In recent years, the tax due diligence landscape for portfolio companies has evolved significantly. One key factor in ensuring a smooth due diligence process is the strength of transfer pricing documentation. This article explores why maintaining comprehensive transfer pricing documentation is now essential in avoiding red flags and preventing potential price chipping during due diligence.
The Importance of Transfer Pricing Documentation
Transfer pricing documentation has transformed from a mere informational tool to a critical component of tax compliance strategy. For multinational corporations (MNCs) with a taxable presence in multiple jurisdictions, tax authorities now expect comprehensive documentation to support the intra-group operating model. This should include:
- Inter-company transactions undertaken by a taxpayer during the financial year;
- Activities performed and risks assumed by each entity involved in each category of the inter-company transactions;
- Economic ownership of intellectual property (IP) within the group; and
- Justification for the pricing of the inter-company transactions.
This documentation, generally referred to as transfer pricing documentation, is comprised of the Master File, which contains group-level business information, and the Local File, which contains transaction-level pricing and benchmark analysis.
The Shift Towards Economic Substance
Historically, MNCs relied heavily on legal contracts to manage their operating models and tax impacts; however, the OECD’s Base Erosion and Profit Shifting (BEPS) initiative has sparked a paradigm shift.
This shift brings several implications, including increased scrutiny of operating model rationales, a greater focus on alignment between profit allocation and actual value creation and enhanced importance of transfer pricing documentation in supporting economic substance claims.
Most OECD member countries now adhere to the principle of economic substance, which places greater emphasis on the actual economic activities of entities rather than just their legal arrangements (i.e., they now focus on conduct versus contract).
Non-Compliance Risks
Failing to maintain adequate transfer pricing documentation can lead to severe consequences such as related penalties, misalignment of profit allocation with IP ownership and funding objectives, red flags during tax due diligence and potential price chipping during valuation processes. Additionally, a broken operating model or inappropriate IP ownership structure not substantiated with appropriate documentation can negatively impact financial statements, raising further concern during due diligence.
Best Practices for Portfolio Companies
To mitigate these risks, portfolio companies should consider the following best practices:
- Proactive documentation: Start documentation early to allow sufficient time for data gathering and analysis.
- Follow OECD framework: Prepare Master and Local Files in line with OECD Guidelines.
- Conduct thorough analyses: Perform functional and comparability analyses for each entity.
- Apply appropriate methods: Choose the most appropriate transfer pricing method to evaluate each category of inter-company transactions.
- Maintain consistency and relevance: Use a consistent format across years while focusing on key value drivers.
- Regular updating: Review and revise documentation periodically to reflect changes and establish ongoing compliance.
- Leverage technology: Use automation and data analytics tools to streamline processes.
- Ensure timeliness: Prepare contemporaneous documentation as per requirements of local regulations.
- Be audit-ready: Have documentation readily available for potential tax authority requests.
- Consider local nuances: Address country-specific requirements (e.g., UK domestic transactions).
- Engage experts: Involve transfer pricing specialists to ensure compliance with complex regulatory requirements.
Key Considerations for Documentation
When preparing transfer pricing documentation, companies should focus on:
- Minimum and Mandatory Requirements: Identify and address the essential elements required by relevant tax authorities.
- Due Diligence Readiness: Ensure documentation is sufficiently robust to withstand scrutiny during potential M&A or investment processes.
- Audit Defense: Prepare documentation that can effectively support the company’s position in case of a tax authority audit.
- Global Consistency: Maintain coherence across jurisdictions while addressing local requirements.
Conclusion
As the tax landscape continues to evolve, robust transfer pricing documentation has become a necessity in ensuring smooth due diligence processes for portfolio companies. By prioritizing comprehensive and up-to-date documentation that aligns with the principle of economic substance, companies can minimize risks, avoid red flags and maintain their valuation integrity.
Given the complexity of transfer pricing requirements and their potential impact on valuations and due diligence processes, many portfolio companies benefit from expert guidance. Firms specializing in global transfer pricing such as Frazier & Deeter, can provide valuable assistance in navigating these challenges. Our expertise in multi-country documentation requirements, access to relevant benchmarking databases which are used by the tax authorities and experience with both growing companies and established multinationals can be instrumental in developing effective transfer pricing strategies and documentation. Whether complying with tax authority requirements, preparing for growth, considering market expansion or anticipating future transactions, prioritizing transfer pricing strategies with the help of experienced professionals can be a key factor in a company’s long-term success and valuation.
For more information, please contact:
Jay Menon, Global Transfer Pricing Partner | jay.menon@frazierdeeter.com