for Transfer Pricing Enthusiasts
The following article was published on the Kreston Global website, authored by Jelena Mihić Munjić. In today’s globalised economy, economic substance in transfer pricingplays a critical role in helping multinational companies align their tax strategies with business operations while ensuring compliance.. It enables companies to allocate income and expenses among subsidiaries in different jurisdictions, ensuring operational […]
The following article was published on the Kreston Global website, authored by Jelena Mihić Munjić. The arm’s length principle (ALP) has long been the cornerstone of international tax, governing how multinational corporations (MNCs) allocate profits and tax obligations across borders. However, this principle, based on the idea of treating each entity as separate, increasingly fails […]
Landmark transfer pricing disputes have become increasingly significant as tax authorities globally scrutinise multinational enterprises (MNEs) to ensure they comply with the arm’s length principle.
As businesses navigate the post-COVID landscape, the dynamics of outsourcing and transfer pricing have taken center stage. With 77% of European countries now favoring intra-continental outsourcing, the focus has shifted toward fortifying the global value chain (GVC) and reducing dependence on traditional outsourcing hubs like China and Russia.
Cost allocation in Transfer pricing is a critical aspect of international taxation for multinational enterprises (MNEs). It is a key component is the proper allocation of costs, which ensures that intercompany transactions reflect an arm’s length standard, as required by the OECD Guidelines.
Jelena Mihic Munjic and Elena Ramirez Marin recently shared their insights on transfer pricing impact on SMEs with Bloomberg Tax.
In a recent feature on women in accounting, Liza Robbins, Chief Executive of Kreston Global, Jelena Mihić Managing Director at Kreston MDM Serbia, and Carmen Cojocaru, ESG Technical Director and Managing Partner at Kreston Romania, share their perspectives on gender diversity and inclusion in the accounting profession in an article for The Accountant.
The following article was published on the Kreston Global website, authored by Jelena Mihić Munjić.
In today’s globalised economy, economic substance in transfer pricingplays a critical role in helping multinational companies align their tax strategies with business operations while ensuring compliance.. It enables companies to allocate income and expenses among subsidiaries in different jurisdictions, ensuring operational efficiency and supporting business objectives. At the same time, economic substance provides the necessary foundation for transfer pricing to function as a compliant and sustainable tax tool. These concepts work hand in hand to support sound tax and business practices.
The Transfer Pricing landscape
At its core, transfer pricing involves setting prices for transactions between related entities within a multinational group. These transactions can include goods, services, intellectual property, and financing. The arm’s length principle, which requires related-party transactions to be priced as if they were conducted between unrelated parties, is the international standard governing transfer pricing.
Chapter I of the OECD Transfer Pricing Guidelines provides the foundational principles for applying the arm’s length principle. It emphasizes the importance of analyzing the functions performed, risks assumed, and assets employed by the entities involved in intercompany transactions. This framework underscores alignment between pricing policies and the economic contributions of each entity.
The guidelines also highlight the need for consistency between a company’s operational reality and its transfer pricing practices, which means that economic substance is integral to demonstrating compliance with the arm’s length principle.
Economic substance principle
Economic substance is the principle that ensures the underlying reality of a transaction aligns with its legal and financial structure. Economic substance should strengthen transfer pricing by ensuring that intercompany arrangements are rooted in genuine business activity.
Chapter VI of the OECD guidelines, which addresses the treatment of intangibles, stresses the need to evaluate economic substance when allocating income from intellectual property. It specifies that entities claiming returns from intangible assets must actively contribute to their development, enhancement, maintenance, protection, and exploitation (the DEMPE functions). This ensures that profits are attributed to the jurisdictions where significant value-adding activities occur.
Indicators of economic substance include:
- Functions Performed – Are the parties involved contributing significant value through their roles and responsibilities?
- Risks Assumed – Does the entity receiving income bear meaningful risks, such as market or operational risks?
- Assets Used – Are critical assets, such as intellectual property or equipment, genuinely utilized in the jurisdictions where profits are reported?
By aligning transfer pricing policies with these indicators, companies can create a defensible position that satisfies tax authorities while reflecting real business dynamics.
OECD Guidelines and Regulatory Trends
The latest OECD Transfer Pricing Guidelines, updated in 2022, emphasize the critical role of economic substance in ensuring compliance and transparency. Key chapters of the guidelines provide a detailed roadmap for integrating economic substance into transfer pricing strategies:
- Chapter II focuses on traditional transaction methods and requires that pricing reflects actual contributions to value creation rather than artificial allocations.
- Chapter V advocates for robust documentation where transfer pricing reports must provide clear evidence of value creation and economic contributions.
- Chapter IX addresses business restructurings, requiring companies to evaluate the economic substance of changes to intercompany arrangements. It highlights the importance of ensuring that these restructurings align with business realities rather than being driven solely by tax considerations.
These principles are reinforced by measures such as country-by-country reporting (CbCR) under BEPS Action 13, which provides tax authorities with a comprehensive view of MNC’s operations and income allocation. Rather than viewing these measures as restrictive, companies can use them to strengthen their transfer pricing strategies and align operations with global best practices.
Practical strategies
To ensure that transfer pricing and economic substance work together effectively, companies can adopt the following strategies:
1. Align Policies with OECD Guidelines – ensure that transfer pricing reflects the actual functions, risks, and assets of the entities involved.
2. Maintain Comprehensive Documentation – provide clear, detailed documentation that explains the rationale for pricing decisions and demonstrates compliance with both the arm’s length principle and economic substance requirements.
3. Focus on DEMPE Functions – evaluating intellectual property allocations considering Chapter VI’s DEMPE framework, ensuring profits align with value-adding activities.
4. Stay Informed on Global Regulations – monitoring updates to OECD guidelines and evolving tax laws in jurisdictions where the company operates to stay ahead of compliance requirements.
5. Expert Advice – when necessary, engage with transfer pricing specialists and legal advisors to navigate complex regulatory environments and optimize strategies.
6. Promote Transparency – building trust with tax authorities by providing timely and accurate information during audits or inquiries.
Transfer pricing and economic substance are not opposing forces but interdependent concepts that, when aligned, form a robust foundation for multinational business operations. Specific chapters of the OECD’s guidelines highlight the importance of integrating economic substance into transfer pricing strategies to ensure compliance and transparency. By adopting these principles, companies can achieve compliance, optimize tax outcomes, and support sustainable growth. As global tax rules change, this approach will be key to confidently navigating the international business landscape.
The following article was published on the Kreston Global website, authored by Jelena Mihić Munjić.
The arm’s length principle (ALP) has long been the cornerstone of international tax, governing how multinational corporations (MNCs) allocate profits and tax obligations across borders. However, this principle, based on the idea of treating each entity as separate, increasingly fails to capture the interconnected nature of modern MNCs. With complex value chains, intangible assets, and centralised decision-making, the traditional ALP approach is showing its limitations, prompting the question: is arm’s length now out of reach
The central challenge is a fictional framework
At the heart of ALP lies the assumption that each subsidiary within an MNC operates as a distinct and independent entity. In practice, however, MNCs function as cohesive units, with centralized strategies, shared resources, and tightly integrated operations. This mismatch creates distortions in profit allocation and taxation, particularly for sectors driven by intangible assets such as technology and pharmaceuticals.
Efforts to enforce ALP often involve identifying comparable transactions between independent entities which is a task increasingly difficult in today’s globalized and digitized economy. For transactions involving intangibles or unique business models, truly comparable data may not exist. This results in subjective assessments, complex compliance processes, and frequent disputes with tax authorities.
Rethinking the framework
Despite its flaws, ALP remains central to the global tax system. Replacing it entirely, as some advocate through formulary apportionment (FA), presents significant political and logistical challenges. A more pragmatic path forward involves refining ALP to better align with the realities of modern business while exploring incremental reforms to address its biggest deficiencies. Some of the ideas might include:
1. Expanding Safe Harbors for Routine Transactions
Safe harbour rules simplify compliance for routine, low-risk transactions by allowing standardized profit margins or predetermined methods. For instance, routine services, manufacturing, and distribution activities could benefit from safe harbours, reducing the need for exhaustive documentation and functional analyses. This approach minimizes disputes and allows tax authorities to focus on more complex, high-risk cases.
2. Simplified Profit Split Methods
For integrated operations and transactions involving intangibles, simplified profit-split methods can bridge the gap between economic reality and ALP. By relying on objective allocation keys such as sales, employees, or research and development expenses, these methods reflect the global nature of MNCs while avoiding the complexity of excessively detailed functional analyses.
3. Industry-Specific Benchmarks
Intangible-heavy industries, such as technology and pharmaceuticals, often lack comparable transactions. Presumptive benchmarks, developed using industry standards, offer a practical solution. By establishing fixed ratios or profit margins based on typical industry performance, these benchmarks reduce subjectivity and provide greater certainty for taxpayers and authorities.
4. Simplifying Compliance for SMEs
Small and medium-sized enterprises (SMEs) face disproportionate compliance burdens under ALP. Simplified rules for SMEs, such as fixed profit ratios or streamlined documentation requirements, can alleviate this pressure.
Hybrid solutions
A complete shift to Formulary Apportionment (FA) which allocates profits using predefined factors like sales, assets, or payroll—could address these challenges but requires an unprecedented global consensus and a dismantling of existing tax treaties. Hybrid solutions, however, offer a practical middle ground, combining elements of both approaches to balance reform with stability.
One promising hybrid approach is Partial Formulary Apportionment, which applies FA selectively to certain types of profits or industries. For instance, residual profits, those exceeding routine returns, could be allocated using a formula, leaving routine profits under ALP. Similarly, sectors such as digital services or pharmaceuticals, where traditional ALP struggles due to the dominance of intangibles, could benefit from formula-based allocation.
Another pathway lies in Gradual Transitions, where hybrid rules are introduced incrementally to allow businesses and tax systems to adapt. This could involve sector-specific guidelines or residual profit splits based on simplified formulas, starting with industries most prone to profit shifting. These steps show that we can create a fairer and more efficient global tax system without completely dismantling the existing framework.
Strengthening international cooperation can reduce ALP disputes by providing clarity and efficiency. Advance Pricing Agreements (APAs) offer pre-agreed pricing methods for cross-border transactions, minimizing conflicts, while enhanced arbitration mechanisms, like binding arbitration or streamlined mutual agreement procedures, ensure fair and timely dispute resolution. These measures promote consistency and trust in global tax compliance.
A simpler path forward
The flaws of the arm’s length principle are undeniable, but a replacement is neither practical nor imminent. Instead, a pragmatic approach focused on simplifications, hybrid reforms, and enhanced cooperation offers the best path forward. Expanding safe harbors, adopting simplified profit-split methods, and creating industry-specific benchmarks can make ALP more effective and manageable in the short to medium term.
By addressing its core challenges without abandoning its foundations, we can bring ALP closer to its intended purpose which is ensuring a fair and predictable global tax system that reflects the realities of modern business. While arm’s length may still seem out of reach for some transactions, these steps can help bring it closer within grasp.
Landmark transfer pricing disputes to learn from
Landmark transfer pricing disputes have become increasingly significant as tax authorities globally scrutinise multinational enterprises (MNEs) to ensure they comply with the arm’s length principle.
Several high-profile cases have made headlines in the past few years, shedding light on the complexities of transfer pricing regulations and enforcement. This review covers the most impactful cases, highlighting key lessons and implications for MNEs and tax authorities.
Apple vs The European Commission (2016-2020)
One of the most significant and widely publicised transfer pricing cases involved Apple and the European Commission (EC). In 2016, the EC ruled that Apple had received illegal state aid from Ireland through favourable tax rulings, allowing it to pay substantially less tax than other businesses over many years. The EC ordered Apple to repay €13 billion in back taxes. Apple and Ireland contested the ruling, and in July 2020, the General Court of the European Union annulled the EC’s decision. This case underscored the intense scrutiny on profit-shifting practices and the challenges of aligning tax policies across jurisdictions.
Australia vs Rio Tinto (2017-2022)
The dispute between Rio Tinto and the Australian Taxation Office (ATO) involved allegations of profit shifting to its marketing centre in Singapore. On July 20, 2022, Rio Tinto agreed to almost $1 billion following these allegations. This case emphasized the importance of transparency and the need for MNEs to ensure their intercompany pricing aligns with economic realities. The resolution reinforced public confidence that even the largest companies are held accountable for their tax obligations.
Amazon vs IRS (2017-2021)
Amazon’s dispute with the U.S. Internal Revenue Service (IRS) revolved around the undervaluation of intangible assets transferred to its Luxembourg subsidiary in 2005 and 2006, resulting in a significant underpayment of U.S. taxes. In 2017, the U.S. Tax Court ruled in favour of Amazon, stating that the IRS’s valuation was flawed, and that Amazon’s transfer pricing methodology was appropriate. This decision was significant for the tech industry, illustrating the complexities of valuing intangibles and the importance of thorough documentation and compliance with transfer pricing rules.
Fiat Chrysler Finance Europe vs European Commission (2015-2022)
Fiat Chrysler Finance Europe faced scrutiny from the European Commission over a transfer pricing agreement approved by Luxembourg. The Commission concluded in 2015 that Luxembourg had provided illegal state aid by incorrectly applying arm’s length principle. After multiple appeals, the Court of Justice of the European Union (CJEU) annulled the Commission’s judgment in November 2022. The CJEU’s ruling emphasized the importance of adhering to local regulations in transfer pricing matters.
France vs McDonald’s France (2015-2022)
In June 2022, McDonald’s agreed to pay €1.25 billion ($1.31 billion) to the French tax authority to settle a dispute over its transfer pricing practices. The company was accused of shifting profits to Luxembourg, Switzerland, and Delaware, avoiding significant tax liabilities in France. This settlement highlighted the risks MNEs face with aggressive profit-shifting strategies and the importance of ensuring transfer pricing arrangements reflect economic substance.
HM Revenue and Customs vs BlackRock (2012-2022)
The dispute between HM Revenue and Customs (HMRC) and BlackRock centered on intercompany loans related to BlackRock’s acquisition of Barclays Global Investors. HMRC questioned the arm’s length nature of the loan interest rates and denied shareholder loan interest deductions. In July 2022, the Upper Tribunal ruled in favour of HMRC, emphasizing the need for MNEs to ensure that intercompany financing arrangements comply with the arm’s length principle. Blackrock is appealing the decision of the Upper Tribunal and to re-make the decision of the First-tier Tribunal. This case illustrated the challenges of defending transfer pricing practices in high-stakes acquisitions.
India vs Kellogg India (2021-2022)
Kellogg India successfully defended its transfer pricing practices related to the distribution of Pringles products. The Indian tax authority had challenged the company’s selection of the tested party and the transactional net margin method (TNMM) used for benchmarking. In February 2022, the Income Tax Appellate Tribunal ruled in favour of Kellogg India, validating the company’s approach and highlighting the importance of selecting appropriate tested parties and methods in transfer pricing documentation.
Norway vs ConocoPhillips Skandinavia (2019-2023)
ConocoPhillips Skandinavia contested a tax adjustment by the Norwegian Petroleum Tax Office regarding the interest rate on a loan agreement. The court ruled in favour of the tax office, underscoring the importance of aligning intercompany financial arrangements with the arm’s length principle.
Lessons from Landmark Transfer Pricing Cases and Recent Developments in EU Legislation
These cases offer several key lessons for MNEs, reflecting an evolving landscape where tax authorities are increasingly vigilant. Courts emphasize the importance of economic substance over formal contractual arrangements, requiring MNEs to ensure their transfer pricing reflects actual business operations.
Tax authorities are intensifying their examination of transfer pricing practices, especially those involving intangible assets and high-margin industries. This increased vigilance now also targets mid-sized multinational enterprises, as tax authorities worldwide recognize the potential for significant tax revenue from these entities.
In particular, the recently proposed EU Directive on transfer pricing specifically addresses SMEs and their tax challenges, which indicates that SMEs will also be under increased scrutiny in the future to ensure compliance with fair tax practices.
The European Commission’s proposal for harmonised transfer pricing rules within the EU emphasizes a common approach to transfer pricing issues, ensuring consistency and reducing compliance costs for businesses of all sizes, including SMEs. This approach helps in maintaining a fair tax base and avoiding profit shifting and base erosion, which are critical concerns for tax authorities across the EU.
Robust documentation is crucial for defending transfer pricing arrangements, as inadequate documentation is a common issue leading to disputes. MNEs must maintain detailed records of their methodologies and justifications, as tax authorities become more rigorous. Additionally, MNEs should be prepared for the possibility of lengthy and costly disputes with tax authorities, necessitating thorough preparation, including expert legal and financial support.
Multinational enterprises, regardless of size, must remain vigilant, ensuring their transfer pricing practices are defensible, well-documented, and aligned with economic realities. By recognizing these trends and preparing accordingly, both large and mid-sized MNEs can better manage their transfer pricing risks and ensure they meet their tax obligations effectively.
The impact of outsourcing on transfer pricing in Eastern Europe
As businesses navigate the post-COVID landscape, the dynamics of outsourcing and transfer pricing have taken center stage. With 77% of European countries now favoring intra-continental outsourcing, the focus has shifted toward fortifying the global value chain (GVC) and reducing dependence on traditional outsourcing hubs like China and Russia.
Eastern Europe is emerging as a key player in this evolving scenario. What opportunities lie ahead, and what challenges must businesses address when it comes to transfer pricing in this region?
Biljana Sparavalo, Head of Transfer Pricing at Kreston MDM, shared her expert insights in an exclusive interview with Kreston Global. Her analysis highlights the critical nuances of this transformation, offering valuable perspectives for businesses considering or already engaging in the Eastern European market.
Benefits of European outsourcing: A win-win for accountants and clients
From an accountant’s perspective, outsourcing to Eastern Europe presents an array of advantages. Primarily, it offers cost-effectiveness and enhanced profitability, as labour costs in these regions are notably lower than in Western countries. This enables accountants to access and onboard new team members with specialised skills and knowledge that might be scarce in-house. Flexibility and scalability also contribute to the allure of outsourcing, empowering accountants to navigate varying workloads and adapt to changing demands more efficiently.
For clients of accountants, the benefits are equally compelling. Outsourcing translates into potential cost savings, which can lead to reduced accountancy fees. Clients can still expect high service quality due to the access to skills and modern technologies offered by the outsourcing team. The direct infusion of expertise and diverse perspectives brought by outsourced teams can significantly enhance the client experience. Furthermore, outsourcing can usher in innovative practices and technologies, contributing to improved service delivery.
However, while the advantages are significant, the actual benefits of hiring a European outsourcing partner may vary based on factors such as compliance, data protection, quality control, and cultural and language diversities.
Signs of the shift: Businesses moving towards Eastern Europe
“Before businesses embark on outsourcing in Eastern Europe, they typically explore opportunities in the region”, notes Sparavalo. A noticeable increase in collaborations and partnerships between businesses and European outsourcing companies serves as a tangible sign of this shift. This can be observed through official announcements, press releases, and discussions at industry events.
An additional indicator is the active participation of business representatives in conferences, forums, and industry events hosted in Eastern Europe. This demonstrates a palpable interest in leveraging the local outsourcing options available. Expansion strategies, including the opening of offices or expanding existing ones in Eastern European countries, further underline a commitment to establishing a physical presence that facilitates outsourcing activities.
Strategically, businesses align their service offerings with the strengths and specialisations of outsourcing entities in Eastern Europe. This includes areas such as IT services, software development and customer support. Investment patterns may also shift as businesses allocate funds towards infrastructures that support remote collaboration, showcasing their readiness to work seamlessly with teams spread across regions.
Companies engaged in outsourcing exploration often conduct consultations and market research specifically focused on Eastern Europe. Proactive measures such as adapting business operations to incorporate languages commonly used in the region and an increased emphasis on social responsibility initiatives illustrate a commitment to understanding and navigating the local outsourcing landscape effectively.
Opportunities for Eastern European businesses
For businesses in Eastern Europe, this paradigm shift represents a golden opportunity to actively participate in the global outsourcing market. The region’s strengths lie in its multilingual workforce, shared time zone, cost-effectiveness, and highly educated talent pool. Eastern Europe has become renowned for its expertise in the IT and technology sectors, making it a hotspot for outsourcing contracts in software and web development, as well as IT support.
The potential for European businesses to excel in outsourcing is not just limited to cost-effectiveness but extends to their commitment to delivering high-quality services. To fully capitalise on this opportunity, businesses should strategically develop their expertise to align with changing client needs. A strong focus on marketing and branding to showcase achievements and unique selling points becomes paramount.
Continuous learning and improvement, coupled with staying abreast of industry practices and trends, can make businesses more competitive. Establishing an industry presence through networking is also crucial. Active participation in conferences and engagement with clients and partners contribute significantly to achieving this goal.
Infrastructure also requires attention as businesses must ensure they have the technological and physical resources to deliver high-quality services. Implementing processes that demonstrate a commitment to providing services, flexibility and customisation can further enhance the appeal of the business. Building trust is of utmost importance when handling outsourcing projects involving confidential information. Developing a culture centred around client satisfaction and long-term relationships becomes a strategic approach in this context.
Key transfer pricing regulations in Eastern Europe
“While the rules for transfer pricing in Eastern Europe generally follow the standards set by the OECD, it’s crucial to recognise that specific laws can vary from country to country within the region”, says Sparavalo. A comprehensive understanding of the common aspects and essential regulations is pivotal for businesses navigating the complexities of transfer pricing laws in European countries, she notes.
Documentation requirements:
- Country-by-Country Reporting (CbCR): Multinational enterprises (MNEs) might be required to submit CbCR based on OECD guidelines.
- Local file and Master file: Companies may need to prepare documentation, including a detailed record of transaction-level transfer pricing (local file) and an overview of global business operations (master file).
Arm’s length principle
Transactions between related entities should be analysed at ‘arm’s length,’ meaning that the prices should be consistent with what would be agreed upon between unrelated companies.
Pricing methods
Regulations typically allow for various methods to define the arm’s length price, such as Comparable Uncontrolled Price (CUP), Resale Price Method (RPM), Cost Plus Method, and Transactional Net Margin Method (TNMM).
Advance Pricing Agreements (APAs)
In some countries, businesses may have the opportunity to make Advanced Pricing Agreements (APAs) with tax authorities. APAs enable taxpayers and tax authorities to agree on the methodology for determining transfer pricing, avoiding disputes in the future.
Resolving disputes
Various countries have established mechanisms for resolving transfer pricing disputes, including agreement procedures (MAP) with other nations.
Consequences of non-compliance
Not adhering to transfer pricing regulations can lead to penalties. The severity of consequences depends on the nature of non-compliance.
Documentation thresholds
Certain criteria may exist to determine which entities are obligated to adhere to documentation requirements.
It’s important to note that the development stages of transfer pricing regulations still vary in Eastern European countries, and practices differ. Therefore, conducting individual assessments in each country is advisable.
Common transfer pricing challenges faced by companies in Eastern Europe
Companies operating in Eastern Europe encounter a range of transfer pricing challenges that mirror the intricacies of the business landscape and regulatory characteristics of the region. One major hurdle is the complexity and variability of regulations. Each European country having its own tax laws means that businesses must carefully align their operations with numerous jurisdictional requirements.
In terms of documentation and compliance, companies bear the responsibility of maintaining accurate records to support their transfer pricing strategies. They must navigate through reporting requirements imposed by countries, presenting an added layer of complexity. Accessing comparable data is another significant obstacle, as relevant financial information or transactions for validation purposes can be challenging to find.
Regional economic climates introduce an additional layer of complexity, as market conditions and currency fluctuations impact border transactions and the determination of transfer prices.
To successfully manage these challenges, companies should consider leveraging the expertise of transfer pricing consultants.
Investing in solutions, continuous learning, and proactive risk management tailored to their industry and the unique transfer pricing landscapes in the Eastern European jurisdictions they operate in can also be instrumental.
Adaptation and awareness: Navigating the changing landscape
In conclusion, when dealing with transfer pricing in Eastern Europe, companies need to adopt a flexible mindset and thoroughly understand how local regulations and economic conditions can affect their finances. Keeping up with updates in transfer pricing rules and engaging with tax authorities are imperative steps.
The outsourcing landscape in Eastern Europe presents not just challenges, but substantial opportunities for businesses and accountants alike. Successfully taking part in this evolving trend requires strategic planning, a commitment to learning, and a proactive approach to region-specific transfer pricing challenges.
By embracing these principles, companies can navigate the changing landscape and leverage outsourcing to their advantage.
Cost allocation in Transfer Pricing documentation
Cost allocation in transfer pricing is a critical aspect of international taxation for multinational enterprises (MNEs). It is a key component is the proper allocation of costs, which ensures that intercompany transactions reflect an arm’s length standard, as required by the OECD Guidelines. This article explores the principles of cost allocation in transfer pricing documentation, emphasizing compliance with OECD guidelines.
Understanding cost allocation in Transfer Pricing
Cost allocation involves distributing costs incurred by a multinational group to various entities within that group. This process ensures that each entity bears its fair share of costs, reflecting the functions performed, assets used, and risks assumed by each entity. Proper cost allocation is crucial for determining transfer prices that comply with the arm’s length principle.
OECD guidelines on cost allocation
The OECD guidelines emphasize several key aspects relevant to cost allocation, ensuring intercompany transactions reflect market conditions and adhere to the arm’s length principle.
Firstly, costs should be allocated as independent entities would under similar circumstances, ensuring fairness and accuracy.
The guidelines distinguish between direct and indirect costs. Direct costs should be attributed to specific transactions or activities, while indirect costs, benefiting multiple entities or activities, should be allocated using a reasonable and consistent basis.
Allocation keys or criteria, such as sales revenue, headcount, or usage metrics, are recommended to reflect the underlying economic reality. The chosen key must be justifiable and align with the value contributed by each entity, ensuring fair and economically sound allocations.
Robust documentation is crucial for supporting cost allocation methods. MNEs must include detailed descriptions of the allocation keys used, the rationale behind them, and any assumptions or adjustments made, providing transparency to tax authorities.
Consistency and reasonableness are emphasized, with cost allocation methods applied consistently over time and reasonably reflecting the value contributed by each entity. Significant changes in allocation methods must be well-documented and justified, maintaining the integrity of the cost allocation process.
Practical steps for cost allocation in compliance with OECD guidelines
To ensure compliance with OECD guidelines, MNEs should follow a systematic approach to cost allocation in their transfer pricing documentation:
Identify costs and activities – Begin by identifying all costs incurred by the group and the activities or transactions they relate to. This includes both direct and indirect costs.
Determine appropriate allocation keys – Select allocation keys that accurately reflect the economic contributions of each entity. For example, if allocating marketing costs, sales revenue might be an appropriate key.
Apply allocation keys consistently – Use the chosen allocation keys consistently across all relevant entities and over time. This consistency helps demonstrate that the cost allocation method is reasonable and reliable.
Document the process – Maintain detailed documentation of the entire cost allocation process. This should include:
- A description of the costs and activities.
- The chosen allocation keys and the rationale for their selection.
- Calculations and methodologies used to allocate costs.
- Any assumptions or adjustments made during the process.
Review and Update Regularly – Periodically review the cost allocation methods to ensure they remain appropriate and reflect any changes in the business environment or organizational structure. Update the documentation to capture these changes.
Challenges and best practices
Implementing cost allocation per OECD guidelines presents several challenges. Ensuring access to accurate and reliable data is crucial for effective cost allocation. MNEs should invest in robust data management systems to gather and validate necessary information, as poor data quality hampers the consistent application of cost allocation methods.
Complex business models add another layer of difficulty. For MNEs with diverse structures, identifying appropriate allocation keys can be daunting. A detailed functional analysis helps determine suitable allocation methods by assessing specific activities and economic contributions.
Regulatory variations across jurisdictions further complicate compliance. MNEs must navigate different interpretations of cost allocation principles, ensuring methods align with both OECD guidelines and local regulations to avoid disputes and penalties.
Intercompany agreements should clearly define cost allocation methods and responsibilities, fostering transparency and mitigating disputes. These agreements facilitate justification during audits.
Regular internal audits of transfer pricing practices help identify and rectify discrepancies, ensuring ongoing compliance. Periodic reviews allow MNEs to adapt to regulatory changes and business conditions, maintaining accurate and defensible documentation.
Proper cost allocation is a fundamental aspect of transfer pricing that ensures compliance with the arm’s length principle and the OECD guidelines. By following a systematic approach, maintaining robust documentation, and addressing common challenges, MNEs can achieve accurate and defensible cost allocations. This not only aids in regulatory compliance but also enhances the overall transparency and efficiency of intercompany transactions. As tax authorities continue to scrutinize transfer pricing practices, adhering to OECD guidelines in cost allocation will remain a critical focus for multinational enterprises.
Transfer pricing impact on SMEs: Commentary for Bloomberg Tax
SMEs must adapt to constantly evolving transfer pricing (TP) regulations and the complex global tax landscape to avoid double taxation and reduce compliance costs. Jelena Mihic Munjic, Managing Director at Kreston MDM and Elena Ramirez Marin, Partner at Kreston Iberaudit, recently shared their insights with Bloomberg Tax. Click here to access the full article or read a summary below.
Increasing scrutiny from tax authorities worldwide has amplified the importance of adhering to the arm’s length principle, with recent shifts in TP practices and legislation impacting SMEs. As SMEs engage more in cross-border transactions, compliance with TP rules has become critical. High-profile cases highlight the complexities of TP regulations, as noted in Kreston Global’s “Interpreneur report.” The OECD TP Guidelines offer a framework for determining the arm’s length value of related party transactions but are non-binding, leaving jurisdictions to implement varying domestic regulations. This creates tax uncertainty, higher costs, and double taxation risks, especially for SMEs with limited resources to manage these challenges.
Recent Transfer Pricing Cases
Apple v. European Commission (2016-2020)
The EC ordered Apple to repay €13 billion in back taxes for receiving illegal state aid from Ireland. Apple appealed, and in 2020, the ruling was annulled. The case highlighted scrutiny of multinational tax practices.
Australia v. Rio Tinto (2017-2022)
Rio Tinto settled a profit-shifting dispute with the Australian Taxation Office for nearly A$1 billion. The case emphasised transparency in transfer pricing and the risks of aggressive tax planning.
Amazon v. IRS (2017-2019)
Amazon won a dispute with the IRS over the undervaluation of intangible assets, with courts ruling in its favour. The case stressed the need for solid transfer pricing documentation.
Denmark v. Maersk Oil and Gas (2018-2023)
Denmark challenged Maersk’s transfer pricing, claiming it shifted profits abroad. The case reinforced the importance of clear documentation in transfer pricing.
Fiat Chrysler v. European Commission (2015-2022)
Fiat Chrysler was accused of receiving illegal state aid. The European Court of Justice overturned the ruling in 2023, limiting the EC’s powers over tax rulings.
France v. McDonald’s (2015-2022)
McDonald’s settled for €1.245 billion with French authorities over profit-shifting to Luxembourg, highlighting the risks of aggressive tax strategies.
HMRC v. BlackRock (2012-2024)
The Court of Appeal ruled that BlackRock’s intra-group loan was primarily for tax avoidance, emphasising the need for arm’s length terms in loan agreements.
India v. Kellogg India (2021-2022)
Kellogg India won a transfer pricing dispute, reinforcing the importance of selecting the appropriate entity in analyses.
Norway v. ConocoPhillips (2019-2023)
Norway reduced ConocoPhillips’ interest expenses, ruling its loan terms were not at arm’s length. The case stressed compliance in intra-group loans.
Future Steps
As tax regulations evolve, businesses of all sizes must adapt their transfer pricing strategies to manage risks and stay compliant. The European Commission (EC) has introduced two key Directives (published September 12, 2023), the BEFIT Directive and the Transfer Pricing Directive, aiming to harmonise and simplify tax rules across the EU.
BEFIT Directive
BEFIT targets corporate groups with annual revenues of €750 million or more, aiming to standardise tax bases across the EU. It calculates a preliminary tax result from each group’s financial statements, which is adjusted and aggregated to allow for cross-border profit and loss offsets. Member States can offer additional deductions if they meet the Global Minimum Tax Directive requirements. The goal is to simplify compliance and ensure fair taxation across the EU.
Transfer Pricing Directive
This directive addresses transfer pricing issues, ensuring that intercompany transactions follow the arm’s length principle, aligned with OECD guidelines, to prevent tax avoidance. It sets rules for related entities, transfer pricing methods, and adjustments for non-market transactions.
Directive Impact
The BEFIT and Transfer Pricing Directives will reduce compliance costs, especially for SMEs, and provide greater certainty. They aim to harmonise tax rules, combat tax avoidance, and enhance competitiveness within the EU. However, these directives will only apply within EU Member States, leaving cross-border transactions with non-EU companies unaffected.
Global Developments in transfer pricing
Outside the EU, countries like the U.S., Australia, and Canada have tightened their transfer pricing regulations, increasing scrutiny and compliance costs, especially for SMEs. Globalisation and inconsistent adoption of OECD guidelines create complexities, including double taxation.
Final Thoughts
Businesses, particularly SMEs, must stay informed and agile as global tax regulations evolve. Seeking expert advice and maintaining robust compliance practices will be essential to navigating these changes.
Women in accounting
In a recent feature on women in accounting, Liza Robbins, Chief Executive of Kreston Global, Jelena Mihić Managing Director at Kreston MDM Serbia, and Carmen Cojocaru, ESG Technical Director and Managing Partner at Kreston Romania, share their perspectives on gender diversity and inclusion in the accounting profession in an article for The Accountant.
Professional milestones for women in accounting, shaped by local, regulatory, and legislative changes, mirror broader societal progress towards gender equality. Zoya Malik, editor-in-chief of International Accounting Bulletin, speaks to accounting leaders about their career journeys, the advocacy of trailblazers, and global initiatives aimed at overcoming exclusionary practices and creating opportunities for future generations of female accountants. Insights are shared by Sarah Ghosh, immediate past president of the Chartered Institute of Management Accountants (CIMA); Asmâa Resmouki, president of the International Federation of Accountants (IFAC); Francesca Lagerberg, CEO of Baker Tilly International; Liza Robbins, CEO of Kreston Global; and Allee Bonnard, audit and assurance partner at Deloitte UK.
Pictured left to right: Liza Robbins, Jelena Mihić and Carmen Cojocaru
Liza Robbins: Gender bias
Reflecting on her career, Liza notes, “I entered the accounting industry 16 years ago, when I was appointed CEO of Morison Global. I was the second female CEO of an international group and 16 years on, I am one of four out of nearly 50 groups.” As a long-time advocate for gender diversity, Liza highlights the barriers women still face, including the challenge of balancing family and career, limited access to leadership roles, and persistent biases. “These issues can be overcome by creating more supportive and inclusive work environments, promoting flexible working conditions, and ensuring equity in advancement opportunities,” she adds.
Jelena Mihić: Resilience, adaptability, and support systems
Liza also references the experience of Jelena Mihić, Managing Director at Kreston MDM Serbia, whose career has been shaped by her roles as a woman, entrepreneur, and mother. Jelena’s approach to managing these responsibilities exemplifies resilience and adaptability. She has worked to promote a culture of shared responsibility within her firm, advocating for flexible work schedules, parental leave, and remote work options. “Her mantra is that there are no shortcuts to success: you do things properly, take the time to build a solid base, and the results will follow,” Liza observes.
On a broader scale, Liza notes that women are increasingly outpacing men in educational achievements, and businesses must adapt to attract diverse talent. “The use of remote and flexible work options, enabled by the advances of technology, support the employment of women who often need flexible working arrangements to juggle their non-work-related responsibilities,” Liza says. She stresses the importance of evolving business models that meet the needs of older women in the workforce, including phased retirement and executive coaching.
In her view, the accounting industry must position itself as a dynamic field that embraces new technologies and values empathetic leadership. “As people skills and emotional intelligence grow more important, women’s natural ability to build strong relationships will lead to greater success.”
Carmen Cojocaru: Advocating for women at all career stages
Carmen Cojocaru, ESG Technical Director and Managing Partner at Kreston Romania, also contributes to this conversation, highlighting the need for the industry to actively support women at all career stages. Carmen’s personal journey—from employee to entrepreneur while raising a family—underscores the importance of balancing work and life. In a country like post-revolution Romania, where women often had to prove themselves in ways others did not, Liza believes fostering a culture of diversity, inclusivity, and well-being will empower women to reach their full potential.
A collective vision for the future
The stories of these women collectively highlight the evolving role of women in accounting. The industry is increasingly recognising the need for flexible work environments, mentorship, and the promotion of gender diversity at all levels. However, the journey towards true equality requires continued efforts to break down barriers, both societal and structural.
As more women take on leadership roles, they not only bring fresh perspectives but also help pave the way for future generations of women in accounting. By continuing to promote inclusive practices, ensure equitable advancement opportunities, and provide robust support systems, the accounting industry can create a more diverse, dynamic, and successful future for all professionals.
To read more about Kreston Global’s UN Sustainability Goals, including gender equality, please visit our impact plan.
Kreston MDM Edu e-learning platform offers multiple courses in the area of transfer pricing, so click here to access the knowledge.