Prepare for success. 5Insights for executives. Operational transfer pricing: Failure to implement can hinder performance

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1 5Insights for executives Prepare for success Operational transfer pricing: Failure to implement can hinder performance Of special interest to Chief financial officer Head of supply chain From natural disasters to political unrest, there are many factors that multinational companies can t control. Transfer pricing is one factor you can. You set the price you pay for goods and services delivered within your enterprise. But it has to be done in a way that reflects current market conditions, drives overall business value and efficiency, and effectively manages compliance and risks. Transfer pricing is about more than covering the bases. Failing to optimize transfer pricing can cost an organization multiple opportunities that are critical at a time when companies are looking for the slightest advantage to improve earnings. Being able to delineate where you stand during the year from a profitability standpoint and from a transactional standpoint is important. Making transfer pricing adjustments at year-end or worse, after year-end can prove costly. One company had to pay $15 million in custom duties it could have avoided because the company had to wait until after the end of the year for the necessary data to make its case. By then, it was too late. Paying up was the only option. Your company s reputation also may be at stake. In another case, a tax authority targeted a public consumer products company, bruising the business s image. The authority portrayed the company as one that would not pay its fair share. Instead of waging a fight, the company decided to maintain its brand and paid additional tax dollars.

2 1What s the issue? Misaligned policies and performance metrics can lead to intercompany pricing that s not competitive with the market. Sales and operations people may find themselves negotiating more internally than with third-party customers. If the transfer price is artificially high, and it s cheaper to buy elsewhere, they do. Companies typically view transfer pricing as a compliance issue and spend vast sums drafting documents. The US Government developed documentation rules to capture revenue from companies shifting their profits offshore. Now, companies must present their transfer pricing policies within 30 days of request or face non-deductible penalties of 20% to 40% on any adjustments. In recent years, many countries have enacted similar documentation rules and increased enforcement. When it comes to policies and documentation, what s missing and what taxing authorities care about most is making sure those policies are implemented correctly. Now, the IRS is honing in on real figures, such as the markups on standard or fully loaded costs. Many organizations struggle to execute the policies they set and then fail to monitor compliance. They don t have the proper systems or necessary data to manage their pricing in real time. If the pricing and reporting are not automated, concerns about data integrity often surface. Manual effort typically leads to a high probability of error. Operational transfer pricing defined Documentation Operational transfer pricing Monitoring Execution Policy 2 ey.com/5

3 Multinational companies have repeatedly ranked transfer pricing as the leading tax controversy issue. There are also double taxation, customs and VAT consequences for getting transfer pricing wrong. Taxes generally make up between 15% and 35% of a company s cost structure, and that s a big number when companies are streamlining costs. You don t want to pay more than you have to, and you really don t want to pay unnecessary interest and penalties. Misaligned policies and performance metrics can lead to intercompany pricing that s not competitive with the market. 2 Why now? Companies are starting to realize and acknowledge the importance of intercompany transactions when it comes to achieving strategic objectives. Global and local responsibilities have to be aligned as transfer pricing is defined. The global economic crisis hit countries and companies hard. Governments are using austerity measures to stop the bleeding, and they are pressuring companies to pay more in corporate taxes. Transfer pricing is an easy target. The authorities have become more technologically savvy, and they want access to a company s enterprise resource planning systems to test how it implements transfer pricing policies. Authorities around the world are taking a hard line on enforcement. They want proof that the policies your company puts on paper are the policies your company follows. They want to make sure your stated strategy is embedded in the organization and that it yields the results you report on income tax returns. 3

4 3 How does it affect you? Incorrect or inconsistent transfer pricing could drive suboptimal behavior throughout the company or a lack of indirect visibility of the company s performance elements. When companies report the wrong profits in the wrong locations, it becomes a problem from an overall tax management standpoint. Companies may pay too much or too little tax in countries where they shouldn t. If a taxing authority comes in and makes a large adjustment, the company could face catastrophic effects financially. In these cases, transfer pricing is the leading area targeted. Penalties can cost millions or more, not to mention the reputational backlash. Getting ahead with an automated system on the front end would allow a company to better plan and realize the benefits of tax effective supply chains. In these cases, you can attribute the right amount of value and profit based on the functions, risks and assets attributable to a particular location. Assigning the right profits to the right jurisdictions can save between US$15 million and US$100 million a year in taxes based on the size of the organization. 4 ey.com/5

5 4 What s the fix? The operationalization of transfer pricing deals with aligning business and compliance. It reviews transfer pricing from multiple angles such as strategic, process, organization and technology. It takes a cross-functional team to build a business case and execute the project. That team can assemble data to prove whether the financial rewards will outweigh the expense of the project. 5 1 Operationalizing transfer pricing can be a complex but rewarding process. There are five steps companies should take: Conduct an opportunity assessment: collect information about your pricing goals and challenges, and define your pain points. For example, it may take 20 people to extract raw data and present it in a way that s useful for transfer pricing. Conduct a workshop with the right group of stakeholders, such as the leaders of finance, IT, tax and supply chain. 2. Establish the feasibility: select key jurisdictions and galvanize your team to find the economic leakage, such as double taxation. Evaluate the challenges and the root causes. Create a road map for a pilot project or a prototype. 3. Create a detailed design for the process: construct an operating model, with supporting policies, procedures and system capabilities, and a detailed plan for implementation. 4. Deliver the model you plan to use: build and validate your design to roll out across the organization. 5. Sustain it: determine a way to measure and support continuous improvement. Companies are not static; they are continuously changing. If you make an acquisition, you want flexibility when developing ways to integrate the new entity. 2 How do you know you re addressing what s needed to achieve your objectives? Key operational elements include: Prospective transfer prices Integrated processes Real-time monitoring Master data management Intercompany agreements and document management Transfer pricing governance and managed work flow Goals and key performance indicators reflected in performance measurements 5

6 5What s the bottom line? For years, companies have viewed transfer pricing as a tax-only compliance issue, rather than a strategic component that can impact shareholder value. It s really a business issue that requires companies to be proactive and implement consistent systems across the enterprise. At the same time, one cannot underestimate the impact of a transfer pricing audit by an aggressive taxing authority. It s the No. 1 tax issue that keeps executives awake at night. If in the back of your mind you know your systems and implementation are below par, you could be in for an expensive surprise when taxing authorities come to review. 6 ey.com/5

7 Want to learn more? The answers in this issue are supplied by: Andrew Sliwa Partner Transfer Pricing Ernst & Young LLP Robbert Kaufman Principal Transfer Pricing Ernst & Young LLP For related thought leadership, visit 7

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