Expanding your business offshore? Here’s what you need to know about transfer pricing
Tax Alert - September 2022
By Allan Munro & Lucy Scanlon
There are a myriad of issues to consider when expanding your business offshore, one of which is transfer pricing. But what is transfer pricing and why is it important to get transfer pricing right?
First up, what actually is transfer pricing?
With corporations operating across multiple countries, every revenue authority wants to make sure that it receives its fair share of the tax pie. Transfer pricing is simply the rules applied to make sure every country gets the right amount of tax. The rules apply to ensure that every entity within a multinational group (whatever size that group may be) earns an arm’s length return for the functions performed, assets held and risks assumed by the entity. A good way to think of transfer pricing is as the economic overlay on the commercial operations to make sure every entity is rewarded fairly.
What do you mean by arm’s length?
Arm’s length simply means that any transactions between associated entities across jurisdictions are undertaken as if the related entities were independent third parties, i.e., as if the two entities were unrelated and transacting with each other on standard commercial terms.
But transfer pricing is just a year-end compliance requirement, right?
Not quite. While there are compliance requirements to prepare an appropriate level of transfer pricing documentation annually (we will come back to what an appropriate level of documentation looks like), to be able to meet those compliance requirements the transfer pricing approach needs to be in place during the year, so you need to understand and apply the transfer pricing approach in the business operations before you can document the approach to meet any compliance requirements.
OK, so what is an appropriate level of documentation?
Inland Revenue expects taxpayers to support the arm’s length nature of its related party transactions through the preparation of an appropriate level of documentation. The appropriate level depends on the level/materiality of the transactions and should always include the appropriate intercompany agreements. So, if the transactions are limited Inland Revenue would anticipate a level of documentation in line with that risk (so practical and succinct) as opposed to a large multinational business with complex and multiple transactions (in which case Inland Revenue would anticipate full technical transfer pricing documentation).
How do I figure out my transfer pricing approach and how do I apply it?
In short, talk to a transfer pricing person. The mistakes we often see are ignoring transfer pricing until it’s too late or applying a transfer pricing model that worked for a mate who did something similar or just assuming that the offshore entity should be in a loss because it is in a start-up phase and reverting back to ignoring transfer pricing. Please do not fall into these traps, they can be expensive to unravel especially when discovered a few years down the track, remembering that revenue authorities can go back at least four years to ensure to correct amount of tax has been paid and an adjustment in one jurisdiction will also require an adjustment on the other side of the transaction. The key to getting the right transfer pricing model in place is to talk to a professional about what’s happening in your specific circumstances. A good practitioner will identify and tailor the level of assistance you need for your circumstances and the level of any supporting documentation required to ensure a practical and efficient outcome.
So, I should sort the transfer pricing but really, what’s the worst that can happen if I don’t, I’m pretty small and I’m sure I can fly under the radar…
- It’s not just one year and it’s not just one revenue authority – transfer pricing looks at transactions between related entities. In every transaction, there are two parties. If one revenue authority decides to adjust, that means the other side of the transaction also needs to adjust. A revenue authority can also typically go back at least four years to ensure an arm’s length outcome so the risk is not just for one year (Inland Revenue in certain circumstances can go back seven years).
- Thinking about transfer pricing can help you think strategically about your offshore expansion – transfer pricing looks at the business operations at an economic level and can help clarify exactly what you want your offshore entities doing and from that, where your people should be sitting/what they should be doing/when further expansion may be required, which can also help in mapping and managing other tax considerations and requirements (i.e., compliance, residency, etc).
- Permanent establishment risk – permanent establishments (i.e., a taxable presence) in other jurisdictions can be easily created, often unintentionally created and only discovered in retrospect (please note that if you have people offshore then you need to be thinking about whether these people are creating a permanent establishment). If you have considered your transfer pricing upfront you will know who is and should be doing what functions in which entity, ensuring an arm’s length return for the offshore entities, thereby reducing the risk of invertedly creating taxable presences and tax risks in offshore locations.
- Tax deductibility – transfer pricing should be part of your business operations and not just a year-end journal entry to retrospectively reflect the right economic outcome. There needs to be real transactions between the related entities, supported by actual executed intercompany agreements, to ensure expenses are deductible in the right company and in the right year. The risk of not considering, implementing and supporting your transfer pricing approach in real-time is that a revenue authority could consider that there is no actual legal transaction, potentially leaving deemed transfer pricing income in one jurisdiction but no deduction in the other jurisdiction.
- Tax losses trapped– if transfer pricing has not been set up correctly then tax losses may be recognised in the wrong jurisdiction. To the extent, a profitable return is expected by the foreign jurisdiction but the entity has returned losses, these losses may not be allowed to be utilised, effectively trapping the losses offshore. Alternatively, paying too much tax offshore (and not enough in New Zealand) could lead to double taxation.
- Tax obligations missed – if you don’t think about your intercompany transactions upfront, you might miss some tax obligations in relation to those transactions. A good example is royalties and interest transactions, both of which have withholding tax obligations on payment and likely penalties for late payment.
- Global compliance rules – documented transfer pricing approaches are a common requirement in all markets, major and minor alike. These compliance expectations vary greatly between jurisdictions. It is therefore important to be aware of what these may include to avoid any unwanted surprises. In addition, adhering to compliance rules often mitigates any shortfall penalties (within reason) in most jurisdictions.
- Customs is also interested in your transfer pricing - Import and export transactions should be correct at the time of transaction. Importers who find they need to change the value of goods after importation can be subject to fines and penalties on underpaid GST and customs duty. As such it is important that transfer pricing has been considered early and followed throughout the year to ensure no unexpected customs problems arise later. It also pays to remember that in many jurisdictions the customs authorities work closely with the transfer pricing teams at the relevant revenue authorities so consistency is key.
- Sale and exit – If the ultimate goal is to eventually exit, transfer pricing will come up as part of the due diligence process. Potential acquirers will want to see that an appropriate transfer pricing approach has been applied and documented. Not having a transfer pricing approach or the appropriate level of documentation can be identified as a tax risk that can impact the purchase price.
What should I do?
From a New Zealand perspective, Inland Revenue expects an approach that is commensurate with your transfer pricing risk. This can range from a discussion through to full suite of documentation. As such, it is critical to have a discussion with a transfer pricing specialist upfront to understand the appropriate transfer pricing approach and what level of documentation would be required for your level and risk profile. This discussion would also cover the implementation and operationalisation of transfer pricing to ensure these processes become part of BAU operations.
If you would like to discuss any of the above in more detail, please contact your usual Deloitte advisor or Deloitte’s specialist transfer pricing team.
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