Transfer pricing compliance in the ESG era

In today’s ESG-driven climate, global transfer pricing (TP) compliance is an ever-greater headache for tax functions. And it’s not going to get any less complex, any time soon.

To stay compliant, tax leaders must ensure that the right governance strategy, technology and workforce capabilities are in place. 

Tax transparency is high on the international political agenda, and collaboration between tax authorities is a priority.

The EU is introducing public country-by-country (CbC) reporting for large multinationals operating within its borders – with reports due to be published from 2026.

That may seem a long way off, but organisations can’t be complacent, as it will fuel public interest in transfer pricing. Once TP data becomes available, anyone interested can analyse it – and assess a firm’s policies from an ESG standpoint.  

Meanwhile, tax authorities worldwide are demanding more rigorous governance of: 

• the implementation of TP policies at a transactional level
• the documentation produced to demonstrate the arm’s-length nature of the transfer pricing applied
• the preparation and submission of TP-related returns and disclosures
• the internal procedures relating to all of the above 

Here in the UK, HMRC is also upping its game on transfer pricing compliance. It raised over £2 billion in additional taxes – a record yield – from TP compliance activities during the year to 31 March 2021. These include regular enquiries, diverted profits, investigations and the Profit Diversion Compliance Facility. 

What’s more, a number of new reporting and transparency requirements have been introduced – the most recent being an Uncertain Tax Treatment notification regime. This applies to returns due on or after 1 April 2022, and includes transfer pricing uncertainties.

In addition, new master and local file documentation requirements, aligned with OECD rules, will come into force next year.

These oblige UK members of large groups to produce a Summary Audit Trail (SAT), along with the local file, to demonstrate the quality of inputs into the UK local file. The SAT is expected to comprise a questionnaire, to be provided along with the UK local file within 30 days of a HMRC request.

These new rules will have teeth: failure to provide the necessary documentation could result in financial penalties (which are yet to be announced). Tax functions must be ready to comply the moment they land; early adoption is therefore advisable.

Overall, we’re seeing a shift across developed economies towards more targeted, risk-based TP audits for large multinationals. It’s a reflection of the increased volumes of data available to tax authorities to make transfer pricing risk assessments. 

For tax leaders, documentation is the number-one protection against having to make TP adjustments and incurring penalties. But of course, the degree of protection depends on the quality of the documentation; and that in turn depends on four crucial factors: 

1. Proportionality: Make sure that you focus on the key transactions from a risk perspective.
2. Evidence: Base the functional analysis that informs your choice of TP method for key transactions on a detailed interrogation of the facts. This should consider each of the parties’ activities, and the wider group context
   
3. Data: Documentation is only as robust as the data it’s based on. Working with the finance function to extract quality transactional data is essential to transfer pricing compliance.
   
4. Comparability: When identifying comparable transactions and companies, information on the specific circumstances of your business and industry must be meaningfully applied in your economic analyses. 
   

‘Quality over quantity’, and ‘proactive not reactive’, should be your maxims here.

It’s also worth being aware that transfer pricing disputes can take many years to resolve, and put a significant drain on company resources. Recent litigation involving a Danish group centred on events leading up to 2008.  Compiling evidence from 15 years or more ago will mean accessing old data, potentially from old systems, which may have been set up by people who’ve since left the company.

You’ll therefore need robust governance processes, to ensure you’re capturing transaction data and evidence on decision-making procedures (and the key individuals involved) – in as close to real time as possible. Contemporaneous evidence will put you in the best position to defend your approach later on.

Documentation is your primary safeguard. But proactive engagement with tax authorities can be invaluable if they’re considering examining your transfer pricing.  HMRC statistics on the Profit Diversion and Compliance Facility illustrate this – more on which can be found here.

Through ongoing dialogue with tax authorities, you can explain the activities and financial results of a local entity; how these fit into your corporate group; and the nature and relative importance of intercompany transactions throughout the group. That could prevent enquiries altogether, or at least mean that they’re more focused (and therefore less onerous).

In the digital era, technology is central to how businesses implement and manage TP at the transactional level; and how they assess and mitigate transfer pricing risks. 

Technology solutions provide central control and visibility over TP documentation, production and compliance globally – which helps achieve a global level of consistency.

Technology can also be used to extract and manipulate data in real time, ensuring that transfer pricing outcomes are in line with expectations (and permitting prompt action if not). Plus, analytics dashboards generate rich insights from transactional data, bringing greater focus to your risks and opportunities.

All of which makes managing TP documentation production, and enquiries from tax authorities, more efficient. That not only cuts costs, it also frees your team up to focus on other value-added tasks.

Embracing technology will also enable you to keep pace with new compliance obligations and approaches from tax authorities – which are digitalising their own operations and taking a more data-driven approach.

HMRC, for example, is using CbC reporting data to inform risk assessments on businesses. We can expect it to continue to integrate data and use digital solutions, to improve its processes for examining companies transfer pricing policies.

In my experience, groups that manage transfer pricing documentation and compliance the most effectively typically share four critical success factors:

1.  Senior-level engagement 
   Leaders contribute to transfer pricing compliance strategy. They make sure that they understand the key risks, and commit resources to managing them.
   
   
2. Flexible risk-based approach 
   Risk informed choices should be made on how to approach documenting transactions and tax authority engagement in each country.  Advance pricing agreements remain important particularly for transactions involving the United States and there have been positive strides made with programs in emerging markets, most notably China.  Alternatively, some groups are now producing special enhanced local files which are “over-compliant” to be fully audit-ready on high risk transactions.
   
   
3. Intelligent use of data and technology 
   Tax teams take the time to understand their internal systems, so that they can extract quality transactional data as efficiently as possible.  This is part of a structured approach to documentation production, aimed at driving quality, efficiency and consistency of outputs (this typically starts with mapping in detail the status quo documentation process).
   
   
4. A continuous improvement mindset 
   Management actively seeks to learn from audit experiences and considers their implications for its transfer pricing compliance strategy.  For example, best in class groups capture data on the cost of compliance (higher tax on profits, double taxation, penalties, interest and internal and external resource).