Control over transfer pricing

22 November 2018

PwC

Agenda

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1. Importance of having a transfer pricing control framework2. Pricing under control? IFRS 16 changes!3. IFRS 15 − Agent versus principal4. Key takeaways

Transfer pricing control framework

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Tax audits reaching record numbers

“Fair share”

Reputational risk

External audits

Emerging tax systems

Tax Technology

Data sharing

Governments competing

Tax governance

Digitisation

Increasing attention and exposure

Transparency

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What clients tell us about their lack of control over transfer pricing

‘Near misses’

Inconsistent TP results Informal processes and reliance on

‘goodwill’

Patchwork of data sources

Ambiguous terms in intercompany agreements

Hero dependency

Frustrating quarterly/annual close

Difficulty in ETR forecasting

Excel dependency

Lack of TP monitoring

Lack of controls

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Main purpose of a transfer pricing control framework (TPCF) is safeguarding the level of certainty with regard to the transfer pricing-related financial statements / tax position(s) for the relevant parties involved.

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Internal

Tax Department Management Internal auditors CSR Communications

External

Tax authorities External auditors Others: e.g. regulators

This means: risk mitigation – for example: double taxation, reputation, etc.

Who are the relevant parties?

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Transfer Pricing Control Framework

Based on OECD Tax control framework

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Transfer Pricing Control Framework (cont’d)

Strategy Operational

Consulted / Informed

Responsible / Accountable

TP Policy

Documentation /Compliance

Monitoring /

implementation

Responsibilities Tax Department

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Transfer Pricing Control FrameworkTransfer Pricing Strategy EstablishedApplied Comprehensively

Responsibility Assigned

Governance Documented

Testing Performed

Assurance Provided

Tax Policy

TP Policy

ManufacturingTP Procedure

Sales TP procedure

Corporate services TP procedure

High level Adherence to the arm’s length

principle One pagers Communication/update process

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Transfer Pricing Control Framework

Simple One pager policies Detailed implementation

documents Communication/update process

Sales TP procedure

Corporate services

TP procedure

Job profiles

Business design model

Functional governance documents

Intercompany agreements

Cost base definitions

Product Costing

guidelinesRACI’s

Documentation procedure

Controversy procedure

Exceptions procedure

Transfer Pricing Strategy Established

Applied ComprehensivelyResponsibility Assigned

Governance Documented

Testing Performed

Assurance Provided

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ManufacturingTP Procedure

TP Policy

Tax Policy

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Transfer Pricing Control Framework

Sales TP procedure

Corporate services

TP procedure

Documentation procedure

Controversy procedure

Job profiles

Business design model

Functional governance documents

Intercompany agreements

Cost base definitions

Product Costing

guidelinesRACI’s

Head of Tax

Local ManagementController

HR

Transfer Pricing Strategy Established

Applied Comprehensively

Responsibility AssignedGovernance Documented

Testing Performed

Assurance Provided

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ManufacturingTP Procedure

Exceptions procedure

TP Policy

Tax Policy Legal HR Local management Head of tax

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Transfer Pricing Control Framework

Sales TP procedure

Corporate services

TP procedure

Documentation procedure

Controversy procedure

Job profiles

Business design model

Functional governance documents

Intercompany agreements

Cost base definitions

Product Costing

guidelinesRACI’s

Transfer Pricing Strategy Established

Applied Comprehensively

Responsibility Assigned

Governance DocumentedTesting Performed

Assurance Provided

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ManufacturingTP Procedure

Exceptions procedure

TP Policy

Tax Policy

Includes: By what date When is action required Communication/update process Escalation process

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Transfer Pricing Control Framework

Sales TP procedure

Corporate services

TP procedure

Documentation procedure

Controversy procedure

Job profiles

Business design model

Functional governance documents

Intercompany agreements

Cost base definitions

Product Costing

guidelinesRACI’s

Transfer Pricing Strategy Established

Applied Comprehensively

Responsibility Assigned

Governance Documented

Testing Performed

Assurance Provided

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ManufacturingTP Procedure

Exceptions procedure

TP Policy

Tax Policy

Agree process to test outcome Monitoring throughout the year Agree adjustment process Year-end testing Numbers and operational

processes

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Transfer Pricing Control Framework Model Adherence review in

management meeting Questionnaires / interviews Documentation review Internal Audit? External confirmation Sign off by responsible managers

Transfer Pricing Strategy Established

Applied Comprehensively

Responsibility Assigned

Governance Documented

Testing Performed

Assurance Provided

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Tax

Objective is to comply with national transfer pricing legislation

Remember: Transfer Pricing has multiple stakeholders

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Management accounting

Objective is to set rules relating to performance measurement

There can be overlap and there can be alignment

There can also be friction between these areas

Financial accounting

Objective to transact arm’s length

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…and that transfer pricing lives in multiple Departments

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Pricing & Accounting

policies

Documentation & compliance

Transactional accounting

Adjustments

Monitoring

Testing

Finance / accounting

Transfer Pricing

Tax Department

Controllong

Management

Pricing under control ?

IFRS 16 changes!

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The reason for implementing IFRS 16

Criticisms of the existing accounting standard

IFRS 16

Lessor Lessee

• Continue to recognise underlying asset

• Recognise right of use asset

• Recognise obligation for future lease instalments

Similar accounting for purchased assets

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Lack of transparency regarding operating lease commitments

Lack of comparability between companies that buy versus lease their assets

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Impact might be significant

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IFRS 16 at a glance

The new standard

• All leases > 12 months on balance sheet• Exemption for low value asset leases• Effective as of 1 January 2019

What is different?• Single, on-balance sheet model• Front-loaded lease expenses for lessees

• Balance sheet gross-up• Change in Profit or Loss presentation• Change in Cash Flow presentation

Balance sheet IAS 17 IFRS 16Finance lease Operational lease All leases

Assets Asset ---- Right-of-use asset

Liabilities ----

Off balance sheetobligations ----

Off-balance sheet commitment ----

Profit or loss IAS 17 IFRS 16Finance lease Operational lease All leases

Revenue ---- ---- ----

Operating costs ---- Lease expense Service expense

EBITDA

Depreciation Depreciation expense ---- Depreciation

expense

Operating profit/EBIT

Finance costs Interest expense ---- Interest expense

Profit before tax

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• How does this impact a MNEs transfer pricing policy?• Similar effect under all transfer pricing methodologies?

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• Lease term of 5 year • Interest rate 5% • Straight line depreciation on asset

Impact on financials – example (1)

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Lease liability

• Present value 435• Yearly lease fee 100

Year Opening carrying amount

Interest accrued

Payments Closing carrying amount

2019 435 22 (100) 357

2020 357 17 (100) 274

2021 274 13 (100) 187

2022 187 9 (100) 96

2023 96 4 (100) -

Total 65 (500)

Year Opening carrying amount

Depreciation Closing carrying amount

2019 435 (87) 348

2020 348 (87) 261

2021 261 (87) 174

2022 174 (87) 87

2023 87 (87) -

Total (435)

Lease assets - Right of Use

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Impact on financials – example (2)

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Difference P&L and tax deduction2019 2020 2021 2022 2023 Total

Depreciation (87) (87) (87) (87) (87) (435)

Interest expense (22) (17) (13) (9) (4) (65)

Total P&L (109) (104) (100) (96) (91) (500)

Tax deduction (100) (100) (100) (100) (100) (500)

Timing difference

(9) (4) 0 4 9 0

EBIT effect

PBT effect

• Lease term of 5 year • Interest rate 5% • Straight line depreciation on asset

• Present value 435• Yearly lease fee 100

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Impact on financials – example (3)

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80

90

100

110

120

1 2 3 4 5

Leas

e ex

pens

e

Year

Frontloading of overall lease expenses under IFRS 16

IAS 17 IFRS 16

-13 Under IFRS 16 there is a profit (PBT) fluctuation due to timing difference.

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How does and/or should this impact a MNEs transfer pricing policy?

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Management Accounting/ Consolidated financial statement

IFRS 16

Dutch Statutory Accounts

Dutch GAAP versus IFRS 16

Tax return

Goedkoopmansgebruik / Article 8b CITA (OECD Guidelines)

IFRS 16 - Netherlands

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• How is your transfer pricing mechanism set? • How do you test your transfer pricing?• How do auditors and tax authorities test your transfer pricing?• What will be the standard applied by the benchmark comparables?• If and how to eliminate the timing difference from your transfer pricing policies?

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Global principal Residual profit

Limited risk distributorOperating margin 5%

Benchmark – LQ 4% - UQ 6%

Impact IFRS 16

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EBIT Effect

Benchmark risk

PBT Effect neutralized

IFRS 16

EBIT Effect

Benchmark risk

PBT Effect

No matching solution

PwC

LRD IAS 17 - 2018 2019 2020 2021 2022 2023 Total Average

Revenue 1,000 1,000 1,000 1,000 1,000 1,000 5,000 1,000

(COGS) (700) (700) (700) (700) (700) (700) (3,500) (700)

Gross margin 300 300 300 300 300 300 1,500 300

(Opex) (150) (150) (150) (150) (150) (150) (750) (150)

(Lease) (100) 0 0 0 0 0 0 0

(Depreciation) 0 (87) (87) (87) (87) (87) (435) (87)

EBIT 50 63 63 63 63 63 315 63

Interest income/expenses

0 (22) (17) (13) (9) (4) (65) (13)

PBT 50 41 46 50 54 59 250 50

Timing Difference

(9) (4) (0) 4 9 0 0

Operating Margin

5.0% 6.3% 6.3% 6.3% 6.3% 6.3% 32% 6.3%

Tax expenses at 25%

12.5 10.25 11.5 12.5 13.5 14.75 62.5 12.5

TP reimbursement by Principal

(950) (937) (937) (937) (937) (937) (4,685) (937)

Increasing EBIT

Neutralizing timing effect PBT

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Principal IAS 17 - 2018 2019 2020 2021 2022 2023 Total Average

Revenue 1,000 1,000 1,000 1,000 1,000 1,000 5,000 1,000

LRD (950) (937) (937) (937) (937) (937) (4,750) (950)

Gross margin 50 50 50 50 50 50 315 63

(Opex) (10) (10) (10) (10) (10) (10) (50) (10)

EBIT/PBT 40 53 53 53 53 53 265 53

Operating Margin

4.0% 5.3% 5.3% 5.3% 5.3% 5.3% 27% 5,3%

Tax expenses at 25%

10 13,25 13,25 13,25 13,25 13,25 66,25 13,25

Total EBIT 90 116 116 116 116 116 580 116

Total PBT 90 94 99 103 107 112 515 103

Total tax 22,5 23,5 24,75 25,75 26,75 28 128,75 25,75

Depreciation versus Lease Expense

No full set-off for timing difference due to TP method @ EBIT

Increase total tax for annual accounting purposes

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LRD - 2018 2019 2020 2021 2022 2023 Total Average

Revenue 1,000 1,000 1,000 1,000 1,000 1,000 5,000 1,000

(COGS) (700) (700) (700) (700) (700) (700) (3,500) (700)

Correction (COGS) (13) (13) (13) (13) (13) (65) (13)

Gross margin 300 283 283 283 283 283 1415 283

(Opex) (150) (150) (150) (150) (150) (150) (750) (150)

(Lease) (100) 0 0 0 0 0 0 0

(Depreciation) 0 (87) (87) (87) (87) (87) (435) (87)

EBIT 50 50 50 50 50 50 250 50

Interest income/expenses

0 (22) (17) (13) (9) (4) (65) (13)

Correction (interest) 22 17 13 9 4 65 13

PBT 50 50 50 50 50 50 250 50

Total Correction 9 4 0 (4) (9) 0 0

Operating Margin 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 25% 5.0%

Tax expenses at 25% 12.5 12.5 12.5 12.5 12.5 12.5 62.5 12.5

Amended reimbursement

(950) (959) (954) (950) (946) (941) (4,750) (950)

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Principal IAS 17 - 2018 2019 2020 2021 2022 2023 Total Average

Revenue 1,000 1,000 1,000 1,000 1,000 1,000 5,000 1,000

LRD (950) (959) (954) (950) (946) (941) (4,750) (950)

Gross margin 50 41 46 50 54 59 315 50

(Opex) (10) (10) (10) (10) (10) (10) (50) (10)

EBIT/PBT 40 31 36 40 44 49 200 40

OM 4.0% 3.1% 3.6% 4% 4.4% 4.9% 20% 4.0%

Timing Difference (9) (4) (0) 4 9 0 0

Elimination of timing difference required?

9 4 0 -4 9

EBIT/PBT 40 31/40 36/40 40 44/40 49/40 200 40

OM 4.0% 3.1%/4.0% 3.6%4.0% 4.0% 4.4%/4.0% 4.8%/4.0% 20% 4.0%

Tax expenses at 25%

10 7.75/10 9/10 10 11/10 12.25/10 50 10

Total EBIT 90 81/90 86/90 90 94/90 99/90 450 90

Total PBT 90 81/90 86/90 90 94/90 99/90 450 90

Total tax 22.5 20.25/22.5 21.5/22.5 22.5 23.5/22.5 24.75/22.5 112.5 22.5Imported IFRS timing difference – to be eliminated for Local Stat/ Tax purposes

Neutralizing the LRD

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Management Accounting/ Consolidated financial statement

IFRS 16

Dutch Statutory Accounts

Dutch GAAP versus IFRS 16

Tax return

Goedkoopmansgebruik / Article 8b CITA (OECD Guidelines)

IFRS 16 - Netherlands

• How is your transfer pricing mechanism set? • How do you test your transfer pricing?• How do auditors and tax authorities test your transfer pricing?• What will be the standard applied by the benchmark comparables?• If and how to eliminate the timing difference from your transfer pricing policies?

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IFRS 15 −Agent versus principal

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IFRS 15 – Revenue from Contracts with Customers

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Relevant indicators to assess whether an entity is a ‘principal’ or ‘agent’ for statutory reporting purposes

Current IFRS 15 standards New IFRS 15 standards

Focus on whether company has risks and rewards of a principal

Focus on whether company controls the specified good/service

Fulfilment Primary responsibility for contract fulfilment?

✅ ✅

Inventory risk Inventory risk at any point during the transaction (that is, before the order, during shipment, or upon return)?

✅ ✅Clarification: Obtaining title momentarily beforetransferring a specified good orservice to a customer (i.e. ‘flash title’) does not necessarily constitute control.

Pricing Discretion in establishing prices for the other party’s good or service?

✅ ✅

Credit risk Customer credit risk for the receivable amounts?

✅ ❌

Remuneration Consideration in form of a commission or otherwise?

✅ ❌

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Management Accounting/ Consolidated financial statement

IFRS 15

Dutch Statutory Accounts

Dutch GAAP – IFRS 15 allowed

Tax return

Goed koopmansgebruik/Article 8b CITA (OECD Guidelines)

IFRS 15 at a glance - Netherlands

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• How do you want to set your transfer pricing policies?• How do auditors and tax authorities test your transfer pricing?

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2,5% markup according to BM

IFRS 15 – Example – FactsNew IFRS 15

standards

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P&L - LRD

Revenue 500COGS 287,5----------------------------------Gross margin

212,5Opex 200----------------------------------EBIT 12,5

RoS 2.50%

NLDE

ConsequencesPossible mismatch between Stat versus TP/Tax

P&L - PrincipalRevenue Agent 500

For statutory purposes

P&L - AgentRevenue commission 212,5

For statutory purposes For TP purposes

Tensions / Disconnect statutory vs. tax positionThe basis for transfer pricing control framework?

Ways to mitigate this issue?

Current IFRS 15 standards

2.5% markup according to BM

Alignment treatment for statutory and tax purposes

LRD will for IFRS purposes be labeled as an Agent with respect to revenue recognition. No revenue recognition at level of Agent

• No 3rd party revenue base available to establish TNMM - RoS.

• Intercompany contracts and legal flows/physiscal flows remain the same

• Cost-based remuneration or commission to be applied?

• To be determined how this can be defended from TP perspective and how the arm’s length nature of the mark-up can be substantiated.

LRD

Third-party customers

EMEA Principal

Cost-based or commission remuneration required?

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IFRS 15 – Example – Impact

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Lower quartile

Median

Upper quartile

1.50 %

2.50 %

5.00 %

Tax/TP Benchmark Results (RoS):

TP P&L - LRD

Revenue 500COGS 288------------------------------------Gross margin 212Opex 200-------------------------------------EBIT 12RoS 2.40%

EBIT 12C+ 6%

EBIT 10C+ / ROS 5.00% / 2.00%

TP P&L - LRD

Revenue 500COGS 285-------------------------------------Gross margin 215Opex 200-------------------------------------EBIT 15RoS 3.00%

EBIT 15C+ 7.5%

EBIT 10C+/ROS 5.00% / 2.00%

TP P&L - LRD

Revenue 500COGS 290-------------------------------------Gross margin 210Opex 200-------------------------------------EBIT 10RoS 2.00%

EBIT 10C+ 5%

EBIT 10C+ / ROS 5.00% / 2.00%

FY2018

Annual fluctuations in remuneration for LRD activities mitigate potential adverse exposures regarding ‘revenue recognition’ based on IFRS 15

2.0 %

3.0 %

Lower quartile

Median

Upper quartile

3.0 %

5 %

7.00 %

3.0 %

6.0 %

“Agent” Stat - Benchmark Results (C+):

• Seek TP alignment for financial statement and tax purposes Review intercompany

contracts – terms and remuneration

Assess whether or not to amend intercompany agreements

• Review APAs• Update TCF

Actions

OR OR OR

FY2019 FY2020

Key takeaways

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Key takeaways

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TPCFHaving a solid Transfer Pricing Control framework safeguards the level of certainty on your tax position

IFRS 16Impact of operational leaseIFRS 15Changes in revenue recognition

Considerations• Is your policy IFRS 15 & 16 compliant?• Adjust policy/guidelines where required• Consider for Local File 2018 on wards• Consider impact on CbCR 2019

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© November 2018, PricewaterhouseCoopers Belastingadviseurs N.V. (PwC). All rights reserved. PwC refers to the Netherlands member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see http://www.pwc.com/structure for further details.

Pieter van LunenDirector06 - 20 92 69 10Pieter.van.lunen@pwc.com

Bert MiddelkoopDirector06 - 22 18 52 73Bert.middelkoop@pwc.com