For multinational enterprises, global competition is intense. Prices and margins are under unrelenting pressure, and speed to market can be a critical factor in determining who wins and who loses. The "need for speed" in conjunction with the global rationalization of manufacturing capacity brought about by the desire to manage cost is altering the global supply chain. The above is true under the best economic conditions, but in this recessionary market, the stakes have never been higher.
For companies that rely on their supply chains, proactively managing the worldwide effective tax rate can yield dividends-literally and figuratively. In industries that are truly global in scope, and in which tax rates in major centers of activity vary widely, transfer pricing can play an important role in achieving best-in-peer-group tax results.
What Is Transfer Pricing?
Unlike market prices, which are determined by the market behavior of independent buyers and sellers, transfer prices are determined internally within a company (intracompany) or group of related parties (intercompany), and are therefore subject to scrutiny by tax authorities, financial auditors and other regulators.
Multinational vertically integrated groups that compete in a global economy need to pay acute attention to the tax and accounting implications of all intercompany (typically across international borders) transactions, including the transfer of goods, the rendering of services, the license or sale of intellectual property, the provision of loans, and/or guarantee fees.
In most countries, assessing whether a company is complying with local regulations or guidelines is tested by determining if the company's transfer pricing is consistent with the arm's-length standard. That standard relies on the theory that independent parties engage in rational profit maximizing behavior, not favoring one party or another, and therefore results from related party transactions are expected to be consistent with those results that would have been achieved by independent parties.
Optimal Supply Chain Utilization
Optimal supply chain utilization is critical to multinationals, and the benefits can be substantial; get it wrong and the consequences can be devastating. An optimized supply chain centralizes value-adding business activities (functions) in locations that provide a favorable environment in terms of both general business climate, operating costs and, last but not least, taxation. These functions include but are not limited to:
* Production planning
* Inventory management and warehousing
* Manufacturing oversight and quality control, and
* Financing and cash management.
The benefits of supply chain optimization can include optimization of working capital, improved product availability through better supply chain visibility, efficient asset utilization, rationalization of supplier base, contract compliance, supplier relationship management, increased control and management of spending, and improved financial planning.
To reap the benefits of supply chain optimization from a taxation perspective, and make it stand up to the scrutiny of interested tax authorities, optimal supply chain planning must establish appropriate business processes and associated transfer pricing policies for the resulting transactions between the entities of a group's structure. The centralization of functions, assets and risks creates clear and long-standing operational benefits to multinational firms and will, if done properly, attract (taxable) income to those supply chain hubs. If possible, allocating those centralized activities to a low tax rate jurisdiction, all other things being equal, may provide additional benefits.
Impact of Recession
The environment for tax-efficient supply chain optimization is evolving. How does one identify (and then take advantage of) such transfer pricing opportunities
1) in an environment with increased regulation,
2) with increased enforcement, and to top it all off,
3) in a global economic downturn?
To discuss all the potential regulatory changes around the world is too much to cover here, so the brief comments below focus solely on possible developments in the United States.
In May 2009 President Obama announced a desire to "restore fairness and balance to the U.S. tax code". The initiatives in the proposal, commonly known as "The Green Book" are intended to:
* Ensure that the U.S. tax code does not encourage job creation offshore versus in the U.S.; and
* Reduce the amount of taxes lost to tax havens, through closing of unintended "loopholes" that allow companies to legally defer U.S. taxation on foreign source income or through tax evasion.
While tax reform seems to have taken a backseat to other items on the president's agenda, and it is not known what will ultimately happen, the theme is certainly clear, stricter enforcement and additional hurdles. We do expect, however, that tax planning for global supply chain optimization will continue to be a viable option if implemented and documented properly.
In addition to potential sweeping tax law changes, President Obama has stated that he wants the Internal Revenue Service to hire, between the current IRS fiscal year and IRS fiscal year 2010, a total of 1500 new agents. This new headcount is expected to consist primarily of international examiners and economists. In addition, the U.S. Competent Authority, whose primary function is to resolve double-taxation issues arising from transfer pricing audits, has already hired 12 new analysts, For multinationals with U.S. operations, the writing is unmistakably on the wall: the number and intensity of transfer pricing audits is certain to increase substantially.
Global Economic Downturn
Transfer pricing in a recessionary environment is a potentially very broad and comprehensive topic. Two topic areas of considerable interest are:
1) The challenge of setting and testing appropriate returns for functions, risks and assets along a global supply chain (so-called "routine returns"); and
2) The impact of the significant change in discount rates on asset values, in particular on intercompany transfers of businesses and assets such as trademarks, patents, contracts, and general business goodwill.
The basic notion of transfer pricing is to provide a framework for allocating taxable income among the relevant related parties. This idea, with minor variations, is formalized in both U.S. transfer pricing regulations, the OECD guidelines, and transfer pricing regulations in 30-plus countries ... and counting. Invariably, these rules, and transfer pricing methods contained within, presume that there is a system profit (not loss), i.e., that the overall value chain generates income rather than a loss.
What happens when that is no longer the case?
In the current market environment, many multinationals are struggling with the following challenges in setting and documenting defensible transfer prices:
• Routine returns -- how to treat routine (usually more or less guaranteed) profits for activities that are part of a global supply chain (such as the activities mentioned above, but also distribution, manufacturing and other corporate services). Can a multinational group sustain a transfer pricing policy that guarantees profits to some members when there is no group-wide profit?
• Business and asset transfers - what is the impact of shrinking margins, changing discount rates, and valuation multiples on the transfer of businesses, IP or other assets?
• Financing - What is the impact of the credit crisis on interest rate benchmarks? What does this mean for intercompany loans and guarantees?
For companies with global supply chains this is a time of opportunities and challenges.
Consider revisiting your company's intercompany pricing policies and agreements. Don't hesitate to be creative (within the applicable legal and regulatory framework)-the current environment supports adjustments to and optimization of your existing tax and transfer pricing structure.
Even better, evaluate whether this is a good time to make more fundamental changes to your global supply chain. Governments are competing harder than ever to attract foreign investment, the resulting opportunities for its citizens, and of course tax revenue. Tax holidays or even direct subsidies are available in many jurisdictions. Supply chain hubs lend themselves particularly well to taking advantage of such incentives, and may offer opportunities to improve both tax and customs outcomes.
How can you get certainty that it will work?
Proper implementation and professional documentation is a prerequisite for success. Depending on your company's appetite for risk, one way is to proactively seek resolution with taxing authorities. Many countries now have Advance Pricing Agreement (APA) programs. An APA program is designed to resolve actual or potential transfer pricing disputes in a principled, cooperative manner, as an alternative to the traditional adversarial process. An APA is a binding contract between one or more taxing authorities and a taxpayer by which the taxing authority agrees not to seek a transfer pricing adjustment for a covered transaction if the taxpayer files its tax return for a covered year consistent with the agreed transfer pricing method. An APA can take the uncertainty out of transfer, which can be particularly helpful, especially in these turbulent times.
Source: DLA Piper
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