Arm’s length borrowing the transaction (e.g. interest cover mezzanine debt is often issued in capacity should be and gearing/leverage ratios/LTV). situations where bank debt is not available. As such, careful thought determined based on Several factors relevant to the should be made with respect to the independent comparables real estate industry may impact use of LTV ratios in a mezzanine the borrowing capacity of an debt capacity analysis, particularly Volume of the debt entity, for example, in relation to when such LTV ratios are derived As described above in the case property backed lending: third purely from bank loans. Because of Japan, some jurisdictions use party lenders are more prepared publically available information safeguards other than transfer to grant a loan if land or buildings on non-bank LTVs is scarce, it is pricing rules to indirectly limit are available to put forward as recommended to substantiate the the volume of debt that may be security. They will still, however, arm’s length volume of the debt by borrowed from related parties. look closely at the borrower’s additional analyses such as free Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

cash flow analyses (i.e. will the In terms of estimating a (shadow) on executed transactions and property generate sufficient cash credit rating of the debtor evidence of actual market activity, for the debtor to repay the debt in relation to the mezzanine and tend to be less willing to and make the required interest financing issued, a potential accept notional offers of finance, payments). approach could be to use a which have neither had to be credit scoring tool or to map the issued or accepted in reality, Credit risk in relation to the borrowing entity’s financial ratios without any additional supporting mezzanine debt against S&P/Moody’s evidence. In a transfer pricing context, ratios (e.g. Moody’s Approach typically one of the most important for REITs and Other Commercial Higher values of ratios such as steps in analysing debt transactions Property Firms, 30 July 2010) DEBT / EBITDA (Earnings Before is estimating the credit rating to estimate the corporate credit Interest Tax, Depreciation and of the borrower adjusted for the rating of the debtor. Amortization) and debt: equity are transaction under review. tolerated by lenders for a period Subsequently, the corporate of time following an acquisition, Under normal market conditions, credit rating of the debtor may as long as the projections clearly the higher the credit rating of be adjusted to take into account show that the debt payments the debt issue, the lower the the specific characteristics of can be met and that the level of associated interest expenses (and the mezzanine financing (e.g. its gearing is going to be reduced over vice versa). As such, in a transfer junior characteristics). time.8 Typically, this means that pricing context, the estimate of the focus is on the intercompany the credit rating of a borrower is Interest rates offered financing arrangements that are of great interest to tax authorities by other lenders in in place at a point in the future since this is one of the clearest comparable circumstances that can be considered to represent signals that the intercompany debt When looking for third party a steady state (usually three to transaction has been structured at comparables, tax authorities five years). arm’s length. typically focus their attention

8 http://www.hmrc.gov.uk/manuals/intmanual/INTM578090.htm 9 http://www.hmrc.gov.uk/manuals/intmanual/INTM579030.htm Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

Publically available information on debt issued (such as loans characteristics and interest rates for companies with similar size and bonds) by companies active that are commensurate with and character in a particular in the real estate industry such risks. As a result of the high industry is typically preferred for and can be searched based interest rates, and given that suitable comparables. For example, on a wide range of debt terms mezzanine debt is most prevalent the De Montfort report which is such as mezzanine financing. in the real estate sector, many published annually, along with a Furthermore, information tax authorities have increased half yearly update, can be applied.9 contained in publications such as their scrutiny on the levels of and The report includes information Property Finance 2013 can be used interest rates on mezzanine debt. covering major lenders within the as corroborative evidence of the UK, US, Germany and outside, as information obtained from the De As the potential for incurring well as the majority of the smaller Montfort report and the databases double taxation through lenders. The information published mentioned above.10 adjustments and penalty includes a range of statistics, payments, as well as the negative charts, and analyses covering Conclusion publicity linked to tax disputes comparisons of loan terms, interest There is general pessimism and litigation, has increased, it rates, types and locations of regarding the availability of is critical for real estate investors lenders relating to the commercial senior debt funding in the market. that a robust transfer pricing property market. As the retreat of the traditional policy is in place which assesses senior lenders is opening a gap and documents (i) the terms and Other sources of potentially in the capital structure, the most conditions of the mezzanine debt, comparable data include publically immediate opportunity in real (ii) the volume of the mezzanine available databases such as estate investment appears to debt, (iii) the credit risk in Reuter’s LoanConnector DealScan be the provision of mezzanine relation to the mezzanine debt and Bloomberg Professional debt, which is typically the most and (iv) the interest rates offered Database that contain information junior debt with equity-type by other lenders in comparable circumstances.

10 For example, PwC UK has prepared their own in-house database of real estate financing deals based on publically information for the purpose of corroborating information from the De Montfort report. In the U.S., the PwC Real Estate Survey provides detailed information on the real estate market in the U.S. which can be used to inform and anecdotally corroborate the debt capacity analysis described above. Transfer pricing perspectives: Managing multiple stakeholders in the new economy The impact of transfer pricing on real estate funding – Mezzanine financing

Authors

Ana Carolina Albero Arthur Mendoza PwC UK PwC US +44 0 20 7212 3452 +1 415 498 6244 [email protected] [email protected]

Christophe Hillion Wout Moelands PwC Japan PwC UK +1 646 471 0718 +44 0 20 7213 8168 [email protected] [email protected]

Raymond Kahn Aamer Rafq PwC Japan PwC UK +81 0 3 5251 2909 +44 0 20 7212 8830 [email protected] [email protected]

Robert Kissner-Ventimiglia Ryann Thomas PwC Japan PwC Japan +81 0 80 4104 5535 +81 0 3 5251 2356 [email protected] [email protected]

Patrick Leung Monica Winters PwC US PwC US +1 646 471 4222 +1 646 471 9064 [email protected] [email protected]

Transfer pricing perspectives: Managing multiple stakeholders in the new economy

Leading practices for integrating tax and transfer pricing requirements with enterprise resource planning (ERP) for multinational enterprises

The intersection of ERP systems and transfer pricing Transfer pricing perspectives: Managing multiple stakeholders in the new economy The intersection of ERP systems and transfer pricing

Rapid expansion creates a high volume of intercompany Leading practices for challenges in tax and transactions. The ability to integrating tax and transfer transfer pricing integration accurately price, record, and pricing requirements of ERP systems report transfers of tangible goods, Although there are complexities in As multinational enterprises licenses or sales of intellectual integrating tax and transfer pricing continue to expand through property, and the provision of requirements into an existing acquisition and organic growth, services and financing between ERP system, companies can take the need for accurate and timely related parties - or transfer pricing certain practical steps to close reporting of operational and - is critical to correct and timely gaps and improve data collection financial data has never been tax reporting domestically and and reporting. As a threshold more critical. Companies rely on abroad. Poor tracking of transfer matter, generally companies their management information prices translates to increased are most successful when they systems to deliver reports that enterprise risk and a possible leverage core ERP functionality enable corporate executives to impact to the bottom line. rather than trying to fit the ERP make informed decisions in real into what may be a jumble of time. However, rapid expansion Corporate executives within existing manual processes and – particularly through acquisition multinational businesses must incompatible software. – can result in companies having work cross-functionally – an excess of accounting, supply bridging operational, financial, Alignment of policy and chain, human resources, and and information management execution. To the extent that other systems and software systems – to integrate tax and companies can employ their ERP platforms that often cannot be transfer pricing requirements system to execute the transfer integrated easily. into their enterprise resource pricing policy, gaps between policy planning systems. and execution are narrowed. These systems gaps result in poor management reporting and Early communication on integration efforts can save costs are of even greater concern for in the long run multinational enterprises with Transfer pricing perspectives: Managing multiple stakeholders in the new economy The intersection of ERP systems and transfer pricing

Leading practices direct that transfer pricing. These systems tend Corporate information tax departments communicate to be harder to scale and less robust management executives and their user requirements to the than enterprise systems which their advisors are well advised ERP system team early in the aim to synthesise and integrate to consider user requirements implementation process and work virtually all functional areas across carefully and to select scalable, closely with their management a business. enterprise-wide systems that information systems colleagues to have the capabilities to meet the achieve appropriate integration. Issues with desktop-based tools changing needs of the business. Many companies have rejected this appear when companies try to approach because the upfront set up generate segmented profit and costs can be high. However, when loss statements by legal entity that Taking the time to compared to the cost of remediating incorporate tax and transfer pricing understand & leverage these disparities on an annual adjustments. Leading practices available information is key basis, the initial expense is often dictate that companies prepare for choosing best transfer significantly less in the long term. these financials by leveraging an pricing policies ERP or business intelligence (BI) Moreover, ERP system upgrades system to ensure accuracy and do not always keep pace with completeness. Similarly, many Know your data. Often, the ERP growing geographic footprints or companies rely on spreadsheet system is perceived as a so-called operational expansion, particularly models to determine overhead “black box” as opposed to a key in newer companies. Often the and headquarters cost allocations. tool that gives tax departments frugal and entrepreneurial mindset These documents are often used visibility into critical financial of an emerging multinational year after year without considering detail. This distinction is enterprise translates into systems structural changes internally, important because, from a price- that lag behind the needs of the such as the addition of new cost setting perspective, companies business over time. Commonly, new centers, and externally, including need to identify all cost elements businesses start out with several modification of local tax rules. – including cost of goods and desktop-based tools to manage inventory variance and customs Transfer pricing perspectives: Managing multiple stakeholders in the new economy The intersection of ERP systems and transfer pricing

duties. Specifically, tax departments The proper level of detail must be Specifically, companies should can leverage the detailed cost included in the invoice for both consider how their ERP system data buried within ERP systems income and indirect tax purposes. manages trading parties to track to make better decisions, set Single, lump sum invoices may be intercompany sales, which can appropriate policies, and enhance rejected by tax authorities who want be challenging if the appropriate the quality of their transfer pricing visibility into cost of goods versus modules are not in place to documentation. It is a leading other operating expenses. monitor related customer or practice for personnel vendor lists. Incorporating terms, to invest the time and effort to Appropriate confguration. such as INCOTERMS, is also a understand what information Closely related to the integrity key consideration. Instead of is available and leverage that of the data contained within an manually capturing the movement knowledge to select the best transfer ERP system is the quality of the of goods, companies should pricing policy for each transaction outputs it generates. As tax and leverage the ability of ERP systems based on the granularity of data transfer pricing compliance is not to configure flash title transfers available and the ability of the limited to tax returns and written for drop shipments and other system to accurately calculate and reports, supporting documentation transactions. ERP systems are record the transfer price. is a key part of substantiating and, also able, through customisable when necessary, defending tax modules, to manage parallel Management does not typically positions. This additional support valuation of goods dynamically, prepare forecasts on a legal entity may include invoices, expense allowing for the tracking of cost or product segmentation basis. reports, and executed agreements in both management and tax This data is important though for with both related and third parties, accounting instances. setting and managing transfer among other things. Configuring pricing targets. It is recommended the data warehouse, general Cross-functional collaboration. that finance and transfer pricing ledger, and other information Implementing and maintaining personnel work as a team to caches to generate useful an efficient ERP system requires monitor planning systems. Invoice outputs is a leading practice for coordination and communication generation is another key concern. multinational enterprises. across corporate departments Transfer pricing perspectives: Managing multiple stakeholders in the new economy The intersection of ERP systems and transfer pricing

Successful ERP systems require a team effort – and good communication

and operational business to understand additional reporting within the ERP system is units. Understanding the user or data capture that may be paramount. For example, the requirements of groups ranging necessary as the business evolves, controller group should be made from design and engineering to the company enters new markets, aware of interest payments, marketing, legal, tax, accounting, or tax laws change. unrealised inventory profit, and regulatory compliance, year-end true up adjustments. information technology, and Depending on the intercompany treasury helps to develop a pricing policy, transfer prices may More is not necessarily better. system that truly integrates the need to be submitted to finance Although an excess of add-on business and allows for real-time as absolute prices, a mark-up on modules is available for most strategic and tactical decision- standard cost, a discount from a ERP systems, multinationals are making. Especially important for list price, or another mechanism. well advised to use moderation multinational enterprises is the Proper communication between and restraint when it comes to involvement of the tax department departments and propagation adding supplemental systems Transfer pricing perspectives: Managing multiple stakeholders in the new economy The intersection of ERP systems and transfer pricing

to their existing ERP. Carefully are better positioned to mitigate with their tax, treasury, and evaluating the cost and the enterprise risk. finance colleagues - to guide the benefits of additional modules development, implementation, is necessary to avoid creating Return on investment. When tax and on-going maintenance of the a system that is unwieldy and and transfer pricing integration ERP system. Ultimately, the ability disjointed. At the same time, with ERP systems becomes a to report and analyse operational businesses should also be vigilant business imperative, companies financial data in real-time typically in creating exit strategies for legacy are better able to leverage their turns to increased profitability and systems. Particularly a concern systems to monitor profit level the easing of enterprise risk. for highly acquisitive companies, in local jurisdictions - enabling often there are significant intervals business results that are consistent Making tax & between the time a new company with the economic realities and transfer pricing is purchased and the sunset of the functions performed, assets integration with employed, and risks borne - and its previous systems. With older ERP systems a software, compatibility issues closely track the enterprise’s frequently arise that result in effective tax rate (ETR). priority benefits the need for manual actions to Understanding the drivers of ETR the business translate data from one system in real time can help corporate tax to another. These added steps and finance professionals quickly to create opportunities for potentially identify unutilised deductions and costly errors. non-beneficial transactions that do not support the business and take Generally, companies that seize action to remedy the situation. upon corporate lifecycle events – mergers, divestitures, acquisitions, It is vital that corporate and reorganisations - as a management information systems springboard to enhance and realign professionals work together within ERP systems with the business their organisation - especially Transfer pricing perspectives: Managing multiple stakeholders in the new economy The intersection of ERP systems and transfer pricing

Authors

David A. Nickson PwC US +1 646 471 6814 [email protected]

Andrew K. Hwang PwC US +1 646 471-5250 [email protected]

Elizabeth A. Sweigart PwC US +1 713 356 4344 [email protected] Transfer pricing perspectives: Managing multiple stakeholders in the new economy

“The art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.” 1

The politics of taxation

1 Jean Baptiste Colbert, French Economist and Minister of Finance under King Louis XIV of France 1619-1683 Transfer pricing perspectives: Managing multiple stakeholders in the new economy The politics of taxation

Criticisms, perceived on international groups to ‘wake shortcomings is still at a fairly shortcomings, and up and smell the coffee’ when it embryonic stage – and far reaching responses to today’s comes to paying tax; US Senate change will require plenty of changing environment public hearings into the failings (political) courage to implement. It is an understatement to say of the US system of corporation These factors complicate further that the last year has been an tax and perceived abuses by US companies’ decision making on a interesting one for transfer pricing groups; and the leaders of the G20 robust course of action. practitioners. When asked what group of countries come out in we do, for a lot of us, it’s no longer favour of real reform of the current a case of blank looks, but rather system of business taxation. Critics feel multinationals suspicion and an attempt to are abusing a tax system explain the arm’s length principle This article takes a look at designed for another era in layman terms (the authors the criticism and perceived wish the reader good luck in shortcomings of the current that endeavour). system. It also looks at the So why the criticism? potential alternative and policy Undoubtedly business tax has Since our global transfer pricing developments to date because been caught in the headwinds of conference in New York last year, of public and political pressure. austerity, with companies under we have witnessed unprecedented We also look at how companies pressure to not only pay their share criticism of some of the largest might react to the changing but be seen as paying their share. and best known multinational environment. With the (social) groups for their apparent ability media attention unlikely to fade One of the leading criticisms to avoid paying their ‘fair’ share any time soon, a ‘wait and see’ of the current system is that of tax. We have also seen senior approach to the OECD’s Base multinationals are able to abuse executives of multinationals called Erosion and Profit Shifting (BEPS) a system of taxation designed for before parliamentary committees project is unlikely to be enough. a different era. Indeed to some in the UK to explain their tax However, the OECD’s suggested extent that is a fair assessment. affairs; a UK prime minister call remedies to address system The present system is set out in Transfer pricing perspectives: Managing multiple stakeholders in the new economy The politics of taxation

double tax treaties, many of which promoted by over 100 NGOs, is profits (and therefore taxes) are were put in place decades ago a leading example of this line sales, fixed assets and headcount. based on an era where capital was of argument. less mobile. However these allocation keys may Is there an alternative? well lead to greater (and not less) Critics argue that the system But if the current system of inequity in the system. Because allows multinationals to set up corporation tax (based on the developed countries are wealthier their operations in a way that arm’s length principle) is no than developing ones, assets separates value creation and profits longer fit for purpose, what other values are likely to be higher. A (the latter often located in low option exists? system that allocates profit based tax jurisdictions). Multinational on assets risks pushing more (not less) profit to developed countries groups also have the ability to Is achieve double non-taxation – which goes against the very through mismatches within the a solution to current system arguments NGOs use to criticise international tax system. of corporate taxation... the current system. Moreover, or will it lead to more (but shifting from residence to source Others, and particularly non- different) problems? based taxation (eg using sales as governmental organisations one of the allocation factors for (NGOs), have chosen to highlight profits) will create winners and the impact of what is now The most common suggestion is losers among countries and so commonly referred to as transfer formulary apportionment (also international consensus is unlikely ‘mispricing’ on developing known as unitary taxation). to prove possible. countries, depriving them of This system would be based on corporate tax receipts which certain factors, by which profits Not only this, these factors would allow local governments to would be allocated and taxes themselves may not reflect where improve the lives of their citizens. then levied. The most common value (and profit) is created. Most The ongoing ‘IF’ campaign2, methods suggested for allocating systems that use some form of

2 http://enoughfoodif.org/issues/tax Transfer pricing perspectives: Managing multiple stakeholders in the new economy The politics of taxation

apportionment (eg US In so doing, the OECD came out or the EU’s proposed common firmly against systems such as OECD upholds consolidated corporate tax base) formulary apportionment and arm’s length ignore intangibles. Yet these re-stated its view that the arm’s principle as are increasingly driving profit. length principle remained the fundamentally Other factors that are commonly fundamentally sound method sound considered may not actually by which company tax will be have a significant link to profit determined between countries. generation.3 Only in those cases where a comparability analysis is The OECD’s Base Erosion and impossible to perform would it Profit Shifting project be possible to introduce “special Nevertheless, with very significant measures” that go beyond political momentum behind the the arm’s length principle. An case for reform, the OECD has example would be the measure been tasked with updating the similar to the US “commensurate system of taxation, under the with income standard” recently auspices of its Base Erosion and mentioned by Marlies de Ruiter of Profit Shifting (BEPS) project. the OECD at the IFA Conference in Copenhagen. As most of you know, the latest stage of the BEPS project was the Where should key areas of release of a 15 point action plan in action be centred? July 2013 to modernise and tackle Volumes have been (and continue the failings of the current system to be) written about the OECD’s of corporation tax. BEPS work. It’s not our intention

3 For example, headcount has been shown not to be a significant driver of profit generation yet is included in most examples of apportionment. See http://www.nber.org/papers/w15185.pdf for further details. Transfer pricing perspectives: Managing multiple stakeholders in the new economy The politics of taxation

to replicate that knowledge • It will be necessary for groups is likely to become readily here, other than to highlight the to understand and justify their identifiable to tax authorities; insightful material available on global value chain. It remains an and business structures designed the PwC website http://www. open question as to what level of to avoid tax (particularly those pwc.com/gx/en/tax/tax-policy- disclosure will be necessary, but without sufficient commercial administration/policy-trends. it is clear that more transparency substance) will become more jhtml. Suffice to say, the key areas will be required. Indeed the obvious to tax authorities. of action are centred on countering requirement to show ‘big picture’ This will heighten the risk base erosion and double non- information on the global value of tax authority challenge to taxation, aligning taxation and chain is mentioned in the OECD’s these structures and, perhaps substance, and transfer pricing and white paper on documentation4 more importantly in the the arm’s length principle. as a risk assessment tool rather long term, could do serious than an adjustment tool for reputational damage. So with all this change, how tax inspectors. This being said, should companies react? companies should be able to • The era of generic and superficial While we authors are not known explain consistently (ie same local country functional analysis for our clairvoyance (and do story across multiple territories) is likely to come to an end as not count a crystal ball among where the value in their business is widespread use of one-sided our possessions), it is possible to is generated. transfer pricing analyses. There identify certain outcomes from the was much debate on this same BEPS project that will have direct • Companies also need to consider point in 2010 with the release relevance to transfer pricing (there how their tax strategies might be of the revised OECD Guidelines are many changes that are not viewed with greater disclosure. (which abolished the hierarchy directly related to transfer pricing Preferential rulings will need to of methods) but tax authorities so are not dealt with here). be made public; the significance worldwide have not used the of intra-group transactions to ammunition these changes overall company profitability provided to challenge the

4 http://www.oecd.org/ctp/transfer-pricing/transfer-pricing-documentation.htm Transfer pricing perspectives: Managing multiple stakeholders in the new economy The politics of taxation

approach of many taxpayers. in developing economies and the Model Tax Treaty provision Nevertheless, with the current give levers to tax authorities of Article 7 (profit attribution political backing and focus on (eg explicit support for local using SPFs, which looks at what the use of profit split as part of a comparables in the latest draft people do and where) and Article value chain analysis, it is more Intangibles chapter) in those 9 (transfer pricing under the than likely that over time tax countries to argue for higher arm’s length principle where the administrations will demand a local returns. starting point is the contractual two-sided approach. arrangements). Less good news • Functions are going to is that tax authorities will move • The OECD is moving to accept increasingly drive where quickly to look at what people the arguments of the BRIC profit is located. First we do in cases where the actual economies in particular around had key entrepreneurial risk conduct departs from what the higher returns for ‘routine’ takers (KERTs; for branch contracts say. functions performed in fast profit attribution in financial developing economies. This services), then came significant • The issue of permanent point rings true particularly people functions (SPFs; for establishments is coming in light of the recently issued profit attribution in the widget back into fashion among tax OECD’s updated draft chapter world), and now we have authorities (leaving aside on intangibles5 and its important functions (in relation potential changes that may come recognition of workforce in to intangibles). Indeed newer in relation to PE definition). place, location savings, etc. Even CFC regimes, such as the UK, Outside of though these factors appear also draw on these concepts the question of PEs had gone to be seen as comparability and look at where functions away in a large number of factors affecting prices rather are performed in calculating countries. This is partly because than intangibles, this will put jurisdiction to tax. The good it is a difficult topic and tax pressure on the returns allocated news though is that this does not authorities often did not have to local operating companies mean a convergence between the experience. However with

5 http://www.oecd.org/ctp/transfer-pricing/transferpricingaspectsofintangibles.htm Transfer pricing perspectives: Managing multiple stakeholders in the new economy The politics of taxation

increased tax authority resources To wait will probably be too late, Can subject matter experts going into the area, eg the UK particularly as we see tax authority and PR specialists help the has set up a specialist PE unit, behaviour changing and becoming tax function counter (social) the risk of challenge is set to increasingly aggressive in light of media challenges? increase. This is particularly favourable political headwinds to true for digital business which take on multinational groups and will continue to be a high profile the amount of tax they pay. area. Tax authorities can be expected to pay close attention On a final note, many companies to how business is conducted are asking these days whether the and whether local territory tax functions should be staffed activities give rise to a PE of the with subject matter experts or PR offshore principal. specialists who may proactively counter (social) media challenges. Conclusion This is a difficult question to Undoubtedly these are challenging answer and a fair response is likely times for companies looking to be that one needs both. This will to deal with the changing tax not go away soon. environment. A number of changes are clearly signposted by the It will be fascinating to take stock unilateral actions of governments a year from now and consider as well as the OECD’s direction where the debate stands over half of travel. As such, companies can way through the OECD’s two year act now with a significant degree timetable for its action plan. of confidence to meet the new conditions and should not wait until specific actions are agreed multilaterally at the OECD level. Transfer pricing perspectives: Managing multiple stakeholders in the new economy The politics of taxation

Authors

Isabel Verlinden PwC Belgium +32 2 710 7295 [email protected]

Kevin Norton PwC UK +44 20 7804 5013 [email protected] Transfer pricing perspectives: Managing multiple stakeholders in the new economy

Some of the notable trends in the current landscape of the pharmaceutical industry bring about complex transfer pricing (TP) dilemmas that require companies to tailor their TP strategy accordingly.

Transfer pricing symptoms of chronic industry challenges Transfer pricing perspectives: Managing multiple stakeholders in the new economy Transfer pricing symptoms of chronic industry challenges

Some of the toughest challenges Pricing controls increasingly tough market. Growth for you as a professional in a Challenge: Soaring public economies are joining mature pharmaceutical and life sciences healthcare costs economies in using direct and company come from rapidly Tighter economic governance indirect pricing controls. Russia, changing market conditions and driven by a global fiscal crisis India, and Turkey are a few of a complex global economy with significantly reduced industry the countries that have recently multiple stakeholders. Pricing revenues over the last few years. introduced new or amended controls, the patent cliff, parallel Constraints on budgets and pricing controls. trade, realised and unrealised firm healthcare expenditures will likely synergies and the creation of local continue. Healthcare reforms Pricing controls can inevitably marketing intangibles are only in countries such as Portugal, decrease your company revenues, some of the key areas of concern Greece, and Italy are expected which are expected to be reflected in the industry. You may deal with to reduce costs and overall in local country income tax these issues day to day, but have pharmaceutical spending. collections. For some countries, you considered all their potential the decrease in public healthcare transfer pricing implications in costs may be tempered by a today’s evolving tax environment? Why are pricing controls loss of tax revenues from the becoming more prevalent pharmaceutical industry. Some of the notable trends in nowadays? the current landscape of the TP impact: Pressure on pharmaceutical industry also local margins bring about complex transfer To combat the unsustainable Government pricing controls pricing (TP) dilemmas that require trend of soaring public healthcare generally impact the residual profit companies to tailor their TP costs, many governments have claimant or the local distribution strategy accordingly. tightened pricing controls and entity. To insulate a local have increased regulation of the distribution entity from regulatory pharmaceutical industry. These or pricing control risks, you may actions have contributed to an consider various alternatives, Transfer pricing perspectives: Managing multiple stakeholders in the new economy Transfer pricing symptoms of chronic industry challenges

depending on the nature of the The interplay of regulations emerging markets, such as China, pricing controls. For example, imposing pricing controls India, and Brazil. Healthcare, you may consider decreasing with TP requirements and income tax, and customs the transfer price, if permitted. customs regulations may create authorities in a single country Pricing controls may also give you inconsistencies that can lead to often take divergent positions a business reason for setting up conflict. While many countries on pricing issues. For example, regional regulatory centres which do not have customs duties for Poland recently introduced a may support your company’s pharmaceutical products, such pharmaceutical reimbursement strategy of centralising functions. duties are still prevalent in law that applies maximum prices

Who should bear the impact of pricing controls? Transfer pricing perspectives: Managing multiple stakeholders in the new economy Transfer pricing symptoms of chronic industry challenges

and gross margin restrictions 2015 is expected to shrink sales TP impact: Comprehensively and also limits marketing nearly as much as in 2012. These redefne transfer pricing policy activities. Complying with the developments put pressure on The patent cliff may spur new requirements may lead to research and development (R&D) companies to take a closer look intercompany results below an in a market where sales and new at the value drivers of their arm’s length level and it is unclear product launches are expected to business. In the past, many whether the law overrides existing be limited. The anticipated result companies ascribed value to TP rules. is fewer blockbusters and more product intellectual property and high-priced specialty and orphan manufacturing-related functions, As a pharmaceutical company drugs. Patent cliff concerns are which is most likely no longer you can address the challenges of less prevalent for biologics as these the case after patent expiry. pricing controls by establishing a large molecule drugs are more Therefore, companies may need flexible TP system and a robust end- difficult to replicate. to carefully consider their post- to-end process that accommodates patent commercial value drivers the challenges of multiple tax and Also, the patent cliff and the and, if appropriate, unbundle regulatory requirements. inherent pressure on the R&D product intellectual property, pipeline may generate more manufacturing intangibles, Patent cliff and post-patent merger and acquisition activity in other corporate functions and life of drugs the industry. A recent example is distribution intangibles. Challenge: Survive the fall Amgen’s $10 billion acquisition of As a pharmaceutical company, you Onyx. Companies with promising How does the patent cliff may have tasted the bitterness of Phase II/III drugs in their portfolio impact your transfer pricing the so-called ‘patent cliff’ during make attractive acquisition targets. 2012 – when the patents for a More companies may also consider strategy? number of blockbuster drugs spinning off an established cash- expired, and sales of generics generating business from a more The distribution TP policy might eroded industry profits. A second speculative drug development have received little attention wave of patent expirations in business as it happened for Abbott. during the patented life of Transfer pricing perspectives: Managing multiple stakeholders in the new economy Transfer pricing symptoms of chronic industry challenges

blockbusters when the local in local distribution returns also company these days is the parallel market enjoyed high margins. creates challenges for local TP trade of drugs on the ‘grey’ market. As products come off patent compliance purposes. and pressure on system profit Parallel imports are increases, the local distributor When patents expire, local pharmaceutical products produced should be properly compensated in health authorities usually like to under protection of a trademark line with its functional profile. ensure drugs reach the market or patent that are placed into at the lowest possible price circulation in one market and You may also want to reconsider (particularly if included on then imported by an unaffiliated your intellectual property licensing reimbursement lists) and could intermediary into a second market arrangements. Prior to patent impose pricing controls that put without the authorisation of the expiration, these agreements pressure on the local distribution local owner of the intellectual often accounted for both product margin. Transfer prices should property right. Parallel trade and marketing intangibles, and be revised immediately after occurs when one takes advantage now their scope may need to be patent expiration as delayed of the price differential between redefined or adjusted. Firstly you action may also have indirect two countries. For example, should analyse which products tax consequences. parallel trade tends to prevail in demand post-patent royalties certain countries of the European and then reassess the royalty Parallel trade Union (EU) where drug prices are rate, which in some cases will be Challenge: Retain brand proft considerably higher than in other expected to be significantly lower. Globalisation has increased the EU member countries. challenges of retaining brand Depending on factors such as the profit. An increasingly complex TP impact: Manage TP audit risk speed of introducing generics or supply chain involving multiple Parallel trade products may certain manufacturing advantages, stakeholders across geographies compete with and benefit from the margins for generics can erode makes preventing product marketing activities of the local almost instantly or progressively diversion more difficult. Therefore, distributor or licensee. Therefore, over time. The resulting volatility one real threat to a pharmaceutical your local entity sales volume Transfer pricing perspectives: Managing multiple stakeholders in the new economy Transfer pricing symptoms of chronic industry challenges

What is the potential TP exposure triggered by parallel trade?

may decrease in spite of the same • Requiring cost-plus coordinated, consistent, and level of marketing efforts, which compensation on (deemed) local cross-functional approach to proportionally benefit the parallel marketing and promotional brand protection that reaches importer. Tax authorities in some expenses incurred by the local across the entire organisation. countries, such as Germany, are distributor with respect to the In assessing the related risks, considering the TP implications parallel trade sales; or you need to consider the possible of parallel trade as if local impact on your TP strategy and promotional activities provide a • Denying deductibility for tax the potential for adjustments service to affiliated entities whose purposes of the local marketing by local taxing authorities. products get parallel exported. and promotional expenses One option to address the Local tax authorities may adjust incurred by the local distributor parallel trade related exposures taxpayer income to accommodate with respect to the parallel could be to have preventing parallel trade effects by the trade sales. compensating adjustments for the following potential approaches: affected affiliates. A strong brand protection • Deeming the parallel trade programme may help you sales to be sales of the local identify and prevent parallel distribution entity; export. You should consider a Transfer pricing perspectives: Managing multiple stakeholders in the new economy Transfer pricing symptoms of chronic industry challenges

Local marketing intangibles 15 separate action points, intangibles. To avoid the TP Challenge: Keep up with including assuring that TP pitfalls associated with marketing the evolving international outcomes are in line with value intangibles, you should consider tax environment creation (function) with regard aspects of your operations that Tax authorities have recently to intangibles. Shortly after could impact this determination, looked to address the the Action Plan was published, such as relationships developed observational trend that profit the OECD released its Revised with local healthcare professionals resulting from locally-developed Discussion Draft on the Transfer and regulatory bodies, expertise of intangible property often goes Pricing Aspects of Intangibles. The the local sales force, etc. untaxed in the local jurisdiction. Revised Discussion Draft provides Consequently, tax authorities are guidance on allocating intangible- Local Phase IV clinical trials raising more and more challenges related return and focuses on may also present an area of with respect to locally developed functional value creation. concern. Trials can be powerful or locally funded marketing tools in influencing prescribers intangibles when discussing the TP impact: Manage scrutiny of of a product and could generate appropriateness of characterising local marketing intangibles local marketing intangibles. In the local entity a routine entity. Intensely competitive market particular, you should consider the conditions and the strict regulatory funding of local Phase IV clinical To establish a more robust environment in the pharmaceutical trials by a foreign related party to framework on the international industry have increased the inoculate yourself of this risk. treatment of intangible property, importance of local sales and the Organisation for Economic detailing activities, as well as after Why local marketing Co-operation and Development sale complementary activities. intangibles are still (OECD) issued in July its long- As such, as a pharmaceutical awaited Action Plan regarding company you will often come an area of concern for Base Erosion and Profit Shifting under scrutiny when it comes to pharmaceutical companies? (BEPS). The Action Plan proposes the risk of creating local marketing Transfer pricing perspectives: Managing multiple stakeholders in the new economy Transfer pricing symptoms of chronic industry challenges

All these industry developments 3. Flexible in accommodating new operating model, deliberate should be high on your agenda industry and consideration of several factors, when formulating your company’s regulatory developments? lessons learned from the industry’s transfer pricing strategy. It is audit and controversy history, and important to stay abreast of 4. Efficient and reliable? a fresh perspective on the latest marketplace evolution and industry trends. ask yourself, is my transfer As the industry transforms itself pricing strategy: to adapt in a changing global Is it time to think about economy, you are not alone in revisiting your transfer 1. Current? having second thoughts about pricing strategy? some of the above questions. 2. Managing the needs of Crystallising your optimal our various internal and transfer pricing strategy requires external stakeholders? a clear understanding of your

As the industry transforms itself to adapt in a changing global economy, you are not alone in having second thoughts about some of the above questions. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Transfer pricing symptoms of chronic industry challenges

Authors

Brian Burt PwC US +1 646 471 8386 [email protected]

Blanca Kovari PwC US +1 646 471 6817 [email protected]

Horacio Peña PwC US +1 646 471 1957 [email protected] Transfer pricing perspectives: Managing multiple stakeholders in the new economy

Running and growing an international business continues to become ever more complicated in today’s geopolitical and economic environment.

Value Chain Transformation Globalisation Maturity Framework Transfer pricing perspectives: Managing multiple stakeholders in the new economy Value Chain Transformation Globalisation Maturity Framework

Overcoming complex Value Chain Transformation Chain Management: The Five challenges to achieve goals (VCT) Globalisation Maturity Disciplines for Top Performance3 and realise benefits Framework – to enable and PwC’s PRTM Management Running and growing an multinationals to assess how they Consultant’s Insight article international business continues are dealing with these challenges Guiding Global Growth4 and to become ever more complicated and what changes are required discussions with executives in today’s geopolitical and in various dimensions of their of multinational companies economic environment. From management (decision-making), across various industries, we difficulties in attracting and operational (execution) and legal have concluded that the path to retaining talent, managing supply (control) structures to achieve globalisation maturity in today’s chain operations through extreme their strategic goals and realise business environment typically market volatility, disruptive operational and financial benefits. leads through four phases with events and rapidly evolving four different models - Domestic, sales channels, to managing Understanding the multi- Export, Regionalise and financial and regulatory risk dimensional elements of Originate. We have observed that and reputation in the post-BEPS1 globalisation models the implications for international environment, companies across Based on our research, including businesses of all sizes and in all industries find themselves a fresh review through the all industries of adopting these faced with increasingly complex lens of today’s global business models may be analysed using and multi-dimensional challenges environment of Bartlett & a matrix of twelve dimensions as they expand their businesses Ghoshal’s seminal 1998 work covering three types of structure globally. PwC’s recent research Managing Across Borders: The within the organisation – and discussions with executives Transnational Solution2, Cohen management, operational provides a new framework – the and Roussel’s Strategic Supply and legal.

1 Organisation for Economic Co-Operation and Development (OECD): Initial Report on Base Erosion and Profit Shifting (BEPS), February 12, 2013 2 Christopher A. Bartlett and Sumantra Ghoshal: Managing across Borders: The Transnational Solution – 2nd Edition. Harvard Business School Press (1998) 3 Shoshanah Cohen, Joseph Roussel: Strategic Supply Chain Management: The Five Disciplines for Top Performance – 2nd Edition. McGraw Hill (2013) 4 Keith Robinson, David Van Oss, Shoshanah Cohen: PRTM Insight: Guiding Global Growth Q2, 2010. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Value Chain Transformation Globalisation Maturity Framework

Figure 1 opposite defines the model to another is often difficult twelve dimensions used in the VCT and disruptive and companies Figure 1: PwC’s VCT Global Maturity Framework dimension definitions Globalisation Maturity Framework. may retain elements of more than Definition one model as they move through Management 1. Talent Ensure that critical skill sets are structure available where needed Companies typically start with transition periods. 2. Governance Define responsibility for setting strategy Domestic model and grow into and meeting business objectives one of the other three business This model generally applies to Operational 3. Market reach Define and penetrate target markets models to meet various objectives, companies about to embark on structure 4. Market Maintain a product portfolio suited to strategies and requirements. international expansion. They may offering the needs of target markets Enabling strategy requires be leaders in their home territories 5. Operations Define an operating footprint that supporting a company’s key or companies with rapidly balances cost and customer service sources of competitive advantage, growing businesses which may be objectives 6. Procurement Ensure product quality, reliability, and and a good strategy should looking to grow a global footprint timeliness through a network of trusted be aligned, tailored, resilient, initially through alliance with suppliers responsible and adaptable. other companies or cross-border 7. IP Develop strategic technologies while New models may need to be acquisitions. management protecting access implemented over time to align 8. Service Ensure customers’ needs are met before, during and after delivery of with changing circumstances. Companies adopting the Export products and services This may be for a range of reasons model typically have a centralised 9. Partnerships Define and manage internal and from something as commonplace management, operational and legal external partnerships and alliances to achieve the right operational strategy as shifting market requirements structure, with development and for each new market to a single significant event ownership of core competencies Legal structure 10. Capital Ensure access to strategic capital and – such as an industry player concentrated and retained at meet investor expectations for ROI changing model and deriving an the headquarter location. This 11. Legal Frame business structures, contractual model allows companies to scale relationships, corporate transactions advantage as a result, forcing its and compliance competitors to follow or develop up for international business 12. Economics Deploy functions, risks and assets an alternative differentiating with strong control from the across legal entities approach. Progression from one headquarter location. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Value Chain Transformation Globalisation Maturity Framework

The Regionalise model typically involves centralised regional hubs What are the main controlling the business by region. business models Companies using this model put companies use? significant focus on adapting to Domestic, Export, regional market needs, configuring Regionalise and core offerings and multi-domestic Originate strategies as required. Moving to this model involves significant changes in management, operational and legal structures as the company moves towards building core competencies across all regions.

Finally, the Originate model is a globally devolved model. R&D, operational innovations and other valuable contributions may come from any location, be available to affiliates worldwide and jointly owned. This model is often called the industrial franchise model, with worldwide reciprocal interdependency between members. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Value Chain Transformation Globalisation Maturity Framework

Figure 2 below provides a summary overview of the matrix of models, structures and dimensions in our VCT Globalisation Maturity Framework.

Figure 2: PwC’s VCT globalisation maturity framework matrix Domestic model Export model Regionalise model Originate model Management 1. Talent Leadership and talent Senior management from home Recruits locally including regional Senior leaders from various home structure focused in local country country management regions 2. Governance Decentralized federation Command and control approach Increasing regional dimension and Integrated global / local governance evolution Operational 3. Market reach Focused on local market Overseas sales through rep offices Increased overseas presence Market approach adapted for each Structurestructure / third parties region 4. Market Local market Virtually identical products cross- Products adjusted for local Products originate in and tailored to offering markets markets new regions 5. Operations Local country, plus Strong home country supply chain Increasing localization of Global footprint determined by total potentially leverage low with int’l distribution production and supply landed cost cost country 6. Procurement Local country, plus Procurement for low-cost Active sourcing in newly targeted Company manages a global tiered potentially low cost country countries regions partner network 7. IP IP developed, managed, IP closely guarded in home market R&D centers deployed in Global network to exploit wider R&D management retained in local country expansion regions ecosystem 8. Service Predominantly local market Home country resource support Regional service centers of Global best practice applied in each internationally excellence market 9. Partnerships Limited within local market Focus on distribution & potentially Broader use of partnerships Global partnerships based on service & sales across multiple dimensions strategic core competencies Legal structure 10. Capital Local financing on strength Capital financing provided by Increasing regional allocations of Structuring to access new sources Structure of local bal sheet home country capital of capital 11. Legal Autonomous local entities Contractual relationships Hub and spoke contractual Shared responsibility for contractual controlled by center relationships relationships 12. Economics Limited cross-border Key activity concentrated in center Key activity split between center Interdependencies between interaction and regional hubs countries Transfer pricing perspectives: Managing multiple stakeholders in the new economy Value Chain Transformation Globalisation Maturity Framework

Figure 3 provides a diagrammatic illustration of the models. Figure 3: Diagrammatic illustration of the four models5

Implications and application Domestic model Export model The implications of the framework are important and far-reaching for all companies operating or wishing to expand internationally. A move from one model to another forces companies to adopt new approaches for each dimension to support the new model. Different dimensions will carry different levels of importance for different companies, depending on their Regionalise model Originate model strategic and other priorities, but ultimately all dimensions need to adapt to the new model. The level of change required to ensure competitive advantage sources support the strategy under the new model is significant and requires a deep understanding of the issues as well as the drive and discipline to implement. However, the results of high-performing supply chains on business performance are

5 The circles may represent countries, market or legal entities, with the circle size corresponding to importance or size. The lines between the circles represent their interrelationships, with solid lines denoting strong interrelationships and dotted lines representing weaker interactions. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Value Chain Transformation Globalisation Maturity Framework

compelling. Compared with their achieve this understanding and industry competitors, leaders see6: develop a strategy that is aligned, Up to now, companies tailored, resilient, responsible and implementing new models • 50% higher average annual adaptable. Up to now, companies have typically focused on sales growth implementing new models have changing one structure or • 20% higher profitability typically focused on changing • 50% higher net asset turns one structure or a select few a select few dimensions • 15% lower supply chain dimensions. However, invariably, management costs the analysis of the change required PwC’s approach leverages a closely • Less than half the is not comprehensive or holistic integrated team of professionals inventory levels and without understanding all of with the range of experience • More than three times shorter the interdependencies between and expertise across the full cash-to-cash cycle times the full range of structures and range of relevant disciplines to dimensions, it is generally not understand, analyse and evaluate Regardless of industry or size, possible to truly understand the implications of changing the it is vital for management to the overall implications of such various dimensions and, most understand exactly where their change. Successful transformation critically, the interdependencies organisation lies along the starts with setting realistic between them. Our framework for globalisation maturity spectrum, goals. Changes can range from analysis may be applied broadly for where their competitors are incremental improvements, companies of all sizes in different positioned, what they need to such as making processes more industries and aims to align change to meet strategic objectives consistent and predictable, to management, operational and and how they achieve that breakthrough innovations, like legal structures to achieve strategic change. Our VCT Globalisation brand-new ways of competing in goals and realise financial and Maturity Model provides a an industry. operational benefits. focused and objective way to

6 Shoshanah Cohen, Joseph Roussel: Strategic Supply Chain Management: The Five Disciplines for Top Performance – 2nd Edition. McGraw Hill (2013). 7 PwC: 10 Minutes on Strategic Supply Chain Management. September 2013. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Value Chain Transformation Globalisation Maturity Framework

Figure 4 opposite summarises our approach in applying the VCT Globalisation Maturity Figure 4: PwC’s VCT Globalisation Maturity Framework Approach Framework approach. Improved Using the framework to assist Vision and Management Operational Legal delivery multinationals in analysing and strategy structure structure structure to customers evaluating some key questions. (decision) (execution) (control) Increased sales Talent Market reach Capital For example: Governance Market offering Legal Operations Economics Higher earnings Procurement • How do we evaluate whether IP management Improved our current model will Service cash flow continue to help us achieve Partnerships our vision and strategy Optimised going forward? Based on PwC globalisation maturity model for the dimensions to be assessed operational transfer pricing Using the framework, we Minimise identify where multinationals tax exposure currently lie on the VCT Globalisation Maturing Management, operational and legal structure alignment Sustainability Framework spectrum, analyse whether they are as evolved as they should be, evaluate how they compare to their peers and competitors and identify optimal target models. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Value Chain Transformation Globalisation Maturity Framework

• What are the critical The framework is used to assist dimensions for our success companies to attain clarity on A powerful tool and have we focused on the change requirements to to enable you as a these in the right way? Is our achieve the target model and multinational to strategic plan clear, focused develop a clear implementation assess how you are and coherent across different plan covering all of the dealing with the business units, functions and structures and dimensions. many challenges regions? of international Conclusion: A powerful expansion We apply the framework to tool for dealing with evaluate which dimensions the expansion challenges company should focus on to PwC’s new VCT Globalisation achieve its objectives, identify Maturity Framework provides a gaps between the current and powerful tool to enable you as optimal approach, and assist in a multinational to assess how refining the current strategy or you are dealing with the many developing a new one. challenges of international expansion. It also looks atwhat • How do we develop a changes are required in various coordinated and flexible dimensions of your management approach to expansion at (decision-making), operational all levels of business and (execution) and legal (control) how do we execute the structures to achieve their strategic required change? goals and realise operational and financial benefits. Transfer pricing perspectives: Managing multiple stakeholders in the new economy Value Chain Transformation Globalisation Maturity Framework

Authors

Steven Tseng PwC China +86 21 2323 2766 [email protected]

Craig Kerr PwC China +86 21 2323 8686 [email protected]

Shane McEvoy PwC China +86 21 2323 1275 [email protected] www.pwc.com/tptogo

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