The Impact of Transfer Pricing on Corporate Disclosues
Business and Management
Submitted By mnyagilo
The Impact of Transfer Pricing on Corporate Disclosures
Written By: Roger Hsueh
Aiming to plug tax collection leaks, impose reasonable tax burdens and bring Taiwan in line with the international trend, toward the end of 2004 the Ministry of Finance issued and put into effect "Income Tax Audit Standards for Transfer Pricing Inconsistent with Arm’s Length Transactions".
Following the implementation of the transfer pricing audit standards, not only will the taxation authorities be able to investigate back five years to see if corporate income taxes were consistent with “arm’s length” transactions; henceforth the burden of proof will have shifted from the National Tax Administration to corporations. Corporations will have to furnish evidence on their own behalf to prove their transactions are consistent with arm’s length ones, furnishing the relevant documents. As a result of this, thousands of entities - affiliated companies, parts of corporate groups, foreign businesses in Taiwan, and factories set up in Mainland China - face heavy tax risk on their “related party transactions”. And for public companies, because of their larger scale of operations and the ease of obtaining their regularly issued financial statements, the disclosures in public company financial statements prescribed by the transfer pricing audit standards will have a major impact.
As provided in “Guidelines Governing the Preparation of Financial Reports by Securities Issuers”, when a public company prepares its financial statements, in addition to following financial accounting standards, it must disclose in the notes to those statements its related party transaction circumstances, including the names of related parties, transactions having a significant effect on financial conditions, information on investments in other companies requiring disclosure, etc. In addition, to understand the influence of Mainland China investments on the financial statement, it is also necessary to make a special disclosure of the company’s mode(s) of investment in Mainland China, its gains/losses on those investments, and so forth.
In the past, Taiwan’s laws prohibited direct trade with the mainland, so the “Taiwan receives the orders, Mainland China ships the goods” model was developed. The prevailing triangular trade pattern left profits in third countries. Later, although direct trade was opened up, Taiwan’s businesses were accustomed to going through third countries to manipulate their taxed gains/losses. To this was added the trend towards a global division of labor in industry, with Taiwan-based companies clamoring to invest in Mainland China, so in current financial statements one often sees balance sheet pre-tax net profit coming mostly from equity investments, large sums in related-party transactions, and other methods, with long-term expenditures falling short of funds. You also have companies that were set up years ago for tax considerations, but with mainland operations booming, they accumulated huge surpluses offshore. To gain control over those funds while avoiding taxes on surpluses remitted from overseas, they use borrowings from those surpluses, which are given to their Taiwan parent companies for long-term use. For these types of related-party transactions, the demands on public companies for thorough disclosures in their financial statements, plus the recent tendency towards greater strictness in the competent securities authorities’ oversight attitude, mean that non-arm’s length transactions described in the transfer pricing audit standards will find nowhere to hide in financial statements.
Before the transfer pricing audit standards were established, the National Tax Administration mostly used a selective rejection approach to deal with the Mainland China expenses and salaries of Taiwan nationals sent to the mainland by multinationals and companies with Mainland China investments. Although this later evolved to include interest on excessively old accounts receivable and advances, and selective rejection of claimed R&D expenses and investment credits for R&D whose research results were not yet used in Taiwan, there was still no way to effectively get at the crux of the problem. Audit effectiveness was low and positive results were hard to come by.
Following the establishment of the transfer pricing audit standards, in the case of public companies with their larger scale of operations and easily obtained financial statements, the National Tax Administration may carry out non-arms length audit adjustments of the transactions mentioned in the preceding paragraph and disclosed in statements. It may also demand the calculation of reasonable transaction prices and collection of reasonable compensation for transactions that have not appeared in the financial statements, namely those substantive transactions with affiliates that Taiwanese companies have seldom recognized before: income for “management services”, “transfer of R&D results”, “business referrals” and other functions.
Companies now face possible transfer pricing audits by the National Tax Administration, for which they will bear the burden of proof, and a great many documents must be provided as evidence. Besides needing to prepare a corporate overview and organizational structure, summary information on controlled transactions, etc., transfer pricing reports must also be provided where transactions reach a certain monetary value. Then there is all the communication and correspondence over the course of a Tax Administration audit, additional documentary evidence and so on. Inevitably, this will consume a great deal of manpower. Also, once a Tax Administration audit imposes a supplemental tax payment due to non-arm’s length prices, it can use that as the basis for pursuing its audit back five years to see if there were “non-arm’s length” transactions in those years as well, further increasing the firm’s tax risk.
In the past, public companies all made preliminary estimates of income tax and deferred income tax liability on current year investment income from overseas equity investments. However, when an adjustment is made under the transfer pricing audit standards’ “non-arm’s length” criteria, companies will not only see a large outflow of cash to pay back taxes; they will also find themselves in a double taxation predicament, there being no way for their overseas invested companies to make a corresponding adjustment. If a corporation has not established a pricing strategy or planned out sensibly how to divide functions and risk bearing between the parent company and its subsidiaries in different locations, tax arrears “landmines” will make future financial statements vastly more unpredictable. For those with severe transfer pricing problems, these uncertainties may cause independent accountants to issue a qualified audit opinion, or to be unable to issue an opinion.
With the establishment and implementation of transfer pricing audit standards, companies must first use their 2004 data to perform simulations and provide explanations as soon as possible in order to make a thorough assessment of their past transfer pricing risks. Beyond this, in order to increase their sustainable competitive strength, companies should take advantage of this opportunity - starting out from the enterprise’s overall business operation and transaction strategy - to adjust unnecessary transactions with invested companies and affiliates, reexamine how they arrange their transaction procedures, and establish legal and sensible transaction prices for their business functions and the risks they give rise to.
Credit crisis: impacts on transfer pricing
The current economic environment presents not only major commercial and financial challenges for many multinational enterprises but also increases the focus on transfer pricing arrangements. From a management perspective, the focus during this crisis is on managing the downturn of the entire enterprise. The measures available to management vary significantly with respect to their extent and range, from rather straightforward cost reduction approaches to a global realignment of the enterprise’s value chain. From a transfer pricing perspective, the challenge is to closely monitor and review the impact of these abnormal market conditions and the measures taken by management on the assumptions embedded in the transfer pricing systems.
The recent economic crisis does, however, provide a unique transfer pricing planning opportunity to revisit current arrangements and consider amendments for the future. The areas or intercompany transactions within this focus vary among different industries and multinationals. The following highlights some issues applicable to most industries.
Review of intercompany agreements
Intercompany agreements should be reviewed as to whether the terms and conditions still comply with the arm’s length standard, particularly intercompany loan agreements with respect to the interest rates. The recent increase in credit margins and the continued uncertainty of the credit market should be reflected in the interest rates and might require intercompany lender and borrowers to adjust their agreements.
In addition to the interest rate adjustments multinationals should consider changing their intercompany lending/borrowing policy, providing them with the necessary flexibility to cope with unpredictable financial market development in the future, e.g. agreeing on shorter terms or including early repayment clauses.
Managing losses – risk realignment
Profitability across all industries decreases during a recession while particular industries or enterprises may experience significant losses e.g. due to a sharp decline in customer demand. From a transfer pricing perspective, it is essential for the taxpayer to analyse and document the economic and/or commercial reasons for the drop in profits contemporaneously to prevent tax authorities scrutinising the transfer pricing policy. Because the taxpayer’s influence to minimize losses arising from overall economic developments is generally limited, managing the loss utilisation within the group becomes crucial. Managing losses effectively requires careful planning with respect to the jurisdiction the losses incur, the amount of losses and the possibilities to utilise these losses in the future.
The taxpayer might be required, in addition to preparing a contemporaneous transfer pricing documentation, to amend the risk allocation among entities. This could be the case if the decrease in the profitability of certain entities is due to the bearing of risks for which they are currently not being remunerated, e.g. local entities bear downsizing costs due to a decline in local demand. The taxpayer needs to ensure that the transfer pricing policy appropriately reflects the risk allocated to group entities, i.e. entities bearing certain risks have to be compensated for the assumption of these risks. Aligning the risk allocation might require the conversion of fully fledged entities in low risk entities or vice versa.
Transfer of intangible property
Multinationals may consider using the decrease in profitability to transfer intangible property (IP) among related parties. Transferring IP to an IP holding company in a favourable tax jurisdiction, or as part of a value chain restructuring in the current market conditions, could be beneficial in more than one way.
Firstly, the decrease in profitability leads to a lowered valuation of the IP compared to “normal” market conditions and hence, to a lower transfer price. Secondly, the lower valuation will equally affect the basis for the determination of capital gain tax in the location the IP was previously located, thus reducing potential capital gain or exit taxes payable. Lastly, the transfer of IP or an entire business function presents a tax planning opportunity for multinationals to utilise losses accumulated in a specific jurisdiction. The capital gain realised through the IP transfer or the taxation of a business function’s hidden reserves can offset losses previously incurred in this jurisdiction, while depreciation potential is created in the new jurisdiction.
Effectively managing the economic and transfer pricing challenges of the recent recession will be the focus of many multinationals in the short and medium-term future. Understanding the impact of the worsened economic conditions on existing transfer pricing arrangements and intercompany transactions is essential for multinationals to successfully manage the risks and exploit the opportunities.
The economic impact of multinational transfer pricing in Third World countries: The case of Iran by Moussavi, Mansour M., Ph.D., Salve Regina University, 1996, 300 pages; AAT 9706807
This dissertation examines the economic impact of multinational corporation (MNC) transfer-pricing system in the Third-World countries. Iran serves to illustrate the problem that is caused by MNC transfer-pricing system in a Third-World nation.
Transfer-pricing system is a technique that is primarily used in international business as practiced by multinational corporations. Under this method the price of goods and services is not determined by the local market structure, but by a highly sophisticated internal sales system within subsidiaries of an MNC. The system offers opportunities to manipulate the market prices according to the changing demands in various countries. MNCs can thus maximize their global profits by reducing income taxes, tariffs and foreign currency exchange rate risks. The economic dependency of Third-World nations on advanced industrialized countries leaves them highly vulnerable to international transfer pricing. These practices have an adverse impact on the balance-of-payments of less developed nations, and subsequently the poor people of these nations suffer unfairly.
The case of Iran demonstrate the exploitation of a nation through its raw materials since the beginning of this century. The rich oil deposits in the southern region of the country attracted the interest of powerful multinational oil companies, and subsequently many other international trading companies followed.
The heavy influx of initially cheaper foreign goods destroyed many local producers. The gradual price increases on these imports created substantial economic and social conflicts that escalated during the 1978-1979 political upheaval and eventually toppled the regime of the Shah.
In this study the economic impact of the transfer-pricing system by MNCs is also examined from the humanities' perspective. In this regard, this study contends that the burden of moral responsibility is on the MNCs rather than on the poor people in developing countries. The legal issues of the transfer-pricing system are reviewed. These are not heavily emphasized, because the legal issues remain a gray area in many advanced industrial countries.
Finally the study considers measures to control MNCs. For example, the Organization for Economic Cooperation and Development (OECD) reported the danger of intracompany transfer pricing and indicated some rules and approaches to remedy the problems. The United Nations has also developed codes of conduct on transnational corporations with reference to transfer-pricing system. These codes suggest that a global approach to ethical standards may be the effective solution.
New transfer pricing rules and their impact | | |
Business | Written by Bill Page & Fred Omondi | Wednesday, 17 August 2011 19:03 | In this first part of the new Transfer Pricing Guidelines, Deloitte Uganda’s Bill Page and Fred Omondi look at the impact of the guidelines, and why Uganda Revenue Authority is keen on boosting its tax collections through this avenue.Globally, more than half of all cross-border trade is between related companies. Thus it is not surprising that tax authorities, including the Uganda Revenue Authority, are interested in the prices that businesses use for these transactions: the opportunity for multinational businesses to move profits from high tax to low (or zero) tax countries is all too obvious. BackgroundThe Regulations are effected by a statutory instrument issued under the powers given to the Minister of Finance in Section 164 of the Income Tax Act, “for the better carrying into effect of the purposes of [the] Act.”The Regulations should therefore be read in conjunction with the existing provision of section 90 of the Income Tax Act which provides:“(1) In any transaction between taxpayers who are associates or who are in an employment relationship, the Commissioner may distribute, apportion, or allocate income, deductions, or credits between the taxpayers as is necessary to reflect the chargeable income the taxpayers would have realised in an arm’s length transaction.
(2) The Commissioner may adjust the income arising in respect of any transfer or licence of intangible property between associates so that it is commensurate with the income attributable to the property.
(3) In making any adjustment under subsections (1) or (2), the Commissioner may determine the source of income and the nature of any payment or loss as revenue, capital, or otherwise.”It appears at first glance that the regulations apply only for the purposes of income tax and do not have a direct bearing on other taxes, such as VAT.However it should be noted that the regulations require income and expenditures (rather than income tax liabilities per se) to be determined in accordance with the arm’s length principle so we would expect that this regulations would also impact on VAT and other taxes.Who is affected by the Regulations?The Regulations apply to taxpayers dealing with related parties located both inside and outside Uganda. Typically, domestic aspects of transfer pricing do not pose a huge risk of loss of tax revenue and therefore most countries with transfer pricing rules focus on international aspects of transfer pricing, i.e. where the parties are located in different countries thereby creating a potential for shifting profits from one country to the other.Under the Income Tax Act (Section 3), persons are deemed to be related (“associates”) where a person “acts in accordance with the directions, requests, suggestions, or wishes of the other person whether or not they are in a business relationship and whether those directions, requests, suggestions, or wishes are communicated to the first-mentioned person.”Importantly, branches or permanent establishments (PEs) are to be treated for the purposes of the Regulations as separate and distinct entities from the head office, and are therefore regarded as associates.Recognition of OECD GuidelinesThe Regulations recognise the application of the OECD Guidelines as well as the OECD Model Tax Convention on Income and Capital, except where they are inconsistent with the Ugandan Income Tax Act. (The OECD – Organization for Economic Co-operation and Development – is an international organization which has played a key role in creating international norms for taxation of cross-border transactions.)Determination of Arm’s Length PriceThe key objective of the Regulations is to provide taxpayers and the URA with tools to determine the arm’s length price in the case of transactions which have been concluded between associates on non-arm’s length terms.Where companies which are under common control use the pricing of transactions between them to reduce their tax liabilities, the approach of most tax regimes around the World is: for the purposes of recalculating tax liabilities, to substitute an arm’s length price for the actual price charged.This is the price which two independent parties might be expected to agree when acting in the open market with no other factors external to the transaction influencing the price. The Regulations provide five methods to determine an arm’s length price in the case of transactions between associates (which are described as “controlled transactions”). These are;The Comparable Uncontrolled Price (CUP) Method - a transfer pricing method that compares the price for property or services transferred in a controlled transaction to the price for the same goods or services in a transaction at arm’s length entered into on similar terms. If the terms are different, adjustments may be made to reflect those differences;The Cost Plus Method - a method that compares the mark up on costs directly or indirectly incurred in the supply of goods or services in a controlled transaction to the mark up on the costs directly or indirectly incurred in the supply of goods or services in a comparable uncontrolled transaction;The Resale Price Method – a method that involves the comparison of the resale margin that a purchaser of property in a controlled transaction earns from reselling the property in an uncontrolled transaction with the resale margin that is earned in a comparable uncontrolled transaction;The Transactional Net Margin Method – a method that involves comparing the net profit margin relative to the appropriate base such as costs, sales or assets that a person achieves in a controlled transaction with the net profit margin relative to the same base achieved in a comparable uncontrolled transaction; andThe Transactional Profit Split Method – a method that involves comparing the division of profits or losses that a person achieves in a controlled transaction with the division of profits or losses that would be achieved when participating in a comparable uncontrolled transaction. This method is particularly suitable where there are several related parties involved in the supply chainHowever, the regulations allow a taxpayer to apply any other method if the taxpayer can establish that the above methods cannot be reasonably applied and that the alternative method gives rise to an arm’s length result.Set as favorite Bookmark Email This Hits: 1249Comments (1)Subscribe to this comment's feedShow/Hide commentsSenior Consultant written by Stephen Takunya , August 22, 2011
We need to take note of the methods of collection and who determines what?
URA under the GATT Value has 6 methods of valuation. These most applicable and acceptable is the transaction value (1). URA has often through this method of valuation and back slide to Estimation on market value. URA collecting stations have got Value estimates but this is under mines GATT value, the recommended method by World Customs Organization.
How do we then trust that URA will use the most appropriate method. They will run around estimating costs incurred in this regards and cause arbitrary tax collection.
Anologiuos this will not be the case. Once the |