For companies with international operations, proper pricing for cross-border transactions can make a dramatic improvement in cashflow. Even businesses with well-established global operations may be losing cash at an alarming rate – all depending on where profits end up in the supply chain. A fresh look at transfer pricing policies can not only provide support for taxing authorities, but surprisingly, may result in improved cashflow!
Global transfer pricing rules are governed by the arm’s-length principle. A company participating with related entities on cross-border transactions must use prices consistent with pricing between unrelated companies. In essence, multinationals cannot shift profits artificially through incorrect transfer pricing.
For multinationals, transfer pricing can be a challenging exercise, especially where there are no readily available third-party market prices to use as a guide. In some cases, a company may utilize a dated benchmarking study to establish intercompany pricing. Alternatively, management may institute a standard transfer pricing approach and rarely change it.
Where Does This Hurt Most? – Income Taxes
Internationally-focused companies may implement pricing resulting in substantial income tax payments in some jurisdictions while incurring losses in others. This pricing results in multinationals overpaying taxes in one country that cannot be offset by losses in other locations. Without a focused review of transfer pricing, the cashflow losses may continue indefinitely. These changes can usually be implemented without disruption to day-to-day business operations.
The following is a numerical example where a UK parent is selling to a US subsidiary
A UK company has projected taxable income of $10 million for 2015. The US subsidiary has $4 million in current US tax Net Operating Losses (NOL) and is projected to incur an additional $2.5 million in losses during 2015.
To implement this change, the company may consider reducing the intercompany price of goods, lowering royalty rates, or revisiting how intercompany services are charged. While this particular example involves the US and UK, the principles applied here can be adapted to many jurisdictions.
Where Else Does This Hurt? – Debt Servicing
Companies with debt face an additional complication in managing transfer pricing issues. Loan servicing becomes increasingly difficult when profits (and cash) end up in the wrong jurisdiction, often requiring tax-inefficient repatriation strategies. In essence, debt-laden companies are forced to make special arrangements to repatriate cash for servicing debt. In addition, all too often these issues are identified as “end-of-year surprises.”
We find many leveraged US parent companies often select a simple cost-plus methodology approach when selling to subsidiaries. The cost plus margin does not cover interest on debt while leading to the subsidiaries generating large profits. By increasing intercompany pricing and instituting royalties or service charges, a debt-laden company is in a better place to pay loans.
And Then – Tax Audit Risk
From a tax audit risk perspective, the starting point for most transfer pricing auditors is the expectation to see some level of profits for subsidiaries over time. The expected level of profit will vary by industry, but a subsidiary incurring losses is almost always a red flag. Conversely, an auditor of a parent company is concerned about the subsidiaries earning too much profit. Losses regularly incurred by the parent company are also grounds for additional scrutiny by tax authorities.Perhaps surprisingly, improving cashflow and reducing tax losses through corrections to transfer pricing has the additional benefit of reducing the risks of a transfer pricing audit.
What Are Best Practices to Improve Pricing Policies?
A best practice is to build flexibility into transfer pricing arrangements such that senior management can make changes to intercompany pricing on a proactive basis. As a starting point, the chief executive officer, chief financial officer and/or tax director need to have visibility over where profits are ending up within the organization. Ideally, reviews should be conducted on a quarterly or monthly basis. This visibility allows senior management to identify areas for cashflow improvement during the year.
Intercompany agreements are also essential for facilitating adjustments to transfer pricing. The agreements should include clauses allowing companies to change intercompany pricing as needed to comply with the arm’s-length standard. Other helpful clauses include permitting transfer pricing adjustments in response to market conditions or changes in the supply changes.
Finally, a transfer pricing study or documentation report can also be helpful support and guidance for changes to intercompany pricing. A transfer pricing analysis can be a strategic roadmap for companies to monitor worldwide operating results while producing unexpected benefits, such as improved cashflow.