Transfer pricing as an Ombudsman tool
The arm’s-length principle establishes that the conditions agreed between two related enterprises in their commercial or financial transactions cannot be different to those made between independent parties, writes Alejandro Paredes Maldonado of Deloitte Chile. If they differ, the profits of those enterprises may change and will be taxed accordingly.
This statement is usually considered a tax issue but, in practice, it is not solely so. Recently, economic groups have been using the arm's-length principle to either end or avoid inter-company disputes, giving transfer pricing (TP) a concept congruent with that of an Ombudsman, or Defender of the People. Constitutionally, the concept of an Ombudsman is that of an independent entity whose main function is to defend and protect human rights and other rights, warranties and interests guarded by the Constitution and laws in the face of administrative activities.
This concept can be illustrated in the following example: There are three related companies located in Chile. Two of these companies are owned 100% by Shareholder A (from now on Companies A1 and A2), while the third company is owned with a ratio of 90/10 by Shareholder A and Shareholder B respectively (from now on Company AB). The companies carry out daily transactions and the price agreed does not result in tax avoidance.
What would happen if a service provided by Company A1 to Company AB is inside the arm's-length range but closer to the upper quartile/maximum of the range? Even though the transactions may not be questionable from the tax authority's perspective, Shareholder B could argue that the higher value is negatively affecting its profit (margin) and could therefore cause problems between shareholders. The resulting differences between shareholders could in turn trigger questions related not only to mark ups or cost bases, but also to efficiencies. Ultimately, this could create problems between partners.
In such cases, boards of directors have frequently turned to transfer pricing experts to provide internal mediation among associates, so as to conciliate and prevent future disputes where minorities function in biased conditions.
One of the main challenges to improving corporate governance is aligning all of the participants' interests. Questions such as what changes should be executed, how, and when; what benefits will these provide for the corporation, whether the benefits be at a global level or at a specific level; and what risks are assumed and by whom, are guaranteed to come up. These should be addressed at all levels, and use transparent and formalised policies.
Administration structure policies for commercial purposes and business strategies are logical, but more to the point of this article, a proper framework and administration structure of corporate governance is important to address cases where participants (usually minorities) are not being properly represented. For example, generally shareholders execute rights and receive benefits according to their investment; however, as described in the problem, sometimes these rights and benefits are not properly exercised due to preferential decisions that might benefit the group as a whole and not minority shareholders.
Companies Circle Corporate Governance (CCCG), a network which collaborates with several other organisations including the World Bank and the OECD, supports the notion that improvements in corporate governance translates to an improvement in commercial and strategic decisions, hence resulting in an improvement in operational results. CCCG investigated benefits and limitations in models of proper corporate governance and, to evaluate these, analysed operative indicators and costs of capital.
The network concluded that a proper implementation of corporate governance allows for a more equivalent distribution of control, a greater trust in the community of investors, better access to long-term financing, greater trust when implementing changes such as mergers and acquisitions given the increased transparency level, and an improvement in commercial processes, including internal controls and the decision-taking supervision process.
CCCG empirically demonstrated a positive result in implementing or improving corporate governance. However, as it pointed out, more specific and quantifiable results must take into account corporations' specific conditions.
As previously mentioned, inter-company issues arising from differences within a corporate governance, especially when minorities are involved, are becoming more common. Boards of directors are increasingly asking TP experts to review or create TP policies that are aligned with the arm's-length principle in order to resolve issues with minority shareholders.
The conditions established must adhere to tax norms and must also ensure that minority shareholders' interests are not affected. A policy may be suitable for the corporation on a consolidated basis, but its effects on the minority could create disconformity in the group. For this reason, it is crucial that the policy implemented considers corporate governance issues.
Transfer pricing as an Ombudsman tool is particularly feasible in Chile (though not only Chile) due to the corporate structures used. In Chile, minorities are in fact minorities, whereas it is possible that in other countries the common structure is one where minorities might be a substantial part of the corporation and hence have significant decision powers.
In open corporations, where shares are publicly traded, in accordance with the 2009 legislation of Article 50 BIS LSA, and as far as Chilean regulations extend:
"Corporations not only have a Board of Directors, selected by a Shareholders Board, but also at least one Independent Director when a Corporation has market capitalization equal or superior to the equivalent of UF 1.500.000 (about USD 58.560.000) and at least 12,5% of the stock issued with voting rights is in the power of shareholders that independently control at least 10% of the stock."
The previously described regulation attempts to represent the shareholders' different interests. An independent director forms part of the decision-making process and contributes to the sustainability and continuity of the corporation at all levels. As such, their main objective is to provide an unbiased administration, or, more realistically, provide a less unbiased administration.
There is an increasing demand for better practices in corporate governance because when shareholders' rights are protected by law and by the corporation, financial assets like stock have an increased value. Hence, the increasing demand for quantifiable external regulations. Due to this, and as mentioned before, there has been an increasing demand in TP policies as a regulator and dispute settler among corporate governance.
Proper corporate governance has become a pressing matter, and the ability of TP firms to assess and establish fair conditions for internal economic transactions has not gone unnoticed. Transfer pricing proposes a quantified analysis to mediate and support administrative regulations, while at the same time defending unfair functions that minorities within a corporation might endure. Professional and external assessment from TP experts, among others, will help show where new value-generating reference points are, help develop a clear understanding of corporate governance needs and shortages and alleviate internal resistance by outlining a guideline to achieving goals at all levels.
The challenge at hand requires collaboration between parties, a well-defined framework and a transparent line of work. It will not be an easy task.
Alejandro Paredes Maldonado
Partner, Transfer Pricing, Tax & Legal
Tel: +56 22 2729 8216
Alejandro Paredes Maldonado is a partner and the leader of Deloitte's Chilean transfer pricing practice. He has more than 12 years of transfer pricing experience in Venezuela, the US and Chile. He has an impressive track record of achieving successful tax and business outcomes for multinationals by implementing practical and tax-efficient transfer pricing structures and advising on transfer pricing controversy matters.
Alejandro provides transfer pricing advice in a variety of industry sectors including mining, energy and resources, technology, pharmaceuticals, aviation, consumer products, manufacturing and financial services.
Among some of the projects undertaken as the Chilean office partner, Alejandro has been successful in representing clients in different audits from the local tax authorities, achieving reductions in penalties of up to 100%. He also has more than 13 years of experience in transfer pricing policies and corporate governance guidelines.
Additionally, Alejandro has often assisted clients in the mining industry, with important operations in the country, in their different compliance processes. He has worked in the creation, development and improvement of different transfer pricing policies and models for these clients, such as distribution and pricing structures for their products.
Alejandro has extensive experience in effectively collaborating with lawyers and international tax experts both in Deloitte and other professional services firms in both Chile and other jurisdictions, in order to attain holistic, high-quality advice and solutions to complex cross-border arrangements for clients.
Alejandro is an economist graduated from the Universidad Católica Andrés Bello with superior studies, in marketing at the Universidad Central de Venezuela, and in international tax studies at the Universidad de Chile. Alejandro is a frequent speaker at tax conferences, universities, chambers, and transfer pricing seminars.