Who doesn’t love an unexpected cash windfall? Whether looking in the laundry room or under the seat cushions of the family sofa, finding twenty dollars – or even a few quarters – can brighten your day. While certainly not as a lucrative as a lottery win, every little bit helps in tough financial times. Many multinational companies are missing far more than pocket change when conducting business internationally, but they often do not know where to look. Believe it or not, a fresh look at transfer pricing is one tool that is a regularly overlooked opportunity to improve cashflow on a global basis.
What is Transfer Pricing?
Simply stated, transfer prices are the cross-border prices charged on intercompany goods, services, royalties, and other transactions within a company. Transfer pricing is the most contentious tax issue for multinational companies because transfer prices drive how much income tax is paid by country. In over 70 countries, every intercompany transaction has two (or more) tax authorities that can challenge the prices charged across borders.
Why isn’t this just a tax issue?
Intercompany pricing also drives where cash ends up within a multinational company. If a US company selling automotive components for $50 to its UK subsidiary changes the intercompany price to $100, more cash and taxable profit will stay in the US. Conversely, the UK subsidiary will have less cash and taxable profit.
Consider the case of a highly-leveraged company that makes all the right operational moves – rationalizing manufacturing capacity, improving cash collections from customers, and strengthening product development strategies. Unfortunately, management may be surprised to find profits “trapped” in certain tax jurisdictions where cash cannot be readily repatriated to service debt elsewhere. The company will be overpaying tax in some locations while struggling to meet debt obligations globally.
Where do we start looking?
In our experience, a best-practices approach involves looking for entities within a multinational company that are incurring losses or generating large profits. Determining what a “large” profit is will vary by industry, but as a starting point we suggest using Earnings before Interest and Tax (EBIT) as a percentage of sales. A fresh look at transfer pricing may uncover opportunities to adjust intercompany prices to absorb tax net operating losses, and pay less where the company is overpaying tax.
Take as an example, a tax-paying US company that owns a French subsidiary with $100 in tax net operating losses. With consistent losses over time, the company will need to borrow more money to fund the French subsidiary’s operations. By adjusting the transfer prices, the multinational company can start utilizing the tax NOLs in France, while having a lower taxable income in the US. This change represents a tangible tax benefit and cash savings to the company as a whole.
Clearly, tax audit considerations are important here. Multinational companies risk large tax adjustments, interest, nondeductible penalties, and double tax risk by not complying with the arm’s-length standard and transfer pricing documentation rules. However, companies that have not examined transfer pricing in recent years may already face transfer pricing audit risks. In our French subsidiary example, we would anticipate that a French transfer pricing auditor would already be suspicious about a subsidiary of a multinational incurring losses.
Is this a tax avoidance scheme?
Absolutely not. Since many cash-strapped companies do not address intercompany pricing on a regular basis, a strategic review of transfer pricing helps multinational companies manage transfer pricing audit risks while improving cash flow. A proper transfer pricing strategy is a proactive approach to comply with tax laws in the US and internationally.
About that Cashflow
Intercompany pricing cash flow problems occur where companies rely on outdated transfer pricing approaches for intercompany transactions. Reasons vary, but even the most sophisticated companies have “always done it this way.” A renewed look at transfer pricing can make a monumental improvement in cashflow, tax, and borrowing costs.
Multinational companies regularly miss out on cash savings with a renewed look at transfer pricing. Bottom line, finding a twenty-dollar bill can make your day, finding cash within your company can make the difference.