Firmly on the radar of governments looking to curtail tax avoidance are companies owned by the same parent entity that sell and buy from one another in low-tax jurisdictions. And it’s an investigation that could very well capture private equity firms with money flowing through these regions.
Industry tax experts are advising GPs to polish their transfer pricing policies and better monitor any tax efficiencies achieved when structuring an intermediate holding company in Ireland, the Netherlands, Luxembourg and other popular private equity domiciles.
The most high-profile government investigations have so far only involved multinational corporations. UK MPs attacked Google for routing £3.2 billion ($5.2 billion; €3.8 billion) of UK sales through Dublin and Starbucks has been questioned for transferring money to a Dutch sister company. But Jill Weise, managing director of Duff & Phelps’ transfer pricing services unit, says it is easy to see the private equity industry catching unwanted attention when using similar arrangements.
“Private equity [transfer pricing] issues don’t often look or smell any different than that other multinationals face.”
POLICY PERFECTION
To avoid penalties (and negative publicity), firms should see that overseas activities are included in their transfer pricing policies, legal experts advise. In the past, preliminary deal research and general marketing would have made up the majority of a firm’s extraterritorial activities outside of traditional cross-border M&A activity.
But many firms now include deal sourcing and analysis, investment committee representation, deal execution, investor relations, capital raising, fund administration and other back office support functions overseas. For instance, the work of an IR team based abroad should be included in a firm’s transfer pricing policy because intra-group services and intangible property must be priced.
Developing a robust policy comes with many challenges. Chiefly among them is working out exactly how sister companies under the same parent should charge each other for goods and services. The most popular method currently used within the private equity industry is known as the “cost-plus method”. Under this method, transacting parties assume a reasonable level of profit – typically between 5 and 10 percent – to determine how much profit stays in the jurisdiction from which the service was sold.
However tax advisors warn this method no longer cuts it with tax authorities. “Cost-plus is a sort of quick and dirty way of doing things,” says Ropes & Gray tax partner John Baldry. For instance, a firm could be challenged if the tax authority deems the taxable profit to be lower than what is expected under an arm’s length transaction.
A comparables methods is fast becoming the accepted best practice among tax authorities. Under this approach, GPs (or their portfolio companies) gather information on what outside market participants are charging for the same service.
“Tax authorities are keen to see firms using comparables methods as it demonstrates the firm is doing greater analysis of their transfer pricing and comparables show more justification of why a transaction should be a certain price,” notes one UK-based tax lawyer.
For instance, a firm with a management entity located in the UK, but whose fund administration is taking place in Luxembourg, would need to price the fund administration service so the Luxembourg office can record a profit. However, tax authorities will expect the profit margin to be calculated by referencing profit levels achieved by independent third-party administrators providing similar services.
Using a comparables method can be challenging, sources warn. For instance there could be limited data available to benchmark a transaction. And comparing transactions can be difficult because some tax authorities prefer firms strictly use local pricing data, which is not always readily available.
Further complicating matters for GPs is that tax authorities are unable to provide an outline of best practices to follow with respect to transfer pricing. The Organisation for Economic Co-operation and Development (OECD) and some tax agencies have released reports and papers trying to clarify their positions, “but these are not by any means exhaustive” said the UK tax lawyer.
A paper on the matter published by the OECD in July makes suggestions about how transfer pricing documentation rules “might be modified to make transfer pricing compliance simpler and more straightforward, while at the same time providing tax authorities with more focused and useful information.”
But until a consensus is reached among the echelon of tax authorities, private equity firms worried they are missing the mark on their transfer pricing, or those who want to ensure their compliance is bullet-proof, can follow three general steps provided to PE Manager by advisors: Firstly, have on hand a description of the commercial structure of the business as a whole. Secondly, document the types of transactions that take place internally. And lastly, be able to justify the price of transactions by documenting the transfer price methodology (i.e. comparable analysis or some other method).
To better defend your tax position, one industry tax lawyer says consistency and documentation of your policies is also essential, a task that “not all private equity firms are up to.”
KEEPING CONSISTENT
Consistency of methodology is especially important in light of tax authorities evaluating transfer pricing practices in a more “holistic” manner. Rather than reviewing each transaction on a standalone basis, tax agencies are scrutinizing the overall impact of a firm’s transfer pricing arrangement.
The rationale behind this holistic approach is to examine if firms are able to justify transfer prices on a transaction-by-transaction basis but ultimately pay little or no tax in a particular jurisdiction.
“You need to show tax authorities that you are consistent and have seriously thought about what that pricing ought to be,” says Baldry.
Until legislative changes occur the political environment serves as a reminder that transfer pricing practices are being watched closely.
G20 world leaders gave their backing to the OECD’s initiative to help countries prevent tax avoidance, and also create a new set of tax standards to ensure that companies are unable to abuse transfer pricing rules. British Prime Minister David Cameron made the transfer pricing issue a priority for the UK’s presidency of the G8 major economies and Australia agreed to carry on the transfer pricing fight during its G20 presidency next year.
At press time the OECD was reviewing comments on its July paper, and will hold a public consultation on its findings on November 12 and 13. While nothing is certain, William Britain, director in Deloitte’s transfer pricing team predicts tougher policies are likely to be borne out of these meetings as governments look to shore up their state coffers.
No major changes in how governments evaluate transfer prices is expected in the short-term however. “The OECD was considering base erosion; though they are used to moving quite slowly. They have now grasped the political impetus; changes could take two years; but for OECD that is fast,” says Britain.
In the meantime, private equity firms operating in low-tax jurisdictions will continue to be at risk of moving into the crosshairs of tax authorities keen to catch any sign of abusive transfer pricing.
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