National Transfer Pricing Leader at CBIZ and Kreston Global Transfer Pricing Chair
David heads the Transfer Pricing Practice at CBIZ and offers guidance on transfer pricing and tax valuation, boasting over 17 years in the domain, mainly with prominent international accounting firms. His expertise spans transfer pricing planning, intellectual property valuation, financial modelling, and more, serving industries from oil and gas to software and tax-exempt organisations.
Identifying transfer pricing risks in the digital economy
August 18, 2023
Sector: Technology, Media & Telecom
A global economy means hard borders are less visible, creating a sense of ambiguity around regulatory obligations and defining where the value of a digital product begins, subsequently identifying transfer pricing risks in global business operations even more challenging. David Whitmer, National Transfer Pricing Leader at CBIZ and Kreston Global Transfer Pricing Chair explores this emerging challenge in an article on Corporate Compliance Insights.
Understanding existing Transfer Pricing obligations
At its core, transfer pricing sets the rates charged in transactions between related enterprises, like parent companies and their subsidiaries or between different units of a business. The aim? To prevent firms from transferring profits to low-tax jurisdictions, ensuring that taxes align with the actual business activities in a given nation.
The underlying principle is the “arm’s length principle,” which means that transactions between related parties should yield a tax outcome akin to what would have been realised if unrelated parties had conducted a similar transaction.
It’s applicable to tangible transfers like physical goods, intangible transfers like intellectual property, service transactions such as R&D or marketing services, and even financial arrangements.
The impact of the digital economy on Transfer Pricing
Selling goods or offering services used to require a tangible, local presence. However, today’s digital revolution has reshaped the business model. The rise of online storefronts, centralised global warehouses, and ubiquitous smartphone apps exemplifies the shift.
With the advent of technologies like the Internet of Things (IoT), big data analytics, AI, and blockchain, significant profits are now realised from digital avenues. And with remote work and cloud technology, the very definition of service delivery and sales locations is being redefined.
Given these nuances, businesses need to be vigilant and proactive to ensure they remain on the right side of compliance.
The impact of OECD regulations
The loss of tax revenues, estimated between $100 billion and $240 billion annually from profit manipulation, has spurred the Organisation for Economic Co-operation and Development (OECD) into action. They’ve spearheaded the BEPS (base erosion and profit shifting) initiative, with a 15-point action plan and a dual-pillar framework.
Key points include:
Item 1: Targeting proper taxation of digital enterprises, even if they lack a physical presence in the profit-generating jurisdiction.
Item 8: Focusing on the challenge of valuing intangible assets to deter their shifting within a corporate group.
Evolution has brought about BEPS 2.0, with Pillar 1 being particularly significant for transfer pricing. It emphasises taxing MNEs (multi-national enterprises) in the markets they operate and generate revenues, even if there’s no direct physical presence.
Though the OECD has set transfer pricing guidelines, countries might have varied interpretations. The sporadic emergence of digital service taxes (DSTs) in various nations adds another layer of complexity, raising concerns like double taxation. Yet, with the onset of Pillar 1, DSTs are predicted to phase out. Presently, over 135 countries have embraced the two-pillar plan.
Critical steps for MNEs
As the business terrain morphs, digital-first entities must comprehend their standing, anticipate the determinants of transfer pricing across their expanse, and refine their operations. Miscalculations can lead to unwanted income adjustments, tax increments, interests, and penalties. For rigorous planning, MNEs ought to:
- Revisit policies and craft best practices: MNEs must question the relevance and soundness of their current transfer pricing strategies. Does the documentation justify and support the present approach? Do the inter-company deals need recalibration?
- Execute a compliance cost analysis: While compliance demands financial resources, the consequences of non-compliance could be pricier. Thus, shaping transfer pricing blueprints should pivot around decisions that skillfully and economically minimize risks.
- Pinpoint value creation: Recognising the ramifications of digital transformation on the company’s value chain is paramount. This ensures that profit distribution mirrors the tangible economic results of diverse business activities.
- Determine IP jurisdiction: Discerning which entity within the group owns the rights to digital-born intangibles and their geographic locations can significantly influence transfer pricing. Additionally, firms should deliberate if transferring IP ownership internally is strategic.
- Strategise organisational structures: Companies should consider structures like on-ground representative offices, which can facilitate local regulation compliance. Alternatively, establishing a resale entity could be beneficial in managing risks associated with permanent establishments and transfer pricing adjustments. Contemplating cost-sharing arrangements, where the expenses tied to intangible assets are divided among associated bodies, is another avenue to explore.
Beyond these considerations, numerous queries arise. How should the value contributions of remote employees, who service multiple territories, be distributed? How are innovative technologies like AI, VR, and automation influencing revenue streams? How is data acquisition shaping value delivery? The considerations are myriad.
In essence, for MNEs that offer services and goods globally, perfecting transfer pricing strategies to ensure continual compliance with both global and local regulations is vital, albeit daunting. To determine the value of intangible assets and establish apt transfer pricing approaches, extensive analysis, modelling, and benchmarking are typically essential.
What’s evident is that methodologies, which were conceptualised over a century ago for conventional businesses, now demand reinvention for the digital age. This era presents a heightened challenge for transfer pricing and companies should remain proactive and adaptable in strategising to retain resilience.
Get in touch with one of Kreston Global’s transfer pricing experts today.