It pays to pay attention to transfer pricing

Innovation Profile PwC:With recent announcements regarding international co-ordination in relation to corporation tax issues there has been increased focus on the taxation arrangements of multinational firms as well as on their "transfer pricing" policies.

Transfer pricing is sometimes used by people as shorthand for moving profits from one location to another.

The reality is that transfer pricing is simply a description of the process to set prices between related parties where there are goods, intangibles, services or finance being supplied from one to another to ensure that the appropriate quantum of profits are attributed to each party given the activities and functions they carry out, the risks they bear and the assets they own. Once Irish growth stage companies begin to trade in a number of jurisdictions, it is something that they need to pay particular attention to.

Relevant to Irish firms

Its relevance to Irish firms is due to the comparatively early stage at which many of them must begin to export.

“Ireland is a very small marketplace and growth oriented firms have to begin exporting at a far earlier stage in their lifecycle than many of their international counterparts,” says Gavan Ryle, transfer pricing partner with PwC.

“This very quickly gives them a tax presence in different jurisdictions and they then have to plan for how they will be taxed in those locations. Very often what seems like the sensible cost-effective decision early on can turn out to be the most costly in the long run.”

The example he gives is of a firm which is selling products in a number of European markets and has to decide how to apportion the costs of the Irish RD team working on a new product. One way would be to divide the costs equally among the different markets.

This would have the apparent virtue of reducing the tax bills in those countries at a time when sales are relatively low.

However, the corollary of this is that when that product starts to generate profits for the firm the operating entities in the different jurisdictions would be due to pay tax in those countries on their share of those profits even though the most significant contributor to those incremental profits was likely to have been the successful development of the new product by the Irish RD team.

As with so much else in business the solution to this problem lies in planning ahead and in this case putting a transfer pricing policy in place.

Ryle explains that the process in setting prices for related party dealings cannot be arbitrary and must be implemented in the same way as if the parties involved were not related.

So, the price charged between related parties and the method of arriving at it should be very similar to that which would apply to an unrelated party such as an authorised distributor in a country where the company doesn’t have a direct presence.

“Where the rubber really hits the road is where a financial controller in Dublin has to put a value on an invoice for whatever the product or license or service or even a financing transaction is,” says Ryle. “This is then recognised as income in Ireland and expenditure in the other country. This is at the very heart of the process – trying to set that price as if trading with an independent party.”

And the price setting process is far more than simply establishing what a product can sell for in a destination market.

“The emphasis here is on the functions, assets and risks of a business. You have to look at the whole value chain from RD through production, distribution, sales and marketing as well as to areas like executive management and the business support functions such as finance, HR, legal, and so on.

“Break it down into who does what, who owns the intellectual property and who controls the risk, and set appropriate rewards for each link in the chain.”

Applying this process might see an early stage Irish multinational opting to keep the costs of RD and initial investment in developing their products and services and their brand here at home where the ultimate rewards will flow to and actually end up paying some taxes in overseas jurisdictions at a stage when it might not have appeared necessary to do so.

“You have to look at the long term in these things,” says Ryle. “If you are to have a properly structured and fair transfer pricing policy it must be one that will stand up over time.”

Overlooked matters

He points out that Irish firms often overlook these matters because the whole area is so comparatively new in this country.

“I worked on transfer pricing for PwC in Australia more than 10 years ago and when I came back here in 2002 I had a big job to do in terms of educating clients on what it is all about,” he recalls.

“The OECD had produced internationally accepted guidelines on transfer pricing in 1995 but Ireland didn’t actually endorse these guidelines in our legislation until 2010. There is much greater awareness now but there is still less know-how here in the business community in Ireland than in other EU member states or our tax treaty partners and that needs to be addressed.”

And the rapidly evolving business operations and rules framework in which Irish companies are operating makes the requirement for transfer pricing advice and planning greater than ever.

“Transfer pricing policies must follow the operations and the decision making framework in a multinational company,” he explains.

“With these frameworks changing and evolving companies need to ensure that they have a policy in place which will meet not only their current needs but will serve them into the future as well.”