As the pace and scope of global regulation around tax avoidance strategies continues to increase, transfer pricing policy is becoming top-of-mind for multinational companies. Of particular interest is how intra-company transfer pricing and customs work together—or sometimes don’t—so I asked Sam Cicogna, my colleague and a transfer pricing expert, to help me uncover some shared challenges and solutions.
Transfer pricing and customs have a lot in common. Both are subject to regulation and oversight. Both have historically depended on manual processes that companies, as well as countries, are now automating. And both processes are directly linked with substantial tax and duty payments.
On a practical level, the transfer price of a good in a company’s internal supply chain should be closely correlated with the customs valuation on the basis of which customs duties are levied. Creating this alignment can be difficult in practice, however, as each valuation is guided by separate principles. In addition, transfer prices are often adjusted retroactively to maintain alignment with the company’s transfer pricing policy. In those cases, customs valuations of the related import entries need to be adjusted accordingly to result in the correct duty payment.
Transfer Pricing In The Spotlight. The number of countries with specific transfer pricing regulations for direct tax purposes has increased substantially since 1994, when only Brazil, Mexico, France, Australia and the United States had country-specific regulations. By 2011, that number jumped to 65 countries, increasing the complexity of transfer pricing processes.
The world’s tax authorities are rapidly moving toward implementation of Base Erosion and Profit Shifting (BEPS), the latest set of global regulatory actions meant to address tax avoidance. Conveniently, BEPS Action 13 will induce both companies and tax authorities to better leverage technology for transfer pricing. Right now, dozens of countries are aligning their cross-border tax and transfer pricing documentation rules with the Organization for Economic Co-operation and Development’s (OECD) BEPS framework. This alignment is the first step in automating more of the process.
In contrast to the global transfer pricing process alignment that BEPS brings, customs authorities still have varying practices for linking transfer prices and customs valuation, although some progress is being made toward harmonization.
The Cost Of Separating Transfer Pricing And Customs. Due to the way most companies organize their compliance operations, decisions regarding transfer pricing are often made in isolation from the trade compliance team. Overall, transfer pricing tends to have a higher level of chief financial officer focus and visibility due to its impact on global effective tax rates. BEPS in particular is causing large companies to further prioritize transfer pricing, accelerating the trend.
From a process standpoint, transfer pricing policies tend not to reflect how import declarations are made in practice. For example, a transfer pricing policy may deal with multiple product groups in aggregate, while import declarations are instead made on an SKU-level itemized basis.
Furthermore, transfer pricing is typically adjusted during or after the fiscal year. This translates into a process challenge for the trade compliance team, which has to take the transfer pricing adjustments and apply them to the individual import declarations made during the year. Accurately pro-rating the adjustment in most cases is a manual task, and it is further complicated by differences in how the transfer pricing policy is implemented.
Failure to reflect changed transfer pricing in customs declaration has inevitable undesirable consequences: either underpayment of customs duties, which can result in penalties; or overpayment of customs duties, which can result in cash leakage. Many countries do not have regulatory mechanisms in place for refunds in the case of duty overpayments, which often creates a hidden cost to downward transfer pricing adjustments. This begs the question: what barriers prevent customs and transfer pricing from being fully aligned?
Operationally, transfer pricing decision making tends to be centralized, while customs teams work at the borders. The transfer pricing team typically makes decisions on a country entity or line-of-business level, while the customs team’s declaration is made at an individual SKU transaction level. Seldom is there an automated link between the higher level transfer pricing decision and the lower level import declaration, and this lack of communication leads to inconsistent processes, exposing the company to compliance risks and potential tax and duty overpayments.
The two departments also tend to report to different areas of the organization, making end-of-year reconciliation more difficult, time consuming and error prone due to varying reporting structures. Their misalignment creates redundant work. Customs compliance teams need to double-check product-level transfer pricing valuations to ensure they fulfill the criteria set by customs authorities and the relevant transfer pricing regulations. The broader trade team must then ensure these valuations are applied consistently across the enterprise.
A company-wide price list for internal transactions is the most straightforward way to align these processes, and automation can drive it. If a customs authority does challenge any of the assumptions used in valuation for intra-company transactions, automation technology—and the documentation created within it—can support the company’s case, as well as simplify the company’s year-end reconciliation process, saving time and helping it to avoid compliance risks.