Corporate tax: Group Transfer Pricing policy as a tool for transfer pricing risk management

In our previous articles we discussed the process and issues that arise in documenting and proving the arm’s length level of the prices in controlled transactions that have already occurred, i.e. the TP compliance procedures.

The TP documentation confirms and proves only past events, and the analysis is based on the accounting data (revenues, costs, margins) of controlled transactions in the closed reporting period.

Most companies or businesses that already have certain history of TP compliance monitor the TP issues in two directions:

• Compliance: past events (task 1)
• TP planning and controlling: future or planned transactions (task 2).

Chronologically, the management starts to organize process with task 1 (compliance). This includes usually TP transactions notification/declaration (TP disclose form), preparation of Local File, Master File, Country by Country Reporting (CbCR).

As soon as task 1 is settled more or less or repeated several times the management has some sort of statistics on problems/risks and issues which can arise as a result of preparation of deliverables on task 1. These issues could include discrepancies in prices/margins, lack of audit trail to support some statements / facts in local documentation or CbCR, too aggressive or questionable judgements, etc.

Usually it is difficult to mitigate the identified risks in relation to closed reporting periods or already occurred and documented transactions. You can perform adjustments to your actual result on the controlled transaction on some factors (country risk, working capital differences, currency risk), but anyway if for example the wholesales operation margin is too low and does not match benchmark, the only thing you can do is to fix the TP risk and calculate the profit tax based on the adjusted result. Here we come to the task 2 - planning and controlling of transfer pricing in relation to future or planned operations between group entities. Effective management of this task allows to foresee the above mentioned situations and prevent them or mitigate beforehand.

In order to organize the planning and controlling process in a structured way many companies issue official TP policy or rules which regulate the typical controlled transactions.

What could be included in this TP policy and what is important?

TP scope/types of controlled transactions

Usually the management knows or could foresee what type of operations are planned between group entities. That means that “potential risky areas” could be officially named or listed in this document and state that special rules are valid for such types of transactions.

Example: The Group with the headquarters in Dubai has several subsidiaries: in Kazakhstan, Singapore, Russia. The parent company imports goods from third parties and sells them to subsidiaries on a regular basis. Also, there are some management fees and license fees.

The following types of operations should be within the scope of TP policy: sales of goods, management fees and license contract(s).

Terms and economics of TP transactions

As soon as the above-mentioned types of transactions are within potential risk of being reviewed by tax authorities, the management should beforehand prepare to prove and include in the contract the arms-length-basis principle for the planned transactions. 

That means:

• Clear and transparent functional profile of parties involved in the contract;
• Selection of TP method;
• Price or margin depending on the method applied, which is to be close to the market or within calculated benchmark;
• Comparability criteria with relevant documentation support;
• Enough audit trail;
• Other possible alternative evidence/facts that prove that the transaction was performed on arm’s length basis.

Below you will find examples of why the above are important and typical mistakes that can lead to unavoidable risks later on.

Transparent functional profile

Negative practice:

In a sales contract between UAE entity (parent entity and seller) and Kazakhstan entity (subsidiary and purchaser) it is stated that UAE entity carries all entrepreneurship risks and market risks in relation to the goods transferred to Kazakhstan. The excessive margins remain with the UAE entity.

In fact, the goods purchased by UAE entity from Singapore delivered directly to Kazakhstan, the transfer of ownership occurs on the basis of ex works (Singapore) and Kazakhstan entity bears all logistic risks. Also the sales force (employees) are in the staff of Kazakhstan entity. In UAE entity there only 2 persons in staff: General Director and Chief accountant.

It is obvious that the functional profile stated in the contract does not correspond the reality.

Selection of TP method

In practice there are a variety of business scenarios/circumstances that could change or significantly influence the selection of TP method to be used later to confirm the arm’s length basis of transaction.

Sometimes due to some circumstances the TP method should be changed. It is crucial to control and document these circumstances on a timely basis.

Example.

The above mentioned UAE company sells construction components to its Kazakh subsidiary at Cost Plus method. In November 2023 the price for one construction component item was   10,000 + 10% = 11,000 AED.

In January 2024 the TP department or finance сontroller finds out that in December 2023 almost the same construction components were sold to third party at the price of 9000 AED. In December Kazakh entity received components at the same price as usual 11 000 AED.

Issues that could arise here:

• Is the price of a construction component delivered from the UAE to the Kazakh company in December at arm's length?
• Why the CUP (comparable uncontrolled price) method was not applied?
• How could the Group confirm its explanations/statements?
• Does the Sales department have enough documented arguments to describe the circumstances of both transactions?
• Are these transactions really comparable or not?

What is important in order to have clear answers and audit evidence on all questions in relation to the above situation?

• Sufficient and timely information flow between sales and controlling function which covers TP: the fact that there are potentially comparable transactions with the third parties should be shared with TP function at the moment when it occurs (before the reporting period is closed);
• Defined and approved comparability criteria list: it should be transparent algorithm/instrument for proving comparability/incomparability of two transactions.

Example: Comparability

The company receives drilling services from 2 entities: its subsidiary (A) and third party (B). There are some information on both transactions:  

• Volumes of services: (A) 10 000 meters; (B) 2 000 meters;
• drilling rigs: (A) technical characteristics are the same but (A) – new (2022), (B) – 80% amortised;
• warranties/guaranties: (A) – 3 years period; (B) – 1 year.

The question is: are both transactions comparable or not?

The management will definitely have the answer on the situation above if there will be:

• formal procedure,
• check list with comparability criteria and
• as an option – determined weights of each criteria.

In this case the standardized comparison could be done with formal conclusion approved by several departments within the business. Based on the conclusion several options on TP transaction pricing are possible:

1) if transactions are not comparable – to continue with cost plus method  
2) if transactions are comparable – switch to CUP.

The situation above could be in fact more comprehensive in reality. Assume that the sales of construction component to third parties occurred at the end of November, sales to our Kazakhstan subsidiary – in middle of December 2023. Are these transactions comparable? Should we take into the account the actual price for third party or not? Are there any significant market changes which took place between transaction in November and December?

All this reinforces the need for a formal document describing all scenarios and situations with management judgements and decisions supported by appropriate audit evidence.

Usually when talking about the Group TP policy we understand and look at the TP topic as a separate business process. This process should include not only compliance elements but also classical business process approaches: roles, document flow, deadlines, segregation of duties, formats, start and end of the process, deliverables. This makes sense as usually besides accounting and finance function, a lot of other functions are included in the process including: sales, marketing, production and technical, legal and some others.

Sometimes, it is very hard to make correct risk-controlled TP decisions without clear formalized process and responsibility. Therefore, advanced companies which are involved in TP subject for some years prefer to document TP policy as a business process using BPMN language.

The full package can include written formal procedures as a main document, business process scheme and risk control matrix as a supplementary documents to the policy. This could be considered as part of ICFR reporting.

Resuming all the ideas above, the transfer pricing theme evolution starts from typical and more or less standardized steps as local documentation, CBC report and can be developed into complex business process tool which allows management to control all material TP risks on a timely basis and at the same time improve control environment and efficiency of company business processes.