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How understanding business will reduce controversy

Keith Reams explains the importance of understanding the business to successfully navigate TP controversy in TMT.

Technological innovation has been the defining economic force in the world for the last century, leading to profound advances in how individuals interact with the world. Likewise, companies have had to constantly adapt to new realities to produce their products, reach their customers, and develop the next generation of products. However, innovation has not been the only factor influencing companies; faster technology life cycles, constant declines in average selling price, and a growing field of competitors also have had a direct impact on revenue growth and profits in most industries. Together these forces have reshaped how companies organise themselves; specifically, the emphasis has been on forming enterprises that are truly global in scope, but nimble enough to respond to local preferences. For many multinational companies, this has meant moving manufacturing to less developed regions of the world in search of lower costs, while continuing to market and promote products in traditionally developed markets. Similarly, companies have been developing R&D resources wherever they can find a pool of qualified and skilled people.

Governments and their tax systems, unfortunately, have not kept up with these trends, and multinational enterprises are increasingly finding themselves embroiled in controversy. In particular, long and protracted disputes over how companies allocate their global profits between their marketing, technology, and manufacturing functions are becoming the norm. One of the reasons for this imbalance is that the international tax system was established for a different business environment. Use of a largely outdated system to tax global enterprises competing in a rapidly changing global business environment has led to costly and inefficient controversy.

International tax system's origin and the shift away from that system

The international system of taxation was established at a time when simpler business models prevailed. Half a century ago, the economic factors that affected companies were usually local. Moreover, a business was typically functionally clustered together, because development, manufacture, and sales were most often performed in the same country, or at most geographically distributed among countries in close proximity. Foreign operations tended to be minimal, and companies relied on imports from third parties when necessary. Foreign markets were important primarily as sources of raw materials to be imported for home country production. The international taxation system was consequently much simpler. This system worked for many years without major issues, as long as foreign operations did not take on economically significant importance and the core business functions remained in the domestic operations.

Thanks to ever-faster forms of communication and transportation, the distance between countries seemed to shrink, and companies began to view foreign operations not just as sources of raw materials but also as sources of growth. To capitalise on these markets, companies typically had two options: (1) manufacture the product in the home country for sale into foreign markets by shipping them to either a third party or a related party for resale; or (2) manufacture the product in the foreign market for resale locally or regionally, reselling through either a third party or a related party. This shift abroad was also motivated by an effort to reduce costs in the face of aggressive competition. While consumers gained through declining prices, companies underwent significant reorganisations of their business models to keep up and stay in business. To maintain profits, a purely domestic company serving global markets had two choices: innovate constantly to sustain pricing power or reduce costs to compete on price. For many companies, the immediate answer was to lower the costs of manufacturing product by moving abroad, and innovation was a necessity.

As more production activities shifted to foreign locations, most often to Asia, the manufacturing supply chain shifted as well. Logistics became more complex and costly, both in terms of transporting goods and time spent managing the chain. Given the complex and increasingly "we want it now" demands of end consumer markets, time to market became the factor that could make the difference between success and failure. In response, supply chains have tended to become more closely clustered together, so that production can be scaled more quickly. This is one of the advantages of the typical Asian supply chain: suppliers are clustered closely together and top level manufacturers are able to respond quickly to sudden shifts in demand.

Also driving the shift of production to foreign operations has been the declining demand for products in developed countries. The search for new customers has taken companies increasingly into the developing world. China and India have been prime targets for growth, given their billion-plus populations. However, many other emerging markets also have large populations, and may be even more desirable for future consideration. Today, many companies generate over half their revenue from their foreign operations.

These economic forces have driven many companies to realign their organisational structures from ones in which foreign markets were just a source of raw materials to structures in which foreign markets represent a strategic imperative for growth. In addition, companies have been taking advantage of the growing and now vast pools of skilled and highly educated labour in some foreign markets to establish centers of research and development. In realigning their structures to meet the new realities, companies have had to decide where to locate operations, and just how much function and risk to place in their foreign operations.

International tax regime

While companies have been reacting and building out their intercompany arrangements to reflect new business paradigms, the international tax system has changed slowly, mostly through fits and starts. The system has evolved to produce one where taxpayers may face myriad overlapping and sometimes conflicting regulations and interpretations. This has resulted in an inefficient and costly system from the taxpayer's perspective. Frequent complaints have arisen from taxpayers about responding to increasingly expansive information requests that may not provide appropriate benefits, along with the perception that valuable time was lost that could be better utilised by focusing on the needs of the business.

During simpler times, the profit allocation among raw material suppliers and manufacturers and marketers was easily understood, as there were readily observable market prices for commodities. Thus, taxpayers generally relied on – and tax authorities generally endorsed – the use of the comparable uncontrolled price method to establish appropriate transaction prices. However, as functions and risks became more globally distributed, the question of intercompany pricing became murkier. Currently, not all types of intercompany arrangements that companies use have readily observable market prices. The testing of transfer pricing policies has accordingly shifted toward managing certain financial measures, such as operating margins or other financial ratios. This policy has produced new controversies over the issue of comparables. While reliance on comparable uncontrolled transactions has become less frequent in practice, some tax authorities continue to follow their historical preferred methods. Additionally, with tax authorities around the world recognising the increasing importance of transfer pricing and putting pressure on multinational companies, taxpayers may face multiple interpretations for the same transactions. Consequently, while the US may agree to contract development functions, another country may argue that more profit should be reported in its tax jurisdiction, perhaps because of the perceived higher value of the function or because the market itself may require an adjustment to account for lower costs.

Although the current debate in the press has tended to center on intangible property holding structures and concerns of base erosion, the underlying inefficiencies of the international tax system are felt by taxpayers. In addition to a time consuming process, litigation is complicated by turnover in corporate staff and managers. In today's world, it's not unusual for a tax authority to hold interviews with current employees that have no direct experience with what was happening in the business three years previously.

The appropriate response is often for the taxpayer to focus carefully on the underlying dynamics of the business. While not eliminating controversy, proper policies, procedures, and documentation often give taxpayers the ability to respond quickly instead of frantically catching up during an examination.

Evolutions on the horizon

Although many tax jurisdictions around the world have been scrambling to adapt to the realities of the global economy as it has evolved in the last three decades, global business in the second decade of the 21st century has continued to evolve, again creating upheavals in the international tax systems. New forms of market access without terrestrial geographic locations, such as cloud computing, and consumers that never stop moving are changing business paradigms that are likely to radically undo how companies have operated for the last 10 to 20 years. The personal computer market is currently undergoing a shift as tablet computers take share from traditional desktops and laptops. Additionally, delivery of products now occurs over a network, instead of a consumer taking possession of physical goods. Questions arise: if the product isn't different on the cloud as in the prepackaged box, how different is the organisational structure to support a hosted service? How does this change local sales? What does this mean in terms of competitive threats? How does the business respond in terms of functional responsibilities? How will tax authorities react when a transaction involves just design? How to address manufacturing that is not performed for global consumers, but for local tastes specifically? To what extent will global intangible property owned by one member of the group contribute to this manufacturing activity, or will all members act more or less entrepreneurially in their respective territories? The organisational changes that will be required to properly respond to these important questions are just beginning to be reviewed.

Today as more tax authorities around the world become more focused on intercompany transfer pricing, the importance of documentation has never been more important. The OECD's more recent work on issues of base erosion and profit shifting demonstrates the increasing pressure that multination taxpayers are likely to face in the future, as governments move to create additional layers of regulation that will inevitably affect transfer pricing. With or without new regulations and guidelines from the OECD working group, taxpayers can expect more questionnaires and information data requests. Taxpayers must be ready with adequate support and documentation that tells a coherent story, so as not to be caught off guard and drawn into a potentially protracted period of controversy.




Keith Reams


Deloitte Tax LLP

Tel: +1 415 783 6088



Keith Reams is the US and Global Leader for Clients and Markets for Deloitte's Global Transfer Pricing Services practice. He has advised clients around the globe on intercompany pricing transactions with respect to income tax regulations in Argentina, Australia, Belgium, Brazil, Canada, Chile, China, Columbia, Czech Republic, Denmark, France, Germany, India, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Malaysia, Mexico, the Netherlands, Norway, Peru, Poland, Singapore, South Africa, Spain, Switzerland, Taiwan, Thailand, the United Kingdom, and the United States. He has assisted numerous multinational companies with international valuation and economic consulting services involving merger and acquisition activity, international tax planning, and restructuring and reorganization of international operations. Keith is on the global tax management team for Deloitte's Technology, Media and Telecommunications practice and is a leader in the area of transfer pricing for newly emerging industries, such as electronic commerce and cloud computing, where he has extensive experience around the world in helping clients extend their business models into new territories.

Keith has testified as a qualified expert in numerous valuation and transfer pricing disputes, including the cases of Nestle Holdings Inc. v. Commissioner; DHL Corp. v. Commissioner; and United Parcel Service of America, Inc. v. Commissioner. In addition, he is one of only three economists in the United States approved by the New York State Department of Taxation and Finance to provide transfer pricing expertise and testimony in cases involving cross-border transactions within commonly controlled affiliated groups. He has also helped many clients to successfully resolve valuation and transfer pricing disputes before they reach trial.

Keith completed course requirements for a Ph.D. in International Finance from New York University. He holds a Master of Arts in Economics from California State University Sacramento and a B.S. degree in Chemical Engineering from Stanford University.

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