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Technology companies and transfer pricing

Three members of Hogan Lovells transfer pricing team recently joined a host of tech companies and other advisors at the TP Minds West Coast conference in San Francisco. In a series of presentations, panels and workshops spread over three days, participants discussed recent developments in transfer pricing, what tax authorities are doing in the area, and how new technology is posing new challenges and opportunities.

But what is transfer pricing? And why does hardly a week go by, without something appearing in the press about it? In the last fortnight or so, for instance, there has been extensive coverage about plans put forward by Senate and House Republicans in the U.S.to tackle what they see as the untoward behaviour of multinationals in using transfer pricing to avoid paying tax. The sums involved are huge too, running into hundreds of millions, or even billions of dollars.

What is transfer pricing?

In basic terms, transfer pricing is the process by which multinational enterprises go about determining what jurisdictions their global profits are booked in. It’s something they have to do in order to draw-up accounts for all their subsidiaries. It involves almost any transactions for goods, services or IP among group entities. And it’s critical when a business is dealing with an acquisition, the integration of two businesses or any other internal restructuring designed to achieve better operating efficiencies.

For the most part transfer pricing follows a global set of rules and principles: the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. You might think this would be the end of the subject. But over the last 5-10 years, it has become the topic of heated discussion, even by the man-on-the-street, and tech companies are often accused of playing the system to reduce the amount of tax they pay globally.

Why should tech companies worry about it?

Tax authorities all over the world are challenging the transfer pricing arrangements of tech companies. This is due in no small part to the well-publicised profitability and size of many players, and also due to reports of billions of dollars being hoarded offshore. A hard-line is being towed by tax authorities too, due to how tech companies are seen as paying little in taxes in many countries despite earning enormous revenues and profits from them. This is unlikely to change anytime soon either, especially since the transfer pricing arrangements they have entered into are essentially variants of the same model. Tax authorities have successfully challenged this model in a number of cases, and see this as having set the new standard. Moreover, and although the IRS record in TP litigation in the US is not especially good, for instance, that is also expected to change.

What challenges are tax authorities making?

In short, tax authorities across the world (particularly those outside of the U.S.) are arguing that not all of the value in a business is locked-up in the intellectual property or technology platform. There are, it is argued, other important contributors in the value-chain. These could include sales and marketing, managing commercial relationships and trouble-shooting, and the collection and use of customer or user data to generate insights that play an important role in developing or improving products. There are as many other activities that fall into this category as there are business models. And wherever staff in local countries play a significant role, tax authorities are arguing that the “old” transfer pricing model does not work and that more income should be taxed in local countries.

How is transfer pricing changing?

Following the final report issued on Base Erosion and Profit Shifting (BEPS) by the OECD, revised transfer pricing guidelines have been adopted. Even in countries where these guidelines do not have the force of law, they are quite influential. The revisions place greater emphasis on what people are doing in the business, and less on pure contractual relationships, and where, for instance, IP is owned legally. Moreover, new technologies are pushing the boundaries of what a standard supply chain looks like and the new “links” in the chain are often the most difficult to describe and price.

Tax authorities are also approaching audits in different ways. The UK tax authority, for instance, has adopted an intense, forensic approach involving email trawls, site visits, and extensive interviews. The Italian tax authorities if anything are taking an even harder approach. Not only are they also arguing that local entities impact sales and should therefore receive a commission based on a percentage of sales, but that the profits of IP owners should be re-characterised as royalty income that is subject to withholding tax. Either way, a common refrain is that tax audits are becoming more intrusive, and soak up a lot more time from people in the business.

And how is this affected by developments in technology?

In a conference workshop led by Hogan Lovells, participants from a number of tech companies explored how new technologies are compounding the challenges they face in transfer pricing. Blockchain and 3D printing, for instance, have the potential to reconfigure and add to the complexity of supply chains. And where value is being created in a business becomes more difficult to answer where services are provided from the Cloud, or performed remotely using algorithms and AI. Big Data itself is also becoming more important as a value-driver in businesses, and tax authorities inevitably are focusing on where information comes from, who collects and analyses it, and what is done with the results. Technological hybridisation is another issue. As an example, an increasing proportion of value in auto manufacturing is driven by IP, and a good deal of that IP comes from outside the auto-industry.

These developments all make transfer pricing more complicated, and make it harder for companies to explain to tax authorities how their businesses work too. Our view though is that the fundamentals of transfer pricing have not changed. It is still about understanding what drives value in a business. And the picture is not all bad. New technology is being harnessed to drive volumes and margins, and is making it possible to configure businesses in different ways. Effective supply-chain planning if anything is therefore even more important.

Other issues

A final topic discussed by the Hogan Lovells team in the workshop, and also on a panel during the main part of the conference, was how tax is not the only issue that tech companies need to think about in designing and implementing their transfer pricing models. Data privacy, competition, and regulatory issues often have a decisive impact on how a business can be structured. These factors need to be taken into account before designing a transfer pricing system.

A good transfer pricing system for a business is not a tax-driven system. Rather, it is a business-driven structure which enables the business to tell its business story and to maximize its tax opportunities.  It is a structure best designed by the business, with the assistance of economists and lawyers, taking into account all of the relevant economic, tax, regulatory and other legal issues facing the business.