Classical transactional transfer pricing

As contentious as transfer pricing can be in many respects, there is an established set of principles generally agreed upon under the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations issued by the Organisation for Economic Cooperation and Development ("OECD Guidelines") as well as accepted by most regimes.

Most of the debate is around interpreting the facts and the application of suitable methods based on third-party data. Typically, only the prices of individual transactions and the simplest sides of transactions are looked at, while the entrepreneurial entities and the full value chain receive limited focus.

The Base Erosion and Profit Shifting ("BEPS") initiative

The changes brought in by the OECD's BEPS Action Plan have the potential to radically change tax outcomes for many taxpayers. The realignment of taxing rights with economic substance is at the heart of the initiative. The OECD defines this as the need for aligning transfer pricing outcomes with value creation.

Two key pillars of the BEPS Action Plan are:

  • ensuring that substance and value creation are consistent with the location of taxable profits (Actions 8 and 10); and
  • requiring transparency in a Multinational Enterprise's ("MNE's") profitability, tax outcomes and global business value chain (through the country by country reporting and the Master File, as per Action 13).

This means that companies require a coherent and holistic picture of their business, which articulates how and where value is created, as well as helps identify and explain profit and tax outcomes.

The value chain analysis ("VCA") approach

A VCA can be an important tool in demonstrating that the location of a company's taxable profits is consistent with the location of key substances.

A VCA considers an end-to-end view of a company's activities, enabling a better perspective on the way a business works and how each component contributes value.

Classical transfer pricing and the arm's length standard are still the prevailing principles of transfer pricing, however, the requirements for supporting a company's transfer pricing system are rapidly evolving and are demanding a more complete review of the entire value chain. Therefore, a VCA should be performed in addition to the classical transactional transfer pricing analysis.

Each VCA should start with identifying the value chain within the industry and the result of the VCA provides a fair and accurate view of the actual allocation of the group's profit in the global value chain.

The VCA approach looks at the consolidated totality of the MNE and its peers and involves an investigation into the functions, assets and risks of the group as a whole, and an evaluation of how they integrate with the group's key value drivers. The conclusions from these analyses are often used to attribute group profits to key functions, assets and risks, and value drivers of the business.

Issues addressed through VCA

In contrast to a local file, master file, or country-by-country report, the VCA is not a compliance requirement, i.e., in most countries, taxpayers are not obligated to prepare it. Nevertheless, many MNEs are very interested in performing a VCA as it provides so many benefits:

  • Assessing your transfer pricing model's alignment with the OECD BEPS principles:
    • A VCA can help assess the risk of a transfer pricing model for MNEs and test whether the location of key value drivers and business substance is appropriately connected with the location of taxable profits.
  • Supporting your Master File and Country by Country Reporting:
    • Although the VCA is not explicitly required in most countries, it is a beneficial addition to the standard transfer pricing documentation package. A VCA can help explain the drivers of business profit and principal contributions of value creation, as required under the master file requirements as well as explain your country-by-country reports and the location of taxable profits.
  • Deepening your understanding of how your business functions:
    • A well-executed VCA can help you align your operating model to reality, and enable you to articulate this simply and objectively. As businesses evolve, change and restructure, a VCA can ensure that the tax outcomes continue to align with the new operating model. It can then be used to develop the most appropriate transfer pricing approach to apply.
  • Developing a more sustainable model:
    • A VCA can identify a fundamental change in the way a company operates, or may simply reinforce the validity of its existing model.
  • Preparing for discussions with tax authorities and stakeholders:
    • A VCA can help you clearly and transparently demonstrate to tax authorities and other stakeholders how a legal entity's share of the total business profit correlates with its role in the value chain. In APA discussions or audits, tax authorities often want to know how the organisation operates and where the value is created. Presenting the VCA is usually a great way to answer most of their questions.

A VCA creates a context for pricing transactions between entities by assessing the relative contributions made by each entity to the overall business. Our methodology can help companies holistically review their value chain and assess alignment with current transfer pricing arrangements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.