Transfer pricing – don’t get your digits burned

Both the OECD and the EU are exploring options to change how digital businesses are taxed, while NGOs are stepping up their pressure on tax authorities to challenge large companies’ transfer pricing arrangements.

No matter how robust your digital business’s transfer pricing arrangements appear to have been in the past, they may no longer be challenge-proof. If challenged, could you justify your transfer pricing arrangements?

Digital businesses: in the spotlight

Much has been said recently about alleged tax avoidance by multinationals, especially through their transfer pricing arrangements. And given the traditional tools of transfer pricing planning – ‘risk shifting’ and centralisation of IP in low-tax jurisdictions – it’s not surprising that digital businesses, with their valuable software and brands, have been singled out as particularly likely to reduce their tax bills in this way.

Creating an internet gaming business, for example, poses a large entrepreneurial risk. Developing the software from scratch can cost millions, while gaining regulatory approval (ie the gaming licence) is also expensive and requires a minimum level of capital. Creating a brand needs substantial advertising that might cost $500,000 for the initial campaign, followed by around $50,000 each month. Where should this development work be financed from?

Once it’s completed, (related party) licensees are charged arm’s-length fees of up to $350,000 up front, plus around $150,000 and 60–85 per cent of gross profits per year to access the software, the domain name and the payment processing provider. From the remaining gross profit, the national licensees may have to pay related party service and finance charges. There may be little local net profit and, therefore, tax to pay.

These licensees may even license national related party sub-licensees or ‘affiliates’ to carry on the business on a lower risk or lower reward basis. They do not have to do any marketing of their own and affiliates pay no up-front fees either.

Another example might be a software development company. The company may adopt the standard model of a 50 per cent royalty payable by its distributors but only a 15 per cent introduction fee for its related parties, who do not contract with the end customers. It may make separate payments to distributors and introducers for any help they give in managing local second-tier distributors, carrying out additional local promotion and providing customer support.

Digital businesses are uniquely placed to exploit ‘big data’ about customers’ preferences. This has led the OECD to consider the suggestion that this information-gathering is unrewarded locally, that some profit should be earned from it and taxed locally – and that this should be done by taxing the offshore company that makes use of the data, according to standard transfer pricing principles.

Concerns over tax avoidance by digital businesses have caused several countries to take unilateral action. For example, Italy introduced (then had to withdraw) a ‘Google tax’ on internet advertising (by requiring Italian companies to buy the advertising from Italian companies).

Transfer pricing concerns are not just being raised about purely digital businesses – traditional businesses that sell through the internet are also under review. For example, the UK House of Commons Public Accounts Committee questioned several US businesses about their related party trading structures, including one that sells physical goods through the internet. It stores and delivers the goods from a local warehouse but pays only a service fee to its local subsidiary for helping to fulfil the orders in this way.

One option the OECD is considering is to tax the routine tasks of storage and delivery as if they were core profit generators when they form the fulfilment aspect of a digital purchase.

Are you exposed?

No matter how robust a digital business’s transfer pricing arrangements appear to have been in the past, they may no longer be challenge-proof.

Consider a multinational that has centralised its IP and then licensed it to national operating companies. Can all the licensees actually expect to achieve a profit under the current transfer pricing policies? Did they need to take on so much related party debt? What do they actually get for their services fees?

Digital businesses need to take care that activities they regard as relatively peripheral, and might therefore reward with a small profit mark-up on the costs involved, might be viewed by a tax authority as being akin to the activities a digital business’s sub-licensees or affiliates would usually carry out. The tax authority might decide on this basis that they should be rewarded through a sharing of gross profit instead.

OECD thinking is moving towards an allocation of IP-related profits to the group companies whose employees had the practical responsibility for putting the multinational’s funds at risk by choosing how investments in the related R&D or brand-building should be carried out. It may no longer be acceptable simply to allocate rights and risks through related party agreements and transfer pricing policies. Neither will merely financing IP development or risks entitle a group company to the associated profit, unless that company’s employees made the decisions to authorise that expenditure (and then take remedial action when necessary).

Can you justify your transfer pricing arrangements

Negative stories about tax arrangements can seriously damage brands and lead to public action – like the sit-ins seen in UK Starbucks outlets in 2012. This can happen very quickly to businesses that operate in a digital media environment.

The OECD has proposed its member countries agree to collect and share information on how multinational companies’ revenue, profits and corporate income tax in each jurisdiction, and this would suddenly make underlying transfer pricing arrangements more visible. At the same time, NGOs are stepping up their pressure on tax authorities to challenge large companies’ transfer pricing arrangements.

Tax and legal heads of digital businesses therefore need to review not only whether their transfer pricing policies meet the ‘arm’s-length’ standard (and that they can hand over documents to show this), but also that the current supply chain model will not be unwound for tax purposes by imminent changes to the international transfer pricing conventions.

In particular, they will need to review afresh and in more detail individuals’ roles across the group in making key investment and risk-management decisions – not just their roles in teams but also their job descriptions, employment contracts and decision-making authority, as evidenced by email trails and meeting minutes.

They should also apply this thinking to their tax due diligence for acquisitions and disposals.