Transfer Pricing Systems–4th Qtr Planning

Now that autumn has arrived, companies with a December 31st fiscal year-end are well into preparation for fourth quarter, and that means that year-end won’t be far behind.  Transfer pricing should be part of this preparation process. From a transfer pricing perspective, companies with significant related party transactions need to put some thought into both their current taxation year and the one following.  In this article, I outline the steps that companies should take to address their transfer pricing concerns before year-end arises.

Transfer Pricing Is A Journey Not A Destination

Companies should take a cradle-to-grave approach when tackling their transfer pricing issues.  This implies that there is more work required than simply preparing contemporaneous documentation.  Documentation is merely the first step in the process any company should undertake, especially if your transfer pricing processes are complex or your transfer pricing audit risk is high.  Beyond documentation, financial analysis and monitoring of transactions is important.  In addition, fact-gathering and administrative procedures can be handled long before the documentation deadline of six months after a taxation year-end.

Financial Analysis and Monitoring

One of the keys to supporting related party pricing is performing a comparable analysis in the Company’s documentation.  The selection of the most appropriate methodology will ultimately determine the degree of analysis performed.  For example, when employing a Comparable Uncontrolled Price (“CUP”) as the primary methodology, one is comparing related party prices with those of external third-party transactions whereas a Transaction Net Margin Methodology (“TNMM”) analysis will involve the search for third-party public comparables.  Regardless of the methodology, third party pricing can be fluid thus potentially rendering a company offside on its transfer pricing if not carefully monitored.

Related party pricing supported by CUPs may result in more stable systems than other methodologies under certain circumstances, but there is often still risks that third-party prices may fluctuate from year-to-year due to changes in the market place.  For example, due to increased competition, widgets sold to a third-party may now be priced lower than before.  In such cases, related party prices should follow suit assuming comparability remains unchanged. The potential trap exists where over time, the comparability between the controlled and uncontrolled transaction have changed such that the CUP is no longer a reliable methodology.  Care should be taken by taxpayers to ensure that a comparability analysis is conducted each year to ensure the conditions for using the CUP remain true.  Assuming this is true, and potential changes in prices arise, management should consider whether such market forces are temporary (for example, due to a labour strike at a supplier) or due to potentially permanent changes in market forces.

Similarly, when using either the Cost-Plus Methodology (“CPLM”) or the Resale-Price Methodology (“RPM”), which measures profitability using a gross margin metric, caution should be taken to ensure that margins on comparable third-party transactions are not fluctuating such that changes to transfer prices are warranted.  Assuming there are multiple third-party transactions used as comparables, there is likely a range of gross margins that can be employed to set a Company’s transfer prices.  This allows for fluctuations in market forces while still allowing a Company to maintain the status quo on their transfer prices.  Of course, adjustments to related party prices may be necessary, so vigilant monitoring should be implemented.

Statistics show that the TNMM is the most commonly used methodology in Canada, at least amongst Mutual Agreement Procedure cases handled by the government.  Under the TNMM, external comparables are found which are matched up with the functions performed, risks assumed, and assets employed in the controlled transaction.  The risk of not maintaining an up-to-date TNMM analysis is that the financial results of the comparables will often change from year-to-year, thus resulting in the arm’s length range shifting up or down, or narrowing such that a Company’s related party pricing is now offside.  Furthermore, companies within a comparable set may potentially go bankrupt, or may merge with another company, thus reducing the size of the comparable set.  Conversely, new companies may have gone public which should now be included in the comparable set.  Updating a TNMM analysis is important to do on a regular basis for you documentation.  I would advise a company a company with high transfer pricing audit risk (public companies, large private companies) to update their comparable sets once a year.  Companies with lower risk should consider updating no longer than once every two years since the potential changes in comparables beyond that can be material.  In cases where comparable work is done bi-annually, a “roll-forward” of financial information should be considered.  This entails taking the comparable companies from the prior year’s set and updating the financial information through either SEC or SEDAR filings.  This can offer a company an opportunity to flag potential transfer pricing risks on a timely basis.

Fact Gathering

If you work for a dynamic organization, fact gathering is an important part of updating your contemporaneous documentation.  Luckily, much of that effort can be done well before the end of the fiscal year-end.  The fourth quarter presents management with an opportunity to do the following:

  • Identify key areas of the business where facts have substantially changed over the year;
  • Document the nature of any changes in fact patterns as it relates to functions, risks, or assets employed;
  • Assess changes in risk profile of entities within a multinational organization;
  • Determine if changes in approach or methodologies will be required for the updated transfer pricing documentation.

Whether the work is being done internally or with the help of external advisors, gathering information early can help to streamline the updating of documentation and help facilitate addressing changes in risk on a timely basis.

Administrative Considerations

Administratively, the fourth quarter presents a good opportunity for companies to “get their ducks in a row”.  The following checklist is an example of what a typical organization might have to consider before year-end:

  • Year-end transfer pricing adjustments—Sometimes referred to as “true-ups”, these involve the organization finalizing transfer pricing billings to ensure all related party billings are included in the year-end books. It is common for many organizations to simplify monthly intercompany billings through using estimates that need to be “trued-up” at year-end.  Much of this process can be simplified by performing a pre-year end true-up either at the end of third quarter, or at the end of the eleventh fiscal month.  This reduces the potential variance for the final year-end true-up when accounting resources may be extremely limited.
  • Intercompany agreements—If new related party transactions have emerged in the year (such as for licenses of intellectual property, contract R&D, or contract manufacturing arrangements), drafting and finalizing an intercompany agreement will help to solidify the transaction in the eyes of the tax authorities.
  • Discussions with your tax/transfer pricing advisor—It is never too early to discuss any concerns or ask questions of your advisor. If an external party is preparing your documentation, the fourth quarter is a good time to updater them on any significant changes in your business from the prior year and address with them any proposed changes in approach or methodology for the upcoming year.