Transfer pricing has long been recognized as one of the most significant areas of tax risk facing multinational companies, and because management of this risk is linked to the company’s legal structure, it’s an area general counsel should address proactively.

An example of the scale of the risks involved was Microsoft’s announcement last year that the IRS was demanding $28.9 billion in back taxes, penalties and interest.

The demand relates to a long-running transfer pricing dispute concerning the company’s use of regional centers in Singapore, Dublin and Puerto Rico to distribute software, reducing its effective tax rate. Microsoft has said it believes its existing provisions for tax contingencies are adequate and will contest the IRS’s demand. The outcome of the dispute remains to be seen, and even if it is successful, Microsoft will need to invest significant time and money in defending its position.

Transfer pricing risks are not confined to ultra-large corporations. Every business with cross-border operations should assess their risks and put in place systems to manage them. At a minimum, this should involve documenting the legal and economic substance of related-party transactions through intercompany agreements. This requires close cooperation between the legal and tax functions.

Tax rules

In any multinational group, a variety of intercompany charges are made — service fees, royalties, prices for goods, loan interest and so on — which affect where profits are made and taxed. Transfer pricing refers to the international set of tax rules around these charges.

The Organization for Economic Cooperation and Development has adopted the arm’s length principle as the international standard for determining proper transfer pricing for tax purposes. Tax authorities can review a related-party transaction, and tax an entity on the profits it would have made had that transaction been negotiated between independent third parties. However, a transfer pricing adjustment demanded by one tax administration may not be approved by the jurisdiction or jurisdictions at the other end of the transaction. This creates a risk of double taxation. Significant interest and penalties can also apply.

Many tax administrations expect intercompany agreements to be entered into in advance. Some countries (such as Germany) go further, and expressly state that the arm’s length principle is to be applied on the date when the relevant intercompany agreements are concluded, not when the relevant services are performed.

Intercompany agreements are often among the first documents requested in a transfer pricing audit. The taxpayer will need to respond quickly by producing intercompany agreements that align with its transfer pricing policies and correctly document the transactions concerned.

General counsel takeaways

General counsel are well used to prioritizing and managing risks. The following steps can help them manage transfer pricing risks arising from defective intercompany agreements:

• Confirm or establish clear ongoing roles and responsibilities for maintaining intercompany agreements, including the allocation of responsibilities as between “tax” and “legal.”
• Ensure that the tax and legal functions are working from the same “central source of truth” in identifying all group entities (including branches and establishments). This often involves making sure that appropriate company secretarial systems are being used and are up to date.
• Ensure that the group’s existing intercompany agreements are stored in a comprehensive central, online repository. This may be “owned” by the tax, legal or compliance function, as appropriate.
• Carry out a sample review of existing agreements, entities and transactions, to identify any gaps in coverage of intercompany transactions, and any non-alignment between agreements and transfer pricing policies.
• Create a plan to fix gaps and to re-align agreements and policies as needed.
• Confirm or establish the ongoing processes needed to review and update the group’s portfolio of intercompany agreements as needed. This should include, as a minimum, an annual review of agreements to reflect any changes in the group and its transfer pricing policies. 

Transfer pricing disputes are tax matters but general counsel play a central role in helping their organization avoid them by ensuring their intercompany agreements align with their transfer pricing compliance policies.