More than 125 countries are collaborating to combat tax avoidance strategies commonly referred to as Base Erosion and Profit Sharing or BEPs. The OECD BEPs action plan was issued over two years ago although its affects are being felt now.
An international business needs to demonstrate that their transfer pricing reflects economic substance. The task is not easy because determining substance and the correlating value is full of variables. For example, determining the fair value where intellectual property is developed will depend on the IP, its usefulness, economic benefit, development stage and associated risks. An organisation transfer pricing should reflect the substance of where and how value is created and exchanged.
The idea of BEPs was to align taxation with economic substance and assist to reduce double taxation. Each jurisdiction implements their own rules and enforcement procedures, which could lead to cross jurisdictional disputes. It is assumed that most countries will be looking to generate what they see as the right amount of tax revenue, which generally is a higher-than-before amount of tax. It is therefore essential to be able to justify a transfer pricing approach.
A tax authority will consider details of transactions against inter-company financing arrangements, pricing policies, profit drivers and overheads including staffing requirements.
Advance pricing agreements (APA) help to resolve transfer pricing disputes. An APA is a negotiated position with tax authorities. Once an APA is concluded, the local tax authorities (or APA team) will only review the taxpayer’s compliance with the terms of the APA.
APAs help avoid transfer pricing disputes although obtaining one requires a managed representation to the tax authority. Those representations may not be accepted, and the tax authority may challenge representations albeit in a more civil manner than that adopted under a full tax audit.
An APA may be unilateral (one tax authority), bilateral (two tax authorities), or multilateral (multiple tax authorities). Seeking a unilateral APA will evidently be easier, quicker and cost-efficient. The downside is it doesn’t mitigate the audit risk on both sides of the transaction. A bilateral agreement would mitigate the risk. The process for a bilateral APA is likely to involve an analysis of information while considering diverse factors on pricing policy. To prepare a defendable position there must be knowledge why a factor does or does not affect pricing and if it does, how it affects that price. The process could also involve establishing supporting evidence for a price, which may be exceptionally difficult where say the intellectual property is significantly unique. The drafting of an APA application would be prepared for both jurisdictions having regard for their tax legislation.
Depending on the jurisdiction, it may be possible for a pre-filing meeting. Following the submission of an APA application there may be negotiations and requests for further supporting evidence. A pre-filing meeting does a lot to mitigate this. When all is agreed, a letter of agreement will be issued and all that is left is the annual reporting to demonstrate compliance with the APA.