Even in times of economic stability, making adjustments to transfer pricing is far from straightforward. Here’s our guide to year end best practice.
As we approach the end of 2023, UK-based multinational groups have experienced a highly unstable global economy with high inflation and low growth. Resulting erosion of group operating profits is bound to impact the expected returns of individual entities and related party transactions too. This means transfer pricing adjustments, where appropriate, should be made before closing the financial year, both for tax compliance and risk management purposes.
Review of inter-company transactions and pricing
Multinational groups should comply with the transfer pricing rules of the different countries in which they do business. At year end, before approving financial statements and no later than submission of annual tax returns, this compliance requires that groups make an appropriate allocation of income and profits between different tax jurisdictions.
As many UK-based multinational groups approach their year end, they should review what impact the year’s economic conditions have had on their transfer pricing arrangements. Inflation might have affected both internal and external pricing arrangements, in the way it has changed interest rates, foreign exchange rates, forecasts for budgeting or valuation purposes, and inter-company agreements. Groups might also have had to reduce their market prices to reflect lower demand for their products or services.
Multinationals should revisit their transfer pricing policies and make adjustments to reflect the changed economic conditions. These adjustments are corrections to the prices of transactions between related entities made, ideally, on a real-time basis or at the year end where appropriate. They are made to ensure that these prices (known as transfer prices) are in line with what would have been charged if the transactions were between unrelated entities, the so-called ‘arm’s length principle’.
In the UK, legislation allows for a transfer pricing adjustment, in order to increase taxable profits or reduce a tax loss. This also applies to transactions between any connected UK entities. There are certain exemptions that may apply for UK entities that qualify as small and medium-sized enterprises.
Failing to make transfer pricing adjustments: the risks
The absence of appropriate transfer pricing adjustments for financial and tax reporting purposes can trigger significant risks:
Disputes with tax authorities and penalties: Non-compliance can lead to scrutiny and transfer pricing adjustments by tax authorities, with additional exposure to penalties.
Double taxation in overseas entities: If the profits have already been taxed in another country, the adjustments can result in double taxation. Relief may only be available under an applicable international tax treaty.
Reputational damage: Groups may receive adverse publicity if not seen to be paying their fair share of tax.
Reviewing transfer pricing before the year end
To mitigate these risks, groups should take steps to review transfer pricing before year end.
They need to:
Identify related party transactions: Look at all material transactions that have taken place between related parties during the year. These include new transactions and ceasing ones.
Determine arm’s length price: For each of these transactions, decide the arm’s length price. This typically involves a comparability and benchmarking analysis of independent comparable companies. Current practice is a new benchmarking analysis every three years, with annual financial updates of comparable companies.
Manage transfer pricing adjustments: If the price charged in a related party transaction is different from the arm’s length price, it will be wise to make an adjustment.
Maintain records and transfer pricing documentation: The calculation of related party transactions and transfer pricing adjustments should be supported by proper record keeping. Keep transfer pricing documentation in line with local country rules, mindful of potential risks and best practice. For example, large UK-based multinationals must maintain, every year, an OECD-compliant Master File, Local Files, Country-by-Country Report and, potentially, a Summary Audit Trail.
It’s important to note that the rules and methods for making transfer pricing adjustments can be complex and vary by tax jurisdiction. Failure to comply can result in penalties and other consequences.
A transfer pricing review should be a key part of a multinational’s year end process. Appropriate management will help to avoid unwanted financial and compliance consequences. Best practice is transfer pricing planning and monitoring throughout the year in order to mitigate issues at the year end.
We can help
For further guidance, please contact Farhan Azeem in the UK. He collaborates with local experts across PKF Global