Case study: The impact of financial records and subsidiary governance on Transfer Pricing risks

This article appears in the January edition of our International Corporate Structures Newsletter.

We are delighted to feature the following article which was kindly contributed by Paul Harrison, Tax Director at Trident Tax.

Defining what is arm’s length in a modern, digitalised, global economy is clearly one of the major tax questions of our time. However, a more practical question which is overlooked at great risk to the multi-national enterprise (MNE) is this: has the transfer price been accurately captured in the prime records and financial systems of the MNE, and then reported accurately in its tax returns?

This challenge is illustrated with an example, based on a very significant project I led as an advisor working alongside senior management in a US headquartered MNE with significant operations around the world.

Aspects of the MNE’s transfer pricing affairs were technically complex, but the problems arose in an area of relative simplicity: allocation of costs borne in the UK to overseas legal entities benefitting from the expenditure. The MNE’s transfer pricing policy, agreed with relevant tax authorities, was that these costs would be charged out in full with a fixed % mark up. The MNE discovered, almost by accident, that very significant costs had been incurred in the UK and had not been captured for inclusion in the charge, over a period of years. This resulted in a substantial understatement of UK taxable profits.

The root causes of the errors were identified at three levels:

1. Some basic financial processes had not been operated in line with existing policies and procedures. Most significantly, cost centres had been set up without correct identification so were not picked up by financial controllers, thereby understating the revenues of the UK legal entity.
2. The board of the UK legal entity had exercised inadequate governance over the affairs of that company: they had not focused sufficiently on the trading terms between the company and its sister entities and the impact of those on legal entity costs and revenues. There was no evidence of properly constructed and executed legal agreements, or that these matters had featured at all in the deliberations of the legal entity board.
3. At the whole-enterprise level (notably at HQ level in the US) there was inadequate attention paid to governance at subsidiary legal entity level; no risk assessments had been conducted and there was no clear main board ownership of the need to support subsidiary legal entity governance (which underpinned the lack of focus at local level). For example, substantial operations had been offshored without adequate risk assessment or change management (which underpinned the breakdown in some basic financial processes).

The MNE needed to reassure the UK tax authority that a remediation plan was in place and would be executed to remedy the situation. This required substantial resources and external validation. It is not difficult to link this to the Senior Accounting Officer regime in the UK, which requires certification that reasonable steps are being taken to establish and monitor accounting arrangements which are capable of producing materially accurate tax returns.

It seems clear that global tax authorities will be focusing very keenly on MNE transfer pricing issues, not least as Country-by-Country reporting starts to kick-in. It also seems highly likely that any challenge to MNE transfer pricing will include not just the ‘technical’ questions around what is the appropriate arm’s length price, but also on establishing whether the MNE has in fact executed its asserted pricing from prime records to tax returns. MNEs failing to focus on the practical aspects of this challenge will face the real prospect of significant penalties if they cannot sustain their positions – and at least in the UK this would also put the CFO/SAO at risk of personal liabilities.