Value leakage occurring in spite of a group's transfer pricing policy is a commonly occurring problem and can take one or more of the following forms:

• Hidden taxation costs arising from transfer pricing audits (such as adjustments raised by tax authorities for underpaid taxation compounded by interest and tax geared penalties). Significant professional costs, management time and resource will inevitably be required to address transfer pricing audits and there is also a real possibility of a loss of confidence in the group's corporate governance procedures (with a direct impact on share price) as a result of a protracted transfer pricing audit that challenges transfer pricing policy.

• Double taxation in relation to transfer prices that is not effectively resolved by the competent authority mechanism of tax treaties – this is particularly an issue in the light of opposing positions taken by tax authorities in relation to transfer pricing.

• A failure to include transfer pricing in process reviews despite the requirement for many groups (particularly SEC-registrant groups) to assess the effectiveness of all internal controls and procedures.

• Missed opportunities to minimize global effective tax rates (for example, company structures and policies that do not sufficiently take account of taxation mitigation opportunities). In addition to this, transfer pricing policies that are sound in basis may not be effectively implemented, supported or sustained due to a lack of business process in relation to transfer pricing.

The resulting transfer pricing value leakage is significant. Most affected will be multinational groups with significant cross-border activity. Value leakage through, for example, intellectual property infringement and wastage is already likely to be significant for many groups and the introduction of further leakage through transfer pricing is an unwelcome additional concern.

Traditional transfer pricing policy in multinational groups has typically taken one of the following forms:

• Transfer pricing design and planning with no consideration as to the effective implementation and documentation necessary to sustain the benefits and defend the policy.

• Documentation of existing transfer prices with an annual roll forward of this documentation which does not consider business change or tax mitigation opportunities.

Both of these policies involve an element of 'wait and see' and the result is that the business outgrows its existing policy leading to increased exposures in relation to transfer pricing audits and missed tax mitigation opportunities. Traditional transfer pricing policy may not be capable of preventing value leakage; below are some specific changes to the transfer pricing environment that are directly relevant to this debate:

Many multinational groups are witnessing an increase in transfer pricing audits. An increasing number of countries have introduced/extended legislation in relation to transfer pricing documentation and transfer pricing audits have also increased in intensity. A failure to show documentary evidence which is considered by the relevant tax authorities to be 'adequate' can lead to lengthy investigations resulting in professional costs, management time and resource, significant taxation adjustments and penalties.

The aggressive enforcement of transfer pricing legislation in one jurisdiction and differing positions taken by tax authorities make double taxation through transfer pricing adjustments a real concern. International tax treaties typically contain a mutual agreement procedure article under which competent authorities of the two relevant jurisdictions are required to attempt to eliminate economic double taxation where tax has been levied other than in accordance with the treaty. There is, however, a lack of confidence in the treaty process in relation to transfer pricing which has been exacerbated by a number of well publicized cases where tax authorities (particularly the UK and the US) have taken opposing positions and were unable to reach an agreement. Before these high profile cases, many multinationals expected agreement to be reached between competent authorities especially where major trading territories were involved. There was generally a feeling that most, if not all, double taxation could eventually be avoided and transfer pricing adjustments only had administrative and cash flow cost consequences (subject to any negative tax rate arbitrage as a result of an adjustment). It should be noted that many treaties do continue to function well and, within the EU, are augmented by a binding Arbitration Convention under which double taxation should be avoided. However, there remains a real concern that if a transfer pricing policy is unacceptable to all relevant jurisdictions; double taxation may be the end result.

It is not solely the approach of tax authorities that is increasing the transfer pricing risks. SEC-registrant groups that are subject to section 404 of the Sarbanes-Oxley Act are required to publish information in their annual reports concerning the scope and adequacy of the internal control structure and the procedures for financial reporting. These groups must assess the effectiveness of internal controls and procedures. Internal controls in relation to taxation automatically ring warning bells for groups in relation to filing and deferred taxation. However, the extent of transfer pricing controls required are also likely to be significant and should include an assessment of the transfer pricing regimes in the relevant jurisdictions in which the group is active.

Julian Robertson-Kellie: Significant opportunities existed in relation to the transfer pricing of intellectual property

Combining a review of existing transfer pricing structures and policies with a general taxation risk review may assist in creating substantial value for the group.

Transfer pricing is a key ingredient in maximizing value when reviewing existing operating strategies for efficiency improvements and in relation to expansions planned into new markets and products. Groups expanding into new jurisdictions are finding themselves in uncharted transfer pricing waters, ill-equipped to address the necessary regulations. In addition, planning opportunities in relation to expansion and growth are being overlooked.

Groups that focus on documentation to guard against risk (understandable in the face of increased regulatory intensity) may not be in a position to identify planning opportunities. Opportunities will depend upon the group and the industry in which it operates but may include optimal design of funding structures, the use of a management company to centralize intellectual property ownership, or a full supply chain valuation and optimization project to synergize business and taxation planning. The benefits of such projects are likely to be substantial for many groups.

However, even where such opportunities are identified, success in terms of maximizing value will depend significantly on effective implementation and maintenance of the projects on an continuous basis.

Combating value leakage with transfer pricing assurance

Many groups are adopting an assurance-based approach to transfer pricing, which involves a continuous assessment of risks and opportunities. An assurance review, update and ongoing health check of a group's transfer pricing process can create substantial opportunities for multinational groups and the following example may help to give an indication of the potential benefits to business:

A recent review of transfer pricing systems for a multinational group included:

• A review of transfer pricing value leakage and a robust risk assessment to isolate existing transfer pricing risks. This included a risk map and an identification of potential opportunities for mitigation of risk.

• A review of the adequacy of regulatory controls which may impact transfer pricing (for example, tax return filing and SOX 404).

• A review of pricing policies to assess consistency between policy and implementation.

• An indication of transfer pricing opportunities that may be sustainable based on our assessment of group operations.

Benefits of undertaking review

The review identified the following:

• Intra-group service provisions were not being adequately documented and pricing design was archaic in comparison to the current operating environment.

• Pricing policy was not being reflected in operational reality. The result was that opportunities for increasing value already residing in the business were not being exploited despite a number of historic transfer pricing 'reviews' which did not consider operational implementation. Furthermore this represented an exposure due to the mismatch between transfer pricing documentation of policy and actual pricing arrangements.

• Significant opportunities existed in the group in relation to the transfer pricing of intellectual property.

The eventual savings realized were substantial and included:

• annual taxation savings in excess of £100 million.

• reduced exposures in relation to potential transfer pricing audits through a well maintained transfer pricing process.

• skills transfer, enabling the group to identify future transfer pricing opportunities

• alignment of taxation planning with commercial and operational planning which renders 'avoidance'-based attacks from tax authorities largely irrelevant.

Assurance-based approach

Transfer pricing is one of the most important business concerns faced by multinational groups today. A high instance of transfer pricing audits has resulted in a taxation adjustment for multinational groups. However, despite the concerns, a plethora of opportunities exist for groups prepared to invest in elevating transfer pricing on the business agenda.

Shiv Mahalingham: Most affected by transfer pricing value leakage will be multinational groups

Traditional approaches to transfer pricing are unlikely to address the necessary steps in the evolving transfer pricing environment and groups that have adopted an assurance-based approach have proved that the following can be achieved:

• Reduced exposures to the extensive taxation costs associated with transfer pricing audits.

• Reduced exposures to double taxation.

• Greater control of the transfer pricing process in conjunction with overall internal control process reviews.

• Increased ability to identify opportunities for minimizing global effective tax rates and assurance that transfer pricing policy is correctly implemented and maintained to sustain the benefits.

An assurance-based approach which prioritizes transfer pricing as a business process will inevitably assist in minimizing costs and identifying points of sustainable opportunity thus increasing shareholder value.

Julian Robertson-Kellie (jrobertson2@uk.ey.com) is a tax director and Shiv Mahalingham (smahalingham@uk.ey.com) a tax manager at Ernst & Young in London