Structuring a Transfer Pricing Policy

How to structure Transfer Pricing policy

Example 1 - establishing a sales subsidiary offshore

Example 2 - establishing a service provider offshore

Transfer Pricing Compliance - moving it in house

Management Control and Remuneration Structures

Conclusion



Introduction

Transfer pricing is an issue which has been referred to by various revenue authorities as the most important tax issue facing multi-national organisations today. This is evidenced by the fact that global revenue authorities have in general become much more aggressive in the Transfer Pricing arena in recent years. When auditing the tax returns of businesses with foreign affiliates, tax authorities increasingly choose to focus on the area of Transfer Pricing.

The increasing scrutiny by revenue authorities on transfer pricing means that the potential risks to expanding New Zealand businesses in terms of adjustments, penalties, interest, economic double taxation and missed opportunities is mounting.

Therefore New Zealand companies that expand their operations globally need to focus on the importance of structuring their outbound transfer pricing policies effectively.

In this paper, we will address some key points on how setting up transfer pricing structures at the initial stages of offshore expansion can help maximise profit while simultaneously minimising tax exposure.

The establishment of a Transfer Pricing policy does not necessarily require a large upfront cost for a business undergoing expansion. Transfer Pricing structures can be set up on a piecemeal basis taking into consideration the cash flow requirements of the NZ enterprise and the relative size of the offshore operations.

At the early stages of offshore expansion, effective tax planning is often overlooked as the business places commercial success as being the highest priority. The ideal time to structure a transfer pricing policy is in the initial stages of expansion.

The main objective when structuring your transfer pricing policy must be 'getting it right first time'. Any other approach will inevitably give rise to difficulties in resolving the group's tax liabilities in the countries concerned and, in the medium to long term necessitate making changes to Transfer Pricing policy.

How to structure Transfer Pricing policy

A Transfer Pricing policy should achieve the following objectives:

1. Minimise tax in off shore jurisdiction without creating losses
2. Maximise shareholder wealth in NZ by taking advantage of New Zealand's imputation credit regime
3. Be practical and easy to apply on a daily basis.

When dealing with a New Zealand company with primarily New Zealand shareholders that is expanding offshore, it is essential that its transfer pricing policy ensures that the majority of profits are derived in New Zealand. This is because of the existence of New Zealand's imputation credit regime.

New Zealand-owned companies should therefore aim to maximise long term profits in NZ despite the fact that this country may have a higher effective tax rate than a foreign jurisdiction. An inappropriate Transfer Pricing policy may result in excessive profits being left in foreign locations that cannot be tax-effectively repatriated.

The policy however must also ensure that losses are not being created in the foreign jurisdiction. Foreign losses which are trapped offshore cannot be utilised in New Zealand.

Transfer pricing theory attempts to match a company's reward (profit) from a cross border transaction with the functions, assets and risks it undertakes in that transaction. The greater the functions, assets and risks, the greater the reward attributable to that party.

In order for foreign subsidiaries to derive consistently low profits over time, New Zealand based companies must limit the functions, assets and risks of their overseas operations.

Risks are highly transferable in the marketplace. Risks such as market penetration, inventory, credit and foreign exchange can lead to significant fluctuations in the profitability of a foreign subsidiary. As such, transferring those risks to the New Zealand business through the transfer pricing mechanism, results in a lower profit being attributable to the foreign location. Such a pricing structure will also prevent losses occurring in the foreign jurisdiction.

Creating a transfer pricing policy at the initial stages of expansion allows tax objectives of the whole group to be met efficiently. This is important when expanding into aggressive tax jurisdictions such as Australia and the United States.

The best way to structure outbound policy is to set the transfer pricing mechanism at the initial stages of offshore expansion so that the foreign subsidiary derives a guaranteed profit for the functions it undertakes from day one.

Under a guaranteed profit transfer pricing mechanism, the offshore subsidiary can be set up to perform one or two functions, own limited intangible assets and therefore bear little risk. The New Zealand business incurs the start up costs associated with establishing a market presence. This ensures the New Zealand business economically owns the market intangibles.

The theory behind this Transfer Pricing mechanism can be applied across any business sector, be you distributor, retailer, service provider or manufacturer.

To outline how the mechanism may work in different situations consider the following examples.

Example 1 - establishing a sales subsidiary offshore.

Say for example, a New Zealand business develops a unique product which it considers will lead to significant sales in offshore locations. The New Zealand business establishes a subsidiary in the foreign location to sell and market the product.

How should the transfer pricing mechanism be established to ensure the shareholders obtain the maximum benefit from the profit derived from sales made in the foreign location?

The simple answer is to set the subsidiary up as a limited risk distributor deriving a guaranteed profit margin, calculated using an EBIT/Sales ratio, from the day it commences operations.

Such a model would be established by:

• Setting up a legal agreement such as a Distribution Services Agreement which reflects the terms and conditions under which the parties will operate.
• Structuring overseas operations' function, asset and risk profile as that of a limited risk distributor.
• Determining an appropriate return for a limited risk distributor by drawing on extensive experience in the industry or benchmarking.
• Pricing product sold to offshore subsidiaries as to achieve a level of guaranteed return.
  

This process can be undertaken in piecemeal fashion. For example you could put in place legal agreements at an early stage and then backup the mechanism with further documentation and benchmarks as the size of the operations grows. The key is to seek advice from specialists regarding your transfer pricing risk profile at an early stage. This may be all that is required for the early years of expansion until the size of the offshore operations increases.

Under this limited risk distributor model, the subsidiary would be responsible for selling products in its market and implementing marketing policies developed by the New Zealand business. It would own no intangible assets as it did not bear the risks of penetrating the market. It would not bear any other risks, as these would be effectively transferred to the New Zealand business through the guaranteed return mechanism. On this basis it would derive a very low level of profitability as it has limited functions, assets and risks. Profit would be drawn back to New Zealand through the transfer price.

Such a policy is relatively easy to defend as tax authorities in foreign locations can see that there is profit from day one. The benefit to the group is that there are no losses trapped offshore which cannot be utilised and tax is paid in New Zealand creating imputation credits. Overall it's a win win situation for the New Zealand business.

Example 2 - establishing a service provider offshore.

Say for example, a New Zealand company has developed a new software product which is licensed to large organisations. The company wishes to expand into offshore markets.

The New Zealand company establishes a subsidiary in the foreign location to perform a sales liaison function, implement the software at the customers site and undertake some development work in respect of the base software.

Some of these functions could create an intangible asset in the foreign location which may require significant profits to be attributed to the subsidiary in the long term. To ensure this does not occur, the offshore entity can be set up as a low risk service provider.

Under this structure all contracts with customers are entered into by the New Zealand business which contracts its foreign subsidiary to provide sales support, development and implementation services. As reward, the subsidiary will be paid its costs plus a small mark-up.

Such a model can be established in the same manner as the earlier limited risk distributor model. This structure will mean a small profit is derived in the foreign location which hopefully is only a fraction of the overall profit derived by the New Zealand business from the transaction.

If the New Zealand business is spending considerable funds on development it may initially be in losses under this structure. However, once successful, significant profits should be derived in New Zealand in the long run. Intangible assets (for example the establishment of source codes) will be centralised in the parent entity ensuring long term benefits extending from the asset will also remain with the parent entity. Again this structure creates a win for the New Zealand business.

Transfer Pricing Compliance - moving it in house.

Transfer Pricing is a functionally complex area of tax compliance. The creation and implementation of tax effective transfer pricing policies are best handled by specialist transfer pricing consultants. This is because of the importance of getting the transfer pricing policy right the first time.

Attempting to change transfer pricing policy down the track can be difficult as the offshore subsidiary's function, asset and risk profile is already set up in one place. Therefore it is important to establish an efficient transfer pricing structure at the first attempt.

Once operational, an appropriate Transfer Pricing mechanism should usually be easy enough to apply and maintain by a company's 'in house' advisors in consultation with transfer pricing specialists.

Management Control and Remuneration Structures.

It can be argued that setting up a structure where an entity is provided a guaranteed return will not stimulate the employees to ensure sales targets are met or the costs of the subsidiary are kept at a minimum level. This can occur if appropriate remuneration structures such as bonus payments are not put in place.

Bonuses for staff of the foreign subsidiary could be based around performance on particular assignments, sales or even group profits. These bonus systems can be structured according to management preference.



Conclusion

How to structure a transfer pricing policy is an important decision a New Zealand company must make with any expansion into offshore locations.

The best time to put in place a tax effective transfer pricing policy is at the time of offshore expansion. The process is more straightforward at the initial stages of offshore expansion, as the structure is created from scratch without the complications of existing transactions. Dealing with Transfer Pricing issues at an early stage allows a company to build a framework for its operating procedure while at the same time optimising tax requirements.

Structuring outbound prices can be done on a piecemeal basis allowing the transfer pricing policy to be expanded upon as the size of the business and quantum of its transactions grow.

Getting the transfer pricing policy wrong can have lasting implications for shareholders. An inadequate transfer pricing policy can result in an inability to use losses in foreign locations or excessive profits being made, not to mention the contingent costs of defending the transfer pricing mechanism from revenue authority attack. As reassessments of transfer pricing policies can be awkward to explain to the IRD, it is important to set up a suitable transfer pricing mechanism from day one.