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Managing Transfer Pricing to Satisfy Legal Requirements

by Andrew Sliwa and Karuna Mukherjea | insiderPROFILES

April 1, 2013

Multinational companies have historically struggled to manage their transfer prices so that they satisfy legal requirements and meet business objectives. But by following three simple steps and using the right technology solution for the job, companies can “operationalize” transfer pricing and achieve their goals.
 

For organizations that operate across borders, pricing the transfer of goods, services, or intangible property to other related companies — a process known as transfer pricing — is a common part of business. Yet, despite the routine occurrence of intra-company flows, multinational companies have historically struggled to manage their transfer prices so that they satisfy legal requirements and meet business objectives. This inability to align transfer pricing to both legal and business needs can ultimately reduce shareholder value through increased costs and suboptimal business performance.

But lower shareholder value does not have to be a by-product of transfer pricing. By “operationalizing” transfer pricing, companies can align this common function to meet both legal requirements and business objectives with just a few simple steps:

  1. Understand the objectives behind transfer pricing
  2. Recognize the challenges with transfer prices
  3. Set transfer pricing goals and establish processes that allow companies to manage these prices in real time

Step 1: Understanding the Transfer Price

A transfer price is the amount charged for any transfer of goods, services, financial services, or intangible property by one “selling” unit of a company to another “buying” unit of the business. Prices are typically viewed through two separate lenses: the management (or operational) lens and the statutory (or legal) lens. The objective of the management lens is to set a price that induces optimal decision making to increase a company’s overall profit. The aim of the statutory lens is to set a price that ensures appropriate financial reporting requirements are met in each jurisdiction of operation and that tax risks and opportunities are managed across different tax jurisdictions so the company pays the appropriate amount of tax, including income taxes, value added taxes (VATs), customs, and withholding taxes.

Step 2: Recognizing the Challenges

The key challenge for many companies is setting and managing transfer prices so that both management and statutory objectives are achieved. Companies that are unable to effectively manage both simultaneously may experience “economic leakage” — meaning they are unable to increase profits for shareholders — due to suboptimal performance of business units (the operations side) and/or increased external costs, such as customs duties, direct taxes, and indirect taxes (the statutory side). 

The inability to achieve both objectives often stems from how companies view transfer pricing. Instead of viewing it as a strategic element that can enhance shareholder value, many companies view it as a tax compliance issue. As a result, they have not aligned their processes across functions to manage the multitude of management and statutory requirements. Similarly, enterprise systems historically have not been designed to enable the data, automation, and reporting capabilities needed to align and manage the sometimes conflicting requirements between operational and statutory requirements. To deal with these issues, many companies have implemented myriad “Band-Aid” tools and approaches to accumulate their results of operations and then report those results to meet the requirements of operations, finance, accounting, tax, and other stakeholders. 

The need to manage multiple reporting requirements typically requires the dedication of resources, which are often in scarce supply, to maintain and gather (through a great deal of manual effort) the requisite information from existing tools. Many companies approach transfer pricing by focusing on setting and documenting intercompany pricing policies rather than executing and monitoring those policies. To that end, adjustments to profitability are often made at year-end or when income tax returns are filed. These adjustments may create issues with income tax accounting and compliance, the reporting of VATs, customs and withholding taxes, and the performance metrics of various business units. 

Nevertheless, there is hope. By bringing together core competencies in tax, accounting, and technology, companies can improve business performance by setting goals and establishing processes to operationalize transfer pricing.

Step 3: Setting Goals and Establishing Processes

As discussed in a recent article in International Tax Review Magazine,1 operationalizing transfer pricing is the ability to proactively align, manage, and control the implementation of transfer pricing strategies in a manner that drives maximum business value, effectively manages compliance and risk, and increases effectiveness within the organization.

Meeting these goals is a necessary prerequisite for a company to improve business performance. As Figure 1 shows, operational transfer pricing includes properly aligning processes that are critical for a company to manage its global footprint and intercompany relationships. 

Framework for operational transfer pricing — aligning the core elements

Figure 1 — Framework for operational transfer pricing — aligning the core elements


Key to this process alignment is the implementation of a data structure and systems solution that allows a company to accurately set and monitor transfer prices to properly manage both statutory reporting risks and opportunities, without impeding business operations. The SAP Profitability and Cost Management (SAP PCM) application enables the analytics and reporting capabilities needed to achieve these goals.

Trends in Operational Transfer Pricing

The global Ernst & Young organization surveyed a select group of North American multinational Fortune 500 companies about the transfer pricing function and found: 

  1.  91% indicated that they plan to make improvements to the transfer pricing process within the next year.
  2. 60% said they have not been able to achieve a strong level of automation for intercompany transactions.
  3.  56% reported that true-ups at the end of the year have a significant impact on financial reporting and tax results.


Technology Solution: SAP Profitability and Cost Management

Part of the SAP solutions for enterprise performance management (EPM) suite, SAP PCM enables companies to gain deep insight and understanding into their costs. The application also supports advanced techniques for costing and allocations that are required to align, manage, and control the implementation of transfer prices within a company. SAP PCM provides not only reports and dashboards that support the decision-making process, but also a modeling engine that companies can use to define their cost models and accurately calculate cross-charges and adjustments across different legal entities to achieve compliance and optimize results.

First, SAP PCM provides a scalable and multi-dimensional framework for analysis and allocation. Specifically, with this framework, companies can model costs and profitability across multiple dimensions and can analyze complex cost allocations across these different dimensions. Also, the application has been designed to support large data volumes that are needed for costing and analysis along with support for a heterogeneous data set from SAP and non-SAP sources. 

Second, SAP PCM provides improved costing and control. Traditional costing methods are one of the major hurdles for companies looking to monitor and analyze their transfer prices. Inaccuracies in cost allocations make it difficult to monitor and track costs associated with different activities within various legal entities. With SAP PCM, corporations can perform advanced costing techniques, which allow them to standardize allocations across different legal entities to achieve the appropriate profit targets and comply with various statutory requirements. By using multiple drivers to model and allocate costs to products, channels, distribution centers, legal entities, and other dimensions based on actual consumptions of resources, companies can meet requirements for both management and statutory purposes.

Finally, SAP PCM provides for multiple reporting and simulation options. To properly monitor transfer prices from both a management and statutory perspective, accurate and timely reporting is critical. SAP PCM enables companies to define business dashboards and reports with built-in multi-dimensional analysis and simulation. The application also provides flexible options for reporting in situations of high data volumes. Business users can simulate the impact on profitability of a particular legal entity with changes in multiple variables — for example, tax rates or volumes of goods and services. The uniform and consistent cost modeling provides a high level of data integrity and accuracy for the simulations.

The Application in Action

To illustrate SAP PCM’s capabilities, suppose a distribution entity (buying unit) purchases goods manufactured by another entity (selling unit) within a corporate group. To distribute these products, the buying unit may use marketing intangibles that were developed and owned by another legal entity. To fulfill its business needs, this distribution entity may also require support services, such as accounting or legal, from a related legal entity that is located in a separate tax jurisdiction. 

Using SAP PCM, the distributing entity could model alternative scenarios, the results of which could be used to determine transfer pricing adjustments. It could also use the application to address management fees (pertaining to services provided by headquarters or shared service centers) and royalties (pertaining to the license of intangible property, such as marketing intangibles). With SAP PCM, the distributing entity could allocate these different costs consistent with local jurisdiction requirements and bill the allocation on an inter-company basis. This ability to proactively monitor the transfer prices of various legal entities would allow the entity to avoid economic leakage by managing the legal requirements of different revenue authorities and paying the appropriate amount of tax.

In addition, the distribution entity could use the SAP Business Planning and Consolidation application to participate in the sales and operations planning process as a means of defining inter-company transfer volumes. This application allows users to create what-if scenarios so they can test different transfer prices as needed to achieve the appropriate margin on a legal basis for the inter-company purchase and sale of tangible goods. This approach to integrated statutory, financial, and operational planning can be used to set prospective transfer prices. Actual results can subsequently be monitored and price adjustments made on an as-needed basis.  

Transfer Pricing Goes Beyond Tax Compliance

In today’s global economy, shareholders expect executives to improve a company’s performance. As transfer prices directly affect business performance, CEOs and CFOs can no longer afford to treat transfer pricing solely as an issue of tax compliance. Rather, they must approach it strategically as they would any other part of their operations.

Properly operationalized, transfer pricing allows companies to realize economic benefits rather than economic leakage through:

  • Transparency and structure that incentivize and allow operations to make informed business decisions that increase profits throughout the supply chain
  • Operational efficiencies that translate into cost savings
  • Global and holistic risk management that minimizes the negative financial impacts to the company
  • Optimization of supply chain and operations savings through the use of tax-efficient structures

Given the benefits, how can companies afford not to operationalize their transfer pricing? 

Andrew
  

Andrew Sliwa (andrew.sliwa@ey.com) is Market Leader for Operational Transfer Pricing Services at Ernst & Young LLP. He has been advising on transfer pricing matters for nearly 18 years and has direct experience working with business teams and systems engineers in order to integrate transfer pricing from an operational standpoint. Andrew also has extensive experience in complex global assignments, controversy matters, planning, restructurings, and post-merger integrations.

Karuna
   

Karuna Mukherjea (karuna.mukherjea@sap.com) is a Director of Product Marketing on the EPM team. She is experienced with finance and EPM applications and focuses on new technologies, like cloud and mobility, and how they relate to EPM applications.

 

1 International Tax Review Magazine, “Cross border: Closing the gap between theory and reality” by Andrew Sliwa, Hadley Leach, and William Methenitis (March 2013). [back]

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