Why transfer pricing is critical for the world’s premier tech hubs
Why transfer pricing is critical for the world’s premier tech hubs
The foundations of global tax systems are in flux, changing companies’ risk profile – especially where transfer pricing is concerned.
In a deep-dive insight article, BDO’s Laurie Dicker and Dan McGeown detail how transfer pricing tops the complexity scale for tax issues:
Source: Spotlight on Transfer Pricing - Identifying complexity and areas of risk/Global MNC Tax Complexity Survey. Table: BDO Global
Furthermore, BDO’s latest Tax Outlook Survey in the US shows that 73% of tax executives have seen total tax liabilities have increased in the last 12 months. 70% expect liabilities to rise in the coming 12 months.
Transfer pricing is especially challenging for many technology start-ups and companies found in the world’s premier tech hubs, influencing companies’ ability to pursue growth opportunities, build out company structures, and their attractiveness to prospective investors.
What is transfer pricing?
Transfer pricing refers to the rules and regulations that govern the pricing of goods, services, loans, or intellectual property (IP) (for example, technology licenses or marketing intangibles) between related entities.
Authorities look to protect such exchanges against tax-base erosion and expect the transfer prices to adhere to the so-called arm’s length principle. This means that exchanged goods, services, or IP should be priced in a way that matches what an independent third party would charge.
Individual jurisdictions have different tax rates and rules that govern transfer pricing. The differences can include documentation requirements. Furthermore, the related parties are treated as legally separate, complicating tax liabilities and audit requirements – especially if the companies operate in different countries with different tax rules and rates.
Transfer pricing and IP
For technology start-ups, scaleups, and mature entities, transfer pricing will likely be an issue that arises in connection with expanding into new territories, raising growth capital, or related to M&A activities.
As detailed in BDO’s Spotlight on Transfer Pricing - Identifying complexity and areas of risk, transfer pricing creates complexity across many tax-related business processes.
Source: Spotlight on Transfer Pricing - Identifying complexity and areas of risk/Global MNC Tax Complexity Survey. Table: BDO Global
One of the prime concerns and challenges will likely be calculating the IP’s transfer price.
IP generally refers to patents, trademarks, copyrights, and trade secrets. It is often sold or transferred between parties in licensing agreements.
There are several methods to calculate the value of a transfer between related entities, also covering IP, including:
- The Comparable Uncontrolled Price Method (CUP): compares the cost of a transaction between two related entities with comparable transactions between two unrelated parties.
- The Resale Price Method (RPM): uses the resale price of a product or service, reduced with a calculated gross margin.
- The Cost-Plus Method (CPLM): compares gross profits to the overall sales costs with an added, market-based markup.
- The Comparable Profits Method (CPM): looks at the net profit of a controlled transaction between associated enterprises, which is compared to net profits of comparable uncontrolled transactions between independent enterprises.
Each method has its advantages and applications. Therefore, the advice is to consult with transfer pricing experts on which may be best for a company’s situation.
How transfer pricing influences M&A and growth capital
For tech hubs and the companies within them, transfer pricing directly influences growth ambitions.
Transfer pricing rules will directly influence new ventures outside of the company’s national market in the different legislations.
Suppose a company is looking to secure growth capital from outside investors. In that case, the investors will also want to know how said growth will be influenced by growing financial complexities, including transfer pricing.
Investors looking to acquire one or more companies located in a tech hub may view complications due to transfer pricing structures as a reason to lower their offering price – or call off the potential deal.
For example, if a private equity (PE) investor is interested in a scaleup company looking to combine it with several other companies located elsewhere in a bolt-on deal, the PE may look at the applicable transfer pricing rules and regulations – or the company’s transfer pricing setup - and decide the investment will be complicated or likely to miss the desired economic upsides due to transfer pricing issues.
One lesson is that creating clear, easy-to-navigate transfer pricing structures is pivotal for a region’s ability to create a national, regional, or international tech hub.
Source: BDO's Global Tax Outlook 2020. Table: BDO Global.
Furthermore, a company’s preparedness and setup for navigating transfer pricing will directly influence its ability to reach its ambitions. This is one of the reasons why companies surveyed in BDO’s Global Tax Outlook use outsourcing of transfer pricing-related tasks to navigate the complexities.
Constantly evolving regulations
One of the issues affecting companies’ ability to navigate transfer pricing rules is their constant evolution. The most significant change to international regulations is the OECD’s 2021 agreement on taxing the digital economy.
However, rules and regulations are also evolving throughout the different technology hubs.
In the UK, a 2021 consultation could end up having far-reaching consequences for transfer pricing compliance. As a result, some companies may be asked to comply with a new obligation to maintain mandatory transfer pricing master files and UK local files.
COVID-19 has also affected transfer pricing rules and documentation requirements. One example is Singapore, where the IRAS has expanded its prescriptive documentation content requirements, affirming that it is receptive to taxpayers’ explanations about COVID-19 impacted transfer pricing outcomes, to the extent supported by market and independent party evidence.
BDO’s advice for tech hub companies and investors
For both tech hub companies and their prospective investors, certain general recommendations apply to analysing transfer pricing risks:
- Evaluate current transfer pricing readiness and setup: does the company have formalised transfer pricing policies or plans in place to develop them? And do they align with business operations and plans? Review existing transfer pricing documentation with a critical eye.
- Develop strong transfer pricing policies: if gaps exist, develop policies and guidelines to cover them. The policies should be thorough, flexible, and work within a company's overall tax planning.
- Find the right transfer pricing calculation: Selecting a transfer pricing method serves to find the most appropriate method for a particular case. Each method's respective strengths and weaknesses and the availability of reliable information should be considered.
- Consider engaging experts: 43% of surveyed companies in BDO USA’s 2021 transfer pricing survey said they use outsourcing as a way to handle the complexities of specialised tax work.
- Does it demonstrate that the policies in place work and produce arm’s length results? Evaluating the target company’s transfer pricing policies and supporting documentation can reveal issues that would be readily apparent to tax authorities in the event of an audit.
It should be noted that each country has unique setups, and consulting with local experts will be beneficial to reach the optimal outcomes.