As tax authorities more closely scrutinize multinationals’ revenue and cost allocations and the Organization for Economic Cooperation and Development’s proposed standards for income allocation gain momentum, it is increasingly important that transfer pricing policies align with the nature of a company’s operations. Partners Nate Carden and David Farhat discuss double taxation and other problems that can often be headed off with the proactive use of the “competent authority” mutual agreement process and advance pricing agreements authorized by standard tax treaties.
Mr. Carden and Mr. Farhat are the hosts of Skadden’s tax podcast, “GILTI Conscience.”
Nate Carden (00:12):
Hi, everybody. My name is Nate Carden. I’m joined by my colleague David Farhat. We are both international tax and transfer pricing partners. I’m in Chicago. David’s in D.C. Today, we’re going to talk about what once upon a time was a really obscure topic: transfer pricing related to how companies deal with their internal flows and the allocation of income between countries. When I first started doing this a couple decades ago, nobody really paid attention to it. If it made the newspaper, it was on the back page at best. But one of the biggest developments in the last 20 years has actually been how transfer pricing has changed outside of tax departments and increasingly come under public scrutiny. David, let’s start by maybe talking with people about what some of the concerns are that those who don’t work day to day in tax ought to have about transfer pricing.
Reputational Risk and the Need for Consistency Across Jurisdictions
APAs (Advance Pricing Agreements) and MAPs (Mutual Agreement Procedures)
David Farhat (01:07):
I think the biggest one, Nate, is reputational risk. If you have to fight tax examiners in a jurisdiction, and those tax examiners believe that your company is not a good actor when it comes to tax, that could be a problem. I think that problem’s exacerbated by COVID where you may see more aggressive audits, and you may see countries trying to recover some of the spending they’ve had to do as a result of COVID be a bit more aggressive when they’re talking to companies and using tactics like going to the media and attacking a company’s reputation. So that is one of the biggest things you see when it comes to transfer pricing outside of the tax department.
Also, you see the OECD coming up with different policies, and I say different policies because it becomes a bit confusing as to what is the policy behind the rules that they’re passing. What you see from the rules is that they believe taxpayers aren’t paying their fair share. They believe taxpayers are doing things that they don’t like, and they want to get around that. So Nate, throwing it back to you, with some of those rules, what should our clients be thinking about with regards to transfer pricing and with regards to reputational risk?
Nate Carden (02:25):
Notwithstanding all the changes in the rules, I think the overall direction of travel is continuing to try to align your transfer pricing with where your business operations are, which fundamentally means, where do you do research and development? Where do you produce things, and where do you market and sell them?
Now, the relative emphasis of this is going to depend on different industries. And certainly, when we look at what the OECD is doing, there’s an increasing emphasis on market countries and the importance of where the customers are as part of determining your overall allocations of income. But at the end of the day, a lot of these rules continue to be in flux, and the overall international tax system is evolving in a way that is very hard to predict right now. If you look at the United States, we’ve seen one major international tax reform just a few years back. There was an attempt at another one. We’ll see what happens with Build Back Better. At the same time at the OECD, or international level, there’s movement toward a global minimum tax. There’s movement toward an increasing allocation of income, not based on really where the company does things, but rather where their customers are.
But in light of all of these things, you need to still continue to try to align your business operations with your transfer pricing so that you have a consistent story to tell around the world. And that consistency, to me, is one of the most interesting changes that we’ve seen over the last 10 year. I would say 10 to 15 years ago, audits and controversies were handled on a country by country basis, where you focused on what you did in that country and didn’t worry about everything else. I think it’s been a major change in the way tax authorities operate that now we see much more attention being paid to how your whole tax system works.
But, doing the transfer pricing in APA and MAP work that you do, what do you see?
David Farhat (04:28):
No, I think you’re exactly right. The days of the one-sided transfer pricing, they’re gone. You can’t just go to a one jurisdiction, make a deal, or get an understanding for what they want and implement that because you’ll see it’ll come to bite you in another jurisdiction. So consistency is key in talking about MAP and APA work. I think bringing the governments to the table to discuss your transfer pricing, especially for very material transactions, is very important. So the role of the competent authority becomes far more necessary. In the past, it was a thing where if I have an adjustment, I go to competent authority to get rid of double tax.
But I think now it has to become a part of transfer pricing and tax planning. You have to say to yourself, “Where am I going to find my controversy?” not just because of tax problems, as you said, but because of a reputational risk. Do I want to be seen in a certain jurisdiction as a bad actor? And will I be seen that way because I’ve done something wrong or because that jurisdiction’s interpretation of the rules may be different than how I see them or how another jurisdiction sees them?
So if you have that kind of materiality, whether it’s financial or from a reputational standpoint, it may not be a bad idea to engage with these jurisdictions early on, whether it’s through APA, through MAP, or just informally to get a view of where they stand and how to work these things out.
But with that being said, Nate, what are some of the successes and criticisms you’ve gotten from clients that have tried to do this, that have tried to engage or have tried to kind of keep consistency without talking to the governments?
Nate Carden (06:07):
Well, one of the problems, of course, is that, whether you’re talking to the individual governments or not, there’s a lot of disagreement between the governments as to how these different standards that are really new to the international tax community ought to be applied. And in particular, one of the things that we see is a lot of argument between competent authorities ― the people in the governments who are responsible for negotiating this cross border ― over how important certain functions are versus, let’s say, the allocation of economic risk. So fundamentally there’s an enormous debate within transfer pricing about the importance of people versus the importance of capital.
But the overall risk that I see is that if you don’t pursue things in advance with an advance pricing agreement, you’re going to end up dealing with the same people on the competent authority side in the other process you were talking about, mutual agreement procedure, or MAP, which happens after you’ve already been under audit. So feels to me like in the environment that we’re in now, you either are going to go for an APA early, or you’re likely to end up talking to the competent authorities later.
Reputational Risk Can Lead To Regulatory Risk
As we look at this going forward, one of the things that I see happening is that what we call reputational risk now is increasingly becoming a regulatory risk or a corporate governance risk. So as I see it, the biggest recent development has really been the rise of other parts of governments looking at what companies are doing from a tax perspective and potentially having it impact the regulatory environment in which they operate, which is critically important for the folks that are listening to this who don’t do tax every day, because you may find yourself all of a sudden facing regulatory pressure regarding your day to day operations that you weren’t facing before. I also see it for those who work with physical products on the customs side, and more and more we’re seeing demands from shareholders that companies be more transparent about what they’re doing from an income tax perspective.
But I do wonder if you engage with the governments, how much do you think, as somebody that previously worked for the government, how much do you think this public pressure and public attention affects what the folks in the government, who are actually tasked with dealing with these issues, think of these companies?
David Farhat (08:39):
It impacts policy. We all have our bosses. And it’s the same thing with the government. If you’re dealing with the competent authority, if you’re dealing with a tax examiner, they have someone to report to, and they have to let that person know that they’re doing their job. So, to say that there’s no impact is untrue. But for the most part, most tax authorities are principled. Most of them will follow the rules and will have an interpretation of the rules and will want to get to the right answer. As someone once said, governments like to see money coming in and money not going out. So that will also have an influence.
But I think the APA process that we’ve discussed, or the MAP process, where you have governments sitting at the table together, and not just the taxpayer interest versus the tax authority interest, but tax authorities discussing their interest is a good way to get ahead of some of these things. I think that process becomes more and more important as governments demand more information, as tax becomes, not just the concern of the tax authority, but of different regulatory authorities and of customs, and explaining to the tax people why the regulators need something one way, why customs need to see another thing, to be able to explain to them your business. Because what I’ve found is most tax authorities, you have very competent tax people, but they don’t understand your business. They don’t understand the competing interest in the business. So being able to sit at the table and discuss that with them to get certainty for you and for the tax authority, I think is extraordinarily important.
So to kind of put a bow on what we’ve been talking about, I think you have to think about your transfer pricing not just being a tax issue, your reputational risk, consistency in your global allocations, and doing your best to read the tea leaves and talking to the governments as early as you can.
Involving Management in Transfer Pricing
Nate Carden (10:38):
So when I think about people out there who are not in tax departments, who just listen to this segment and are wondering, I wonder what is happening in my company, one of the things that I think is very successful is having engagement between legal, regulatory, the financial accounting folks and the tax department. Oftentimes, those transfer pricing and tax disputes really don’t make it around the organization until it’s very late in the game.
And I think that is a trend that is changing. But I certainly think that it is best practice for everybody to try to get coordinated with their colleagues ― brief up legal, brief up the rest of the finance organization and really have a clear sense as to what the company’s overall posture is going to be. Because if the general counsels out there or the boards out there are learning about these tax positions very late in the game, there’s nothing you can do about it, oftentimes, and at that point, the horse has left the barn and with pretty significant adverse regulatory consequences. So I’d certainly encourage everybody to get a basic handle on what your company does from a tax and transfer pricing perspective.
But I am curious, David, as to whether you’ve seen any particular practices that you think work well?
David Farhat (12:12):
I think just as you described, give tax folks a seat at the table. Listen to your tax people. I think for a long time, tax has been kept in a cubby in the back, and those folks do their thing, and they keep us out of trouble with the tax man, so to speak. But I think those days are over. We have to listen to them. We have to talk to them.
In my dealings with the governments, whether it’s in an APA, in an audit, or a MAP, I’ve seen governments ask to talk to business people. “I don’t just want to talk to your tax people. I want to know what they do. I want to know how they interpret things. I want to know how they see things. I want to know what motivates them, because then that impacts allocation. Because that’s something that doesn’t have to do directly with tax.”
So, as you described, I think having a practice where folks are familiar with your transfer pricing, folks understand the demands that come from the tax authority and have at least a feel for some of those rules is a very healthy business practice nowadays when tax people are trying to find out more and when countries could get a bit more aggressive.
Nate Carden (13:16):
And I think that really brings us full circle. We started this by saying that tax departments need to follow the business and look at the direction of travel. Like you say, tax authorities are going to want to talk to the business, and so the business folks also need to understand what the tax positions are.
It’s going to be an interesting couple of years, as I’ve said before. I’m not sure I can make it through another round of major international tax reform, but we all have to, I think, for the moment, just hold on to our seats and see what happens.
David Farhat (13:48):
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