TP considerations arising from remote working, digitalisation, and business restructuring
Shaun Austin, Karishma Phatarphekar, and Jack Smith of Deloitte consider three factors that are driving changes to business models and set out best practice for transfer pricing professionals in handling the tax implications.
While economies continue to emerge from the shocks caused by the COVID-19 pandemic that has dominated the business environment for the past two years, many multinational enterprises (MNEs) continue to face a challenging outlook. The causes of which include not only the direct and indirect consequences of the pandemic, but also wider macro-economic trends such as the current inflationary environment.
The pandemic has also acted as a catalyst for change and expedited many trends that were already in motion; for example, the widespread adoption of hybrid or remote working, and digitalisation of businesses. These changes have given rise to new business models, altered existing value chains, provided newer business opportunities/challenges, and opened up alternative markets.
MNEs therefore have to reconsider their tax positions and transfer pricing policies as such business models evolve. It will be interesting to see more clearly how tax authorities will evaluate these new business models.
This article explores the transfer pricing implications of such business model changes and focuses on three areas of emerging, and almost certainly in the future increasing, tax controversy and highlights the importance of MNEs addressing the impact of changes on their transfer pricing models:
Changes to global mobility – the implications of changes to workforces and the composition of people functions on transfer pricing models;
The increasing importance and use of data – the ever-increasing availability and importance of data and the transfer pricing implications of capturing and rewarding its value; and
Business model change and reorganisations – business models have continually been evolving, but current developments and changes, particularly in the areas of technology and supply chains, have accelerated the level of change and led to different types of business models.
Changes to global mobility
There has been a widespread and pronounced transformation to businesses emerging from the pandemic and specifically a shift in working practices through the adoption of remote or flexible working. These working practices have clearly grown in popularity globally, initially from necessity during government-mandated restrictions, but subsequently they have been embraced by businesses and employees alike.
Accordingly, many MNEs have redrawn their employment footprint, partly responding to the current ‘war for talent’, bringing them within the scope of certain tax authorities for the first time or changing their footprint in existing jurisdictions.
From an international tax perspective, not only does this bring permanent establishment (PE) considerations, as well as overarching considerations (such as corporate residence), it also generates acute questions surrounding the appropriateness of transfer pricing models.
While any such change to employment locations generates transfer pricing considerations, this is particularly pronounced in the current climate given that many of these changes relate to senior individuals within MNEs.
From a transfer pricing perspective, many of these individuals are likely to constitute significant people functions (SPFs) or key entrepreneurial risk-taking (KERTs) functions. In this respect, tax authorities are often seeking materially higher returns beyond the more traditional approach adopted by many groups of levying a cost-plus service charge where key employees may be physically located outside the country of the core entity that they are effectively working for.
By way of illustration, take a previously centralised entrepreneur, or principal structure, with local employing entities undertaking ‘routine’ activities for transfer pricing purposes and senior management teams being employed, and spending the substantial majority of their working time (when not travelling), in the principal jurisdiction. Many such employees were not nationals of the country in which the principal was located, and their main residence and family may have been in another country.
While such employees may initially have been unable to travel during the COVID-19 pandemic, due to government restrictions, in many instances hybrid working (combined with organisations’ commitments to a reduction in carbon emissions) has resulted in these individuals travelling to the principal country less frequently or potentially permanently relocating to the country of which they were a national.
This has raised fundamental questions about the sustainability of the existing transfer pricing model. In many instances, tax authorities are raising challenges where such changes have not resulted in a corresponding revision to the remuneration basis for the entity (or PE) in the country in which the relevant senior individual now resides. In many instances, tax authorities are seeking returns over and above the local ‘routine’ remuneration and the greater use of the profit split method/revenue split is a clearly observable trend.
It is therefore important that transfer pricing practitioners engage with broader stakeholders, including HR and legal, to ensure that they fully understand revisions to the locations of employees and that appropriate revisions are made to legal contracts and transfer pricing models to accurately account for these.
The importance of this is further evidenced through the observation that in enquiries, many tax authorities are seeking to apply penalties for inaccuracies in the capturing of the local functional profiles where the policy and documentation differs from the core facts on the ground, as well as extending the nature of their audit; for example, detailed interrogation of travel records.
Increasing importance and use of data
The second transfer pricing controversy area considered here concerns the increasing importance and use of data. In the digital era, the use of artificial intelligence, digital platforms, the growing adoption of the Internet of things (IoT), the use of robo-advisers, etc. has led MNEs to significantly increase spend on technology.
Digitalisation allows for innovative working models that are adopted by MNEs, often materially reducing human involvement as a result, including in the markets where customers are located.
The ever-increasing use of technology and digitalisation by MNEs creates new data points that many are seeking to commercialise externally with other parties or internally by using the enhanced data available to up- and cross-sell further products and services to their customers. This trend of the use of technology to exploit data is not confined to digital businesses, as it is also increasingly seen in ‘traditional’ business models, such as the growth of cashless retail and application-based payments, or the selling of digital services to customers buying traditional physical products; for example, in the automotive sector.
As an example, supermarkets in many geographies have experienced vast growth in the demand and popularity of online shopping during the pandemic. While this service is not new, it has provided retailers with an enriched pool of data (over and above that traditionally gathered through loyalty cards). These customer insights and data are then used to inform decision making, but also represent an asset that has economic value not only to the retailer, but also to its suppliers, which retailers are looking to commercialise in many instances.
Similarly, in the automotive sector, significant data on customers’ behaviours around the use of their vehicles gives a base of knowledge and information that can be used to maximise sales of further products and services to customers.
As many MNEs take stock of the data available to them and the role that it can play in enhancing their commercial activities, this creates a number of transfer pricing considerations that are becoming increasingly relevant in interactions with tax authorities. This particularly includes whether the underlying value attaches to the core data itself, as opposed to the analytical functions to facilitate the exploitation of the data.
The starting point here is what intangible assets, within the definition of Chapter VI of the OECD Guidelines, actually exist, and, from there, which entity is the legal owner of the assets. Often there is a lack of clarity and rigour on this core point, noting that the question of who has ownership rights over what data is a legal point that is often not straightforward. From there arises the resulting considerations regarding whether it is the legal owner who has been responsible for the development, enhancement, maintenance, protection, and exploitation (DEMPE) functions and control of risk regarding such assets.
Then follows the challenging consideration of what asset or function has really given rise to what level of value creation. In particular, is the key value in the pure data, which is essential to the value creation exercise, or the technology/algorithms, without which the value of such data may be fairly limited. On the basis that there is material value created, the use of transactional pricing methods may be difficult, a cost plus method or transactional net margin method approach may not be appropriate, and there may not be a clear and objective basis to apply a profit split approach.
These issues become more pronounced as many MNEs consider the appropriateness of data analytical hubs, or principals, that process and commercialise data in an intra-group context, and ever-increasing ways to monetise available data.
As the use of data permeates across industries, including those with more ‘traditional’ business models, these considerations will become commonplace and lead to a corresponding increase in transfer pricing controversy, noting the technical challenges above. Initial experience suggests that there may not be consistent positions between tax authorities, particularly between large developing countries such as India, which is demanding an additional attribution for such data (which comes from the vast customer base/market), and developed jurisdictions such as the US, whose core argument is that the arm’s-length analysis already factors in a return for all these aspects.
Business model change and reorganisations
The final trend explored in this article relates to business model change. Material changes to business models being seen in current trends include the way that businesses sell to their customers, changes linked to digitalisation and the pivot towards services and subscription models. Significant mergers and acquisitions activity is also driving material change.
A particular transfer pricing consideration linked to the above is business reorganisations and ‘exit tax’ considerations. It is increasingly being seen that even relatively small changes in business models can potentially crystallise an exit tax. Clearly such considerations would arise with a transfer of the whole or part of a business from one jurisdiction to another. However, such considerations would also arise with:
The relocation of individual, or groups of, employees across the organisation, which is becoming ever more relevant given remote working;
The transfer of individual assets, including customer contracts;
The transfer of an activity, through termination or substantial renegotiation of existing arrangements;
The transfer of intellectual property (IP), where a party other than the IP owner is considered to have contributed to the DEMPE activities in developing such IP;
Business model changes resulting from integration of an acquisition; here, tax authorities have argued that integration has led to the effective transfer of the acquired business at the acquisition price paid for the business; and
Supply chain changes driven by recent moves towards greater nearshoring.
The question of whether a reorganisation event would trigger a compensatory payment between parties at arm’s length is explored at length in Chapter IX of the OECD Guidelines, including the need to consider whether there is a transfer of value, the commercial reasons for the restructuring, and the options realistically available to the parties. The perspective of the individual parties to the transaction must be considered, noting that a business model change that is the best option for the overall business may not necessarily be the best realistically available option for the ‘transferee’.
As challenges from tax authorities, including certain countries introducing specific domestic provisions, in this area increase, interpretations are evolving as it is increasingly explored by tax authorities and courts globally. Certainly, a clear trend from court cases is the criticality of evidence, particularly as to the business and commercial position.
The main message for TP professionals
Controversy in the three areas considered above will almost certainly increase going forward. The key message for transfer pricing professionals is the importance of engaging with the business and broader stakeholders at as early a stage as possible to ensure that transfer pricing is fully considered and reflected where such business change arises, including intercompany legal agreements and transfer pricing documentation.
In addition, the nature of potential uncertainty in such areas means that many taxpayers are assessing whether advance pricing agreements and the certainty that these provide are the appropriate way forward to address potential controversy.