Operational transfer pricing: Beyond transfer pricing policy and strategy, building sustainable transfer pricing implementation

In brief 

In the current climate, transfer pricing implementation requires more attention than ever to reduce the risk of errors in tax compliance, tax leakage and disputes. This is no longer solely an issue for finance and tax teams but touches a large number of internal and external stakeholders; from the CFO to non-executive Directors and other business departments, tax authorities, statutory auditors and internal auditors. In particular, the tax authorities’ focus on transfer pricing (and profit diversion more generally) has intensified, making headlines in newspapers over the past few months, notably in the UK with the recent Financial Times article announcing that HMRC has ‘multiple live criminal investigations involving transfer pricing disputes’. But also in Luxembourg the number of transfer pricing audits have significantly increased since last September.

This change in landscape means that taxpayers need to consider the implications for their transfer pricing policy, strategy and operational implementation.

In detail 

In response to increasing external and internal pressure, we are seeing clients focus resources on ensuring their transfer pricing processes/governance, and their transfer pricing implementation framework, provide the necessary transparency, data quality and visibility that enable fact-based decision-making and underpin better transfer pricing risk management. 

We now look to explore a number of key topics in more detail including: (i) the transfer pricing lifecycle and operational transfer pricing triggers; and (ii) how governance and implementation processes can be improved to satisfy the requirements of all the stakeholders involved. 

The transfer pricing lifecycle and operational transfer pricing implementation 

Transfer pricing implementation is at the core of the transfer pricing lifecycle. Whilst transfer pricing strategy, policy and documentation are critical, experience shows that failures in execution substantially increases transfer pricing risks. Tax authorities around the globe are becoming more focused on accuracy, transparency and quality of the data used in the transfer pricing calculations, as well as the underlying process and governance followed. Globally, regulators look at transfer prices in cross-border transactions, with an increasing focus on the robustness of the transfer pricing implementation governance and underlying processes and cash flows. 

Experience in the banking and capital markets sector shows that inadequacies in the transfer pricing implementation often materialise in a lack of transparency in the cost allocations processes (e.g. central cost base and cost centres to be recharged), over reliance on advance pricing agreements (“APA”) (e.g. too much comfort is taken from the existence of the APA but whilst the policy is agreed, correct implementation remains important) and in difficulties for segmentation and profitability monitoring (e.g. legal entity, line of business or product level). Operational transfer pricing failures can have material impacts on the financials and as a result potentially impact the firm's regulatory capital position.

Some of the common pain points include: 

• misalignment between the documented transfer pricing policy and the implementation of these policies as result of systems failing, human error, or a disconnect between responsible departments; 

• lack of clarity in roles and responsibilities for managing the end to end transfer pricing process between the tax, finance and operations functions; 

• volume and complexity of financial systems with numerous ‘bolt-ons’ to in-house systems that have not been developed to be scalable and deal with growth or complexity; 

• challenges on accuracy of data received from finance functions in relation to budget and forecast (e.g. when pricing intra-group service transactions or cost recharges);

• complexities and inconsistencies in defining inputs and treatment of routine contributions in the context of global profit split models; 

• difficulties in retrieving historical data for local audits (often because data transparency and visibility are opaque); 

• difficulties in reconciling data (especially where cost allocations are run regularly - for example, monthly or quarterly); and 

• reliance on key individuals or complex spreadsheets running manual processes.

Many banking groups have recently experienced business model changes as a result of e.g. Brexit. It is our experience that increased pressure is often placed on pre-existing implementation issues or that new issues arise as business models evolve. It is also our experience that many, if not all, of these challenges can be successfully addressed through a combination of improvement and optimisation on the people/governance, processes, technology and control aspects of the transfer pricing lifecycle. In particular during transfer pricing audits in Luxembourg, we experience that the tax authorities are keen on verifying the alignments of the transfer pricing documentation with the tax returns, accounts, and intercompany agreements.

What can you do to improve your transfer pricing implementation?

To mitigate the risks inherent in transfer pricing implementation and to satisfy the requirements from the various stakeholders, organisations should seek to build a comprehensive end-to-end framework supporting the implementation of transfer pricing policies, which in some cases may involve wholesale re-work of their transfer pricing systems. We have seen a number of banking organisations engage in large scale finance change programmes recently and this is an opportune time to ensure transfer pricing implementation requirements are communicated, understood and captured. For others, there is an opportunity to significantly improve existing approaches through smaller refinements, additions or upgrades. In either case, components we have seen clients benefit from focusing on include:

• introducing or improving a holistic governance framework involving all key stakeholders and contributors;

• designing and optimising transfer pricing processes and workflows collaboratively across tax, finance, IT and other business areas to develop a coherent framework which also provides clarity on roles and responsibilities across the different teams; 

• clearly understanding the data and system requirements along with any potential data and / or system restraints; 

• standardising transfer pricing processes, by building business process documentation, with the aim of creating an overall robust control environment; 

• identifying opportunities for automation by implementing transfer pricing engines and analytical tools that enable the automation of data extraction, transfer pricing calculations, intragroup invoicing and so on;

• ensuring adequate training is provided to new and existing contributors to the process; and

• capturing and reporting of key risk indicators and the effective operation of key processes and controls

Based on our experience, we are seeing a number of benefits for those groups engaged in the journey of optimising their internal end to end transfer pricing governance and implementation processes. These benefits include, among others: better management of transfer pricing related risks, increased readiness for tax authority scrutiny and potentially disputes, internal cost savings - driven by more efficient internal processes - and enabling data-driven decision making. In practice we see currently most benefit on the governance to ease discussions with the Luxembourg tax authorities.

The takeaway

Understanding and managing transfer pricing implementation is not new for the banking sector, but it is increasing in importance. This is driven by tax authority activity, regulatory scrutiny as well as the broader commercial environment. Together, these are giving many firms the stimulus to think through how transfer pricing implementation can be improved and controlled. To succeed in managing the operational transfer pricing aspects, best practice recommendations are to ensure that:

1. operational transfer pricing pain points are identified both within and outside of tax; 

2. roles and responsibilities in the end to end process are clearly articulated and agreed by all parties; 

3. you develop a coherent response to the various operational transfer pricing pain points, combining people/governance, processes, technology and controls; and 

4. comprehensive end-to-end frameworks are built by designing, optimising and standardising transfer pricing processes, as well as identifying opportunities for automation - whether that is large-scale or tactical.

Banking and capital markets organisations have been most successful in upping their game on transfer pricing implementation where the business case for change is well articulated, clearly understood and has buy-in from senior stakeholders. That typically means tax and wider finance teams being prepared to map out their current processes around transfer pricing execution and understand the pain points and risks as well as the quick wins that operational transfer pricing will bring to the organisation. 

The road to operational transfer pricing improvement may not always be straightforward, but with a clear understanding of where you are starting from, a vision of where you are heading, and a decent map of the organisational environment, the journey for all stakeholders - internal or external - will be smoother, thereby improving the ability to meet everyone’s expectations along the way. 

For a discussion on how to tackle operational transfer pricing in your organisation, please get in touch with the authors of this article or your normal PwC contact.