The (transfer) price is right?

In recent months tax avoidance, and transfer pricing in particular, has been high on the political agenda in many key private equity jurisdictions including the US, UK and Canada.

Put simply, transfer pricing is when one division of a parent entity sells/buys to a sister entity. 

The government may be following the lead of recent media outlets which have slammed multinationals corporations including Amazon and Google for achieving tax efficiencies through intermediate holding company structures domiciled in tax-friendly jurisdictions. One can easily imagine similar media campaigns against the private equity industry for similar arrangements.

Shrinking staff coffers may serve as another explanation for authorities’ increased scrutiny of tax practices. In mid-February, the G20 group of richest nations met to discuss how they can better coordinate their efforts to address transfer pricing methods they see as unjustifiably shifting profits into low- or no-tax jurisdictions. For private equity firms with cross-border holdings, the risk is one of their transfer pricing arrangements could be put into question, leading to fines, or at minimum damage their reputation with LPs.

The G20 discussions were based on a recent Organisation for Economic Co-operation and Development’s (OECD) paper which argued international tax principles have not kept pace with the more innovative private sector, with transfer pricing noted as a key area of concern.

BULLET-PROOF POLICIES

So how can private equity firms protect themselves from a more aggressive taxman?

Limiting the conversation to transfer pricing, tax law requires these transactions to be made at “arm’s length” – meaning buyers and sellers price the product the same way they would with an independent party.

Unfortunately, private equity firms don’t always take enough care documenting or justifying how a transfer price was calculated at arm’s length, warns one tax lawyer.

And as tax authorities sound the alarm on transfer pricing, more private equity tax advisors are urging their clients to look at their transfer pricing policies and ensure they are robust enough to fight off any allegations of unscrupulous behaviour.

In practice, there are many transfer pricing methods available, and each differs depending on what pricing is being taken into account. But the most popular method for private equity firms, which legal sources argue may no longer cut it in the eyes of tax authorities, is the “cost-plus method”.

“Cost-plus is a sort of quick and dirty way of doing things,” says Ropes & Gray tax partner, John Baldry, who explains the method involves transacting parties simply assuming a reasonable profit level – which typically ranges between 5 and 10 percent when the buyer/seller is a private equity management or advisory company.

Using that example to clarify the point: A cost-plus method, which will determine how much profit from each management company contract stays in the jurisdiction from which it was sold, may no longer cut it with more aggressive tax authorities. For instance, if by using the cost-plus method the GP works out that the taxable profit in one jurisdiction should be 5 percent, but the tax authority of that jurisdiction believes the right mark is 9 percent, you are more likely to be challenged, say sources.

Comparables methods are emerging as the new best practice for private equity firms, say sources. This involves – usually a specialist from a firm’s tax advisory, law or accounting firm – gathering information on what outside market participants transacting independently would charge for the same service as the firm’s price point.

“It’s a bit of an art rather than a science,” says Baldry. “It is like trying to decide what a house price should be; you can find things that are quite like it, but you will never find anything that is exactly the same.” Subjectivity aside, firms are moving towards the comparables methods in order to show tax authorities more analysis and justification behind their transfer price points, according to legal sources.

What’s more is tax authorities are evaluating transfer pricing schemes in a more “holistic” manner, as opposed to reviewing the rationale for each transaction on a standalone basis. 

“Although each individual transaction may well have been benchmarked and appropriately documented as being an accordance with the arm’s length principle, we are seeing a clear trend for certain companies to come under scrutiny in relation to the overall impact of their transfer pricing arrangements,” warned a recent report from law firm Baker & McKenzie.

For tax authorities, the logic is to examine the bottom line impact on an entity’s transfer pricing policy, as firms aggressive with their pricing may be able to justify individual arrangements, but ultimately end up paying little to no tax in a particular jurisdiction.

“If you are putting in place a transfer pricing structure for the first time, then adopting a method that tests the bottom line profit of each company concerned is a very good way to start,” says CMS-Cameron McKenna tax lawyer, Nick Foster-Taylor. “That is increasingly likely to be the ultimate test that tax authorities apply on a global basis rather than the traditional basis of looking at individual inter-company transactions in isolation.”

DEFEND YOURSELF

At any rate, setting up a robust transfer pricing policy is certainly easier said than done. That’s largely because tax authorities are unable to provide GPs an explicit set of criteria outlining what best practice is in any given scenario. However the OECD and various tax authorities have tried to clarify their stances by releasing reports indicating their views on improper transfer pricing, but these are by no means exhaustive.

“Consistency and being able to defend your position is everything,” one tax lawyer told PE Manager. He said ensuring you have the correct documentation to back that up is also crucial.

However, as tax authorities become more sensitive to transfer pricing in the private equity market, more guidance is likely to follow, according to Foster-Taylor – who thinks the industry will see increased instruction on what tax authorities want to see in terms of paper work.

Until that time comes private equity firms worried about their transfer price policies can follow three simple guidelines when executing a transaction between related parties: 1) Have on hand a description of the commercial structure of the business as a whole 2) Document the types of transactions that take place internally between group companies, and 3) Be able to provide a means of justifying the price basis of those individual transactions (i.e. a comparables analysis).

Despite the political environment, meeting those three criteria will likely satisfy the expectations of most tax authorities, sources say. Of course, that may change upon the release of further guidance, but at the time of press the OECD said it was only in the beginning stages of an action plan designed to address the problem of tax avoidance. Later this July, the OECD will present its proposals to the G20, who may or may not consider greater coordination and tougher policies (an effort sources believe would need to be led by the US) in the quest for stricter supervision of transfer price policies.