What is the point of transfer pricing documentation?
“I understand my business and the flow of products through different countries. Why should I document anything more than the bare minimum information needed to comply with transfer pricing laws?” We get this question a lot. Thorough transfer pricing documentation serves two purposes. First, it’s an upfront investment in managing time and costs related to a potential examination. Second, a close review of your transfer pricing also provides a close review of your production process, supply chain and international operations. Either one of these reasons alone may justify the extra work. The two reasons combined present a strong case for taking the transfer pricing documentation process seriously.
Penalty protection versus other goals
In many countries, a key motivator for preparing documentation is penalty protection. Some countries, such as France, require documentation and assess penalties where documentation is absent. Others, such as the United States, can charge penalties in the event of a transfer pricing adjustment, but waive such penalties where documentation has been prepared contemporaneously with the corporate tax return. Penalty protection is a legitimate goal of preparing documentation, but companies are often tempted to do only “the minimum required”, and no more, to avoid penalties. While thorough transfer pricing documentation does not ensure that a business will be protected against an examination or penalties, there is a similarity between doing the minimum required documentation and buying a “bare minimum” car insurance policy.
As long as you don’t have an accident, or an examination, the bare minimum approach will likely save you some money. But a lot of consumers who go for the cheapest coverage find that it doesn't help much when something happens to their car. And the same is true for those who opt for the path of least resistance on documentation. Bare-minimum documentation, often fails to properly explain the company’s transactions and transfer pricing policies and so may be of minimal value in an audit. Even if penalties are ultimately avoided, the company may face a much longer, more expensive audit because of the lack of a compelling and complete analysis of the company’s related party transactions. Weak documentation also tends to leave a lot of loose ends and open items that invite round after round of questions from the examiner, which can lead to long, meandering inquiries often ending with unpleasant results. In contrast, robust documentation answers key questions and sends the message that management takes its transfer pricing policies very seriously. A well-reasoned and documented transfer pricing process may suggest that a deeper investigation is unlikely to result in findings and adjustments.
Documentation as a planning and management tool
Bare-bones documentation also represents a lost opportunity for improved transfer pricing management, especially for companies with a large number of foreign affiliates and complex related party transactions. A complete and comprehensive documentation process can force management to clarify points of ambiguity, such as economic ownership of technology intangibles, the possible presence of local marketing intangibles, or an inadequate understanding of how foreign affiliates operate. Effective global documentation can be a means of insuring that far flung affiliated entities are all on the same page, and that local management is making transfer pricing administration a priority. The process will often flush out and address long standing issues that may have been hidden within the business for years.
A corollary point is that transfer pricing documentation is typically retrospective in nature, explaining past transactions and showing why they are consistent with the arm’s length standard. But merely explaining and documenting the past can mean not looking forward and proactively designing an appropriate transfer pricing architecture. So, while documenting the past is a key element of transfer pricing risk management, the development of a documentation process should include effective forward-looking planning conducted across the global group.
Effective global documentation can be a means of insuring that far flung affiliated entities are all on the same page.
So when it comes to answering the question “Why transfer pricing documentation,” it comes down to two reasons. First, it can preclude the need for an examination by a taxing authority or make an examination much less intrusive than it otherwise might be. And second, it provides an excellent opportunity for executives in a multinational business to review, understand and improve operations around the globe.