Companies often spend a lot of time and money to analyze and document their transfer pricing arrangements. But proper implementation is equally important.
A transfer pricing policy ensures that everyone within the firm is “on the same page.” Moreover, it demonstrates that transfer pricing has been considered and implemented correctly, creating a record for internal and external stakeholders.
In this short article, we discuss what a transfer pricing policy is, why you should create one, and how to prepare one.
What is a Transfer Pricing Policy?
These days, Multi National Enterprises (MNEs) operate internal policies for almost everything. Such PDF documents formalize guidelines and protocols in specific areas, ranging from employment policies to risk management.
A transfer pricing policy is similar. It laws down the MNEs policy regarding the application and implementation of transfer pricing rules. It can concern one or more intercompany transactions.
It spells out for different departments what they need to do and how they need to do it. Moreover, it helps the tax/finance department to ensure correct pricing.
A transfer pricing policy doesn’t replace, it strengthens
Clients often ask us if a transfer pricing policy can replace transfer pricing documentation or intercompany agreements. This is not the case.
At a minimum, a successful strategy needs:
- An analyses of the transfer pricing arrangements, such as risk and functional analyses, prices, and terms and conditions;
- Intercompany agreements that formalize transfer pricing arrangements between different group members in a legally binding manner.
A transfer pricing policy supplements the above. It translates ideas into policy.
The objective of a transfer pricing policy
The objective of transfer pricing policies is two-fold:
1. Harmony. Ensure that everyone in the firm is “on the same page” when it comes to the transfer pricing arrangements. Successful implementation of transfer pricing only works if there is “buy-in” from stakeholders. Before becoming reality, it needs to be understood.
Example I: The finance department wants to know what amounts to charge to which group entity (and when), the risk department wants to ensure that transfer pricing arrangements do not create risks, and the manager wants to know whether his/her financial results are affected.
2. Compliance. Demonstrate towards tax authorities that transfer pricing has been considered and implemented the right way. It shows a proactive attitude which is highly appreciated by tax authorities. It sets you apart from the crowd.
Example II: During a tax audit, tax authorities normally check whether compliance / documentation requirements are met. Besides showing the customary 100-page transfer pricing report, it is powerful if a MNE can show exactly how the transfer pricing arrangements have been implemented and are being complied with.
Example III: Added Value of a Transfer Pricing Policy
If you’re not convinced that a transfer pricing policy adds significant value to your transfer pricing strategy, please read the following example (based on a real case):
One day the tax authorities knock on the door. They inquire about the transfer pricing of Teddy Transportation. Teddy Transportation proudly shows them the rock-solid documentation and intercompany agreements. Next, the tax authorities check the books of various associated enterprises. They discover the following:
- The finance department has issued invoices for Intercompany support services for amounts higher than they should be according to the transfer pricing documentation and intercompany agreements.
- There are discrepancies between what is described in the transfer pricing documentation and the actual behavior of associated enterprises. For example, the documentation states that there are one Principal entity and several Low-Risk Distributor (LRD) entities. Under this model, the LRD entities do not assume much risk and do not get involved in marketing, price-setting, etc. In practice, however, the “LRD entities” are assuming (much) more risks and functions. They may very well be considered “Full-Fledged Distributors!”
- Two group entities have concluded an intercompany loan that the tax department did not know of. Thus, it wasn’t included in any transfer pricing documentation.
Based on these findings, the tax authorities are not convinced that Teddy Transportation complies with transfer pricing rules. It starts an investigation to verify:
- whether the allocation of risks, assets and functions on which the transfer pricing has been based is in line with reality (actual behavior)
- whether there is transfer pricing documentation for all intercompany transactions.
The above could have been avoided if Teddy Transportation had clearly laid down the transfer pricing policies. Everyone should have had clarity on matters such as what amount to invoice, how to invoice, how to book the transactions, how to stay within the functionality borders of the Principal/LRD model, and who to inform when a new intercompany loan arrangement is put in place.
Unfortunately, Teddy Transportation now must spend time and money to address this. Resulting potentially in more taxes and penalties if the tax authorities decide to make adjustments to the transfer pricing…
How to prepare a Transfer Pricing Policy?
It goes beyond the scope of this article to discuss in detail what needs to be included in a transfer pricing policy, however, in general, we advise to include the following elements:
- Section 1 – Introduction and scope
- Section 2 – Conceptual framework
- Section 3 – Invoicing
- Section 4 – Accounting
- Section 5 – Intercompany agreements
- Section 6 – Withholding tax
- Section 7 – Documentation
- Section 8 – Exceptions
- Section 9 – Review
- Section 10 – Effect
A good way to get started…
To get started, ask yourself a few simple questions:
- What is the scope of the transfer pricing policy? (single vs. multiple intercompany transactions)
- How are you going to secure the necessary information to prepare the policy?
- Who are the internal stakeholders (e.g. finance, legal, business) and how are you going to secure their buy-in?
- How prescriptive should the policy be?
- Who is going to sign off on the policy?
- How are you going to ensure and monitor compliance with the policy?
Tips when preparing a Transfer Pricing Policy
There are many important aspects to bear in mind when preparing a transfer pricing policy. Our three most useful tips are:
- Make sure that the policy is in line with intercompany agreements, transfer pricing documentation and reality. Material misalignment might raise questions from internal or external stakeholders.
- Involve important stakeholders early in the process and secure their buy-in. For example, if you need the finance department for matters such as invoicing and accounting of the intercompany transaction, ensure they are aware of what is expected from them.
- Seek endorsement of the policy by internal stakeholders and formal approval from a duly authorized officer within the business―usually, this is someone in charge of financial or tax matters.
Transfer Pricing Policies are an important part of the implementation of transfer pricing. A transfer pricing policy helps ensure that everyone within the firm is on the same page. It clearly demonstrates that transfer pricing has been considered and implemented correctly.
By doing this, you stay ahead of the curve. Not doing this places your business at unnecessary risk.
We trust you enjoyed the read.
p.s. If you don’t want to re-invent the wheel, we have created a transfer pricing policy template for intercompany services. It is a ready to use and contains all the information you need. It is a word-file and can be adjusted to your case and used as often as you like.