C5 case study tax compliance and risk control

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C5 case study tax compliance and risk control

  1. 1. CASE STUDY: TAX COMPLIANCE AND RISK CONTROL – BEST PRACTICES IN ESTABLISHING A TRANSFER PRICING FUNCTION WITHIN A TAX DEPARTMENT
  2. 2. Introduction • Multinational enterprises (MNes) typically operate within a wide range of markets, customer segments, business cultures, specialisms and technologies. Managers at various levels of the multinational enterprises are required to make decisions within their area of responsibility, because there is no one individual or group of people with the capability to manage the whole of a complex cross-border organisation. With decision making often dispersed throughout organisations, the role of performance measurement and assessment within divisions and across legal entities becomes vitally important. Transfer Pricing is one of the means by which performance and tax compliance is managed, measured, and risk controlled and it has the potential to be, and often is, one of the most hotly contested aspects of management control.
  3. 3. The Subject matter • Transfer pricing is typically ‘owned’ by tax departments which are mainly concerned with compliance aspects of Transfer Pricing policies. Tax departments are well acquainted with the arm’s length principle which requires organisations to treat different legal entities as if they were independent profit-driven companies for tax compliance purposes. However, transfer pricing design in organisations goes beyond fiscal compliance and plays an important role in ensuring that semi-autonomous business divisions / sub-units behave in a way that contributes towards the achievement of corporate and not merely divisional objectives, that is, overall maximised profit for the group. • An effective transfer pricing system should encourage divisional managers to pursue the interest of the organisation automatically whilst endeavouring to optimise the performance of their own business unit.
  4. 4. THE TRANSFER PRICING CHALLENGE • Determining an appropriate transfer pricing policy may not be as straight forward as it initially appears. There are numerous competing factors that come in to play when designing TP policies: • •External influences: Challenges such as differential international tax rates, foreign exchange rates, varying government regulations, non-compliance penalty regimes, and the financial and reputational risk of non-compliance all have a bearing on trans-fer pricing policy and motivate MNEs to give high priority to transfer pricing tax compliance. As TP regulations across the world have become more de-tailed in recent years and tax authorities have put transfer pricing at the forefront of audit strategy, transfer pricing compliance has continued to move up the agenda for many MNEs.
  5. 5. Continuation… • • Transfer pricing objectives: Transfer pricing systems are designed to accomplish the following objec-tives: • 1. Tax compliance and efficiency optimisation: TP policy can be influenced by a range of considerations, including: avoidance of double taxation, mitigation of duties and other tariffs on imports and exports, reduction in Effective Tax Rate on profits, reduction in foreign exchange risk, avoiding conflicts with host authorities, manag­ing cash flows and competing in global markets
  6. 6. • 2. Management control function: Facilitating performance measurement of the business units involved is another reason for implementing a transfer pricing policy within a tax department. When designed correctly the policy should be consistent with perfor-mance evaluation, motivate subsidiary / divi-sional managers and achieve goal congruence. • 3 Overall goal: Any MNE’s overall goal will be to maximise profit. Transfer pricing may be used as a tool to induce goal- congruent decisions within an organisation.
  7. 7. MANAGEMENT CONTROL VERSUS TAX COMPLIANCE More often than not MNEs opt for a single set of transfer prices for both tax compliance and management control purposes. Generally, it is considered by tax departments that a single comprehensive transfer pricing policy not only guarantees tax compliance, but eases the administrative burden on the company and avoids confusion at divisional or country manager level. Furthermore, MNEs frequently implement uniform profit margins and mark-ups for all similar stages in the supply chain, irrespective of jurisdiction and varying external economic factors. It has been evidenced in academic studies that such approaches adopted for tax compliance, administra­tive simplification and ease of understanding have in many cases led to a reduction in the sense of au-tonomy for sub-unit managers, and suboptimal deci-sions as a result of the loss of negotiation power.
  8. 8. Continuation… • For compliance purposes we typically consider transfer pricing policy as a product of functional and economic analysis. However, behavioural problems can arise when inappropriate prices are set that result in ‘wrong signals’ being sent and non-optimal decisions being made. • There is clearly a potential conflict between tax and behavioural aspects of transfer pricing design. Intra-group products and services are increasingly sold across international jurisdictions. As demonstrated by the increasing number of MNEs undertaking supply chain reorganisations, in such situations it is possible to reduce total group taxes by accumulating risk and profit potential in legal entities that have lower tax rates. In addition to operational savings this repre-sents a real cash tax opportunity and has proven to be attractive for many MNEs. Consequently transfer prices are often set in order to manage compliance re­quirements and fit enterprise-level operational strat-egy rather than to motivate performance and improve decision-making at the entity level.
  9. 9. CASE STUDIES • In the case studies below we examine some of the ways in which Transfer Pricing models can have unintended consequences caused by overly focusing on the tax compliance and administrative aspects of transfer pricing. In addition, we consider ‘solutions’ that could be used to align compliance and behavioural aspects of transfer pricing.
  10. 10. A. Unintended consequences of an ‘arm’s length ‘agreement: • A UK headquartered consumer goods group had fac-tories in Ireland and the UK. There was a bilateral contract manufacturing agreement whereby the Irish factory charged the UK for production based on a margin over a fully loaded cost base. As a result of the transfer pricing policy it was actually cheaper for the UK factory to source from UK third parties. Whilst the UK factory continued to run capacity shortages, the Irish factory continued to have a chronic surplus ca-pacity problem, and under-utilised equipment and workforce. • There is no single ideal solution to this problem. On the one hand the UK factory could be incentivised to utilise Irish capacity if the Irish company priced its goods such that it made marginal contribution but did not recover overheads. This would reduce manufac-tured costs to both the UK Company and the group as a whole, while reducing the loss incurred in Ireland. • Alternatively the competitive tension caused by the UK Company opting to source externally could be seen as encouraging restructuring in the Irish factory in­creasing the long term efficiency of group manufacturing.
  11. 11. • In another example, a Singapore wholesale trading hub purchased from third party suppliers and pro-vided certain guarantees to those suppliers. The Sin-gapore hub then sold to related parties with the price determined on a profit split basis. As a result of the ‘arm’s length’ profit split agreement, the Singapore hub was encouraged to enter into more risky con-tracts with suppliers as it benefited from the ‘portfolio effect’. This effect on behaviour is analogous in some ways to the concept of ‘‘moral hazard’’ in markets where there is no direct consequence of poor decision making, and it led in this case to some very bad busi-ness decisions being made. • Consequently, the group reconsidered its transfer pricing design and adopted a more transactional based policy. Under the revised transfer pricing policy the Singapore was discouraged from entering some of the more risky contracts as it retained the loss when entering into ‘bad transactions’.
  12. 12. B. Using transfer pricing to manage competing priorities: • A chemicals manufacturer operates a classic limited risk distribution model, with the distributors earning a fixed operating margin. The principal company sells to US customers via a limited risk distributor. The local US team is responsible for controlling US logis-tics procurement. The pricing policy means that on the one hand it is in the direct financial interests of the US entity to maximise sales and customer satisfac-tion, regardless of cost; on the other hand it is in the group’s interest to control logistics costs. • In this type of situation, which is common in most limited risk operating models, competing priorities can be managed in one of two ways: through TP, by giving the distributor a target margin before distribu-tion costs, and leaving it at risk for over-spend on lo-gistics, or through a governance framework that sets limits and policies centrally and penalises non-compliance. Whether carrot or stick is the appropri-ate policy varies from company to company.
  13. 13. C. Considering Key Performance Indices (KPIs) as evidence to support transfer pricing • : • A large volume US distributor sold large volumes of product into the US market from the UK via a US sales and marketing company. The US Company had one very senior employee who was responsible for the sales operation in the US. The cost base of this activity was very small, however the volumes were large. Cost could be supported for the US entity, or whether the remuneration policy should default to a return on sales. Ultimately the company opted for a pricing model based on a return on costs, with the decisive factor being the remuneration of the US director. He earned fixed remuneration with no bonus or com-mission based on sales or profitability.
  14. 14. D. Using KPIs to undermine transfer pricing policy: • A US headquartered food group had a manufacturing plant in Europe which operated as a pure cost centre under a toll manufacturing arrangement. The transfer pricing arrangement came under review from the local European tax authorities when they identified a job advertisement for the manufacturing plant which sought to employ a ‘‘senior commercial manager’’. The company sought a potential employee who would be a ‘‘self- starter’’ who would benefit from ‘‘early responsibility’’ and should have ‘‘real ability to make a differ­ence’’. If nothing else, this episode demonstrates the need for a two-way dialogue between those who set Trans-fer Pricing in a business, and those who run it.
  15. 15. Conclusion • Transfer pricing is a critical component of tax compliance and managerial risk control, with two main objectives: • 1. Promote goal congruence, i.e. optimum performance on a group basis, and • 2. Provide a suitable system of performance incentivisation, measurement and evaluation. • However, transfer pricing policy is often ‘owned’ by tax departments and finance functions who are mainly concerned with tax compliance and financial reporting. Consequently, transfer pricing models can have un-intended consequences such as inefficient utilisation of capacity, unhealthy internal competition and exces-sive risk taking behaviour. A well designed transfer pricing policy, in addition to meeting fiscal require­ments, will encourage the right management behav-iour, be consistent with management KPIs, and can be a force for positive behavioural change.

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