Transfer pricing documentation can be viewed as a necessary evil at some multinationals, but the fact is that it provides significant benefits with local taxing authorities and offers an excellent opportunity for global executives to get a better understanding of the flow of their business through different countries. Once a business understands the potential benefits of thorough transfer pricing documentation, the next step is to figure out the best process to use. There are many options to consider, but whichever a company chooses, the key to effective documentation is local input from every country.
Headquarters versus local country documentation
Most major countries have transfer pricing rules. As a result, most entities in a multinational group benefit from maintaining transfer pricing documentation. However, multinationals often struggle with the expense of maintaining documentation for all their affiliates.
One common approach is to let the management of each entity arrange for its own documentation locally. While this allows for independent local action, it can result in inconsistent representations and explanations of the same transaction. Worse, independent explanations and documentation of past activity does nothing to support a coherent, forward-looking transfer pricing policy.
Another approach is for the headquarters entity to prepare both headquarters jurisdiction (say, U.S.) documentation plus “global” documentation, in the form of a so-called “Organization for Economic Co-operation and Development (OECD) report.” This can be a cost-effective approach, but it’s important that the global/OECD report not simply be the headquarters/U.S. report warmed over. Merely replacing U.S. regulatory citations with OECD citations carries several risks:
- Global reports that are just a warmed-over headquarters report will often contain more information and data on the headquarters entity than on overseas entities, especially if there are multiple foreign related entities covered by the study. In such cases, the foreign entities may be described and assessed in a summary, collective manner, without going into the specific facts of each or examining differences. This may be ok for submission to the headquarters country tax authorities, but authorities in the other jurisdictions will likely be dissatisfied with the lack of functional and factual detail on the entity in their jurisdiction. That dissatisfaction can trigger examinations in the non-headquarters jurisdictions, and those examinations may include extensive questions that could have been avoided by better disclosure up front.
- Headquarters documentation can do a good job of explaining transactions through the home jurisdiction (e.g., U.S.-to-China and U.S.-to-Japan transactions) but may miss transactions among subsidiaries (e.g., China-to-Japan). Such foreign-to-foreign transactions can be material to the global group as a whole, but headquarters management often has limited insight into transactions that don’t pass through the home country.
- Subsidiary-specific industry or market considerations may need to be detailed for local documentation purposes. For example, the impact of local economic or political turmoil on an entity’s operating results may not be addressed in an overly generic global report.
- While most major countries align transfer pricing rules with OECD guidelines, the OECD is not a legal or regulatory body. It doesn’t write local rules nor does it conduct transfer pricing audits. Each jurisdiction generally has its own detailed rules, or its own (often unwritten) interpretations of OECD guidelines. These local rules may differ only subtly from the OECD guidelines, but they can lead to substantial differences in how a local transfer pricing analysis should be conducted. For example, while external benchmarking for entities in Eastern Europe can often use “Pan-European” comparables, the use of “Pan-Asian” comparables in documenting a Japanese entity is guaranteed to be rejected by local authorities.
- Global/OECD format reports are thus an important tool in transfer pricing documentation, but it’s important that such reports take a truly “global” perspective. It’s advisable that local versions of the global documentation be reviewed and adjusted from a local perspective by a knowledgeable local adviser.
BEPS and the master file/local file/country-by-country reports
The OECD’s Base Erosion and Profit Shifting (BEPS) initiative has set forth new guidelines on transfer pricing documentation and the country-by-country reporting of business activities. Every country will implement these new concepts on their own schedule and in their own way, but many jurisdictions, both large and small, are already requiring companies to maintain and submit such new documentation. It seems reasonable to expect that a typical report going forward will consist of a global master file, country-specific local files, and an overarching country-by-country report of key economic and financial data by jurisdiction. This development is creating new compliance burdens for multinational groups and is likely to change the way that transfer pricing audits proceed in the future. A particular wrinkle for entities in the United States is that the IRS has now implemented the country-by-country report requirement for tax years beginning after July 1, 2016, but has remained silent so far on the master file/local file concept.
Country-by-country reporting is intended to share key financial and statistical data with all relevant tax authorities, creating a new level transparency in transfer pricing exams. However, the country-by-country report format requires raw numbers to be displayed without context, making the need for robust documentation more important than ever. Companies need to make sure that they clearly articulate context and the background in transfer pricing documentation in order to reduce the chance of tax examiners misinterpreting the numbers. Thus the importance of avoiding “minimum required” documentation can only increase.
Properly managed, the master file/local file concept could make it easier for companies to maintain effective local documentation. As stated above, the master file should not simply be a U.S. (or other headquarter country) report with the “OECD” swapped out for “IRC 482” but rather a truly global explanation of the multinational group’s operations, transactions and policies.
Once a strong, global core master file report exists, creating and maintaining a set of narrower, country-specific local files should be relatively straightforward and affordable. Most global companies should be able to create a generic local file template at the headquarter level; it can then be tailored and expanded at the country level for local facts and considerations and incorporate local variations in transfer pricing regulations. While U.S. authorities haven’t issued guidance on the master file/local file concept, the new format can still satisfy the existing U.S. standards for documentation.
When it comes to documenting transfer pricing, there are numerous options. The key is to make sure that the information presented isn’t just the headquarters view of operations in various countries. To be effective, transfer pricing documentation needs to include input from local resources in each country where the business operates.
