Base erosion and profit shifting (BEPS)/transfer pricing are currently two of the hottest topics in international tax policy—particularly in light of the OECD’s recent release of Pillar One and Pillar Two blueprints for addressing BEPS issues in an increasingly digitized economy.

In addition to the three-tiered approach and reporting requirements for transfer pricing instituted in the OECD’s BEPS Action 13 in 2017, the Pillar One and Two blueprints have further implications for transfer pricing. In this article, we’ll examine how BEPS affects transfer pricing and offer some general best practices for managing risks associated with BEPS.

BEPS Transfer Pricing Goals

BEPS and transfer pricing are inextricably linked because, under previous rules, transfer pricing was used aggressively by some companies to shift profits to lower-tax jurisdictions. One typical way this was accomplished was shifting the tax domicile of intangible assets, such as intellectual property. An easy-to-understand base erosion and profit shifting example from the real world is companies that shifted ownership of valuable patents to tax haven jurisdictions to take advantage of low, or zero, tax rates. In reality, these companies had minimal substance in the low-tax jurisdictions. The net result was that companies using this practice escaped taxation on profits associated with the assets in the jurisdictions where the assets were generated and exploited.

Addressing base erosion and profit shifting was the central goal of the 2017 adoption of new BEPS regulations regarding transfer pricing and reporting. BEPS strengthened the need to have the substance of a transaction meet the form of the transaction. That means the ownership jurisdiction of the asset does not relieve the company of tax obligations in the jurisdictions where the creation of that IP, and where the profit from that IP, is generated. The OECD introduced the concept of DEMPE functions—development, enhancement, maintenance, protection, and exploitation—and that entities performing these functions should be earning the associated profits. The OECD’s central concern is that profit allocation needs to align with value creation.

Going back to our earlier example of base erosion and profit shifting, while a low or zero tax haven may be the ownership tax domicile of record for the IP, all of the activity associated with creating and exploiting that IP is taking place elsewhere, and the profits from the IP must be allocated accordingly.

Struggling to keep your BEPS reporting organized? Download our free template, A Work Plan For Meeting OECD BEPS Requirements.

BEPS Transfer Pricing Impacts

The BEPS guidelines introduced in 2017 turned many companies’ transfer pricing practices on their heads. However, companies had fair warning; the new regulations were under consideration for nearly four years, giving businesses plenty of time to review and restructure their transfer pricing policies.

For those companies that began aligning their transfer pricing policies with the OECD’s goals during that interim period, the biggest challenge in adapting to the new regulations was achieving compliance with the new reporting requirements. These are much more stringent than previous requirements and are premised on creating transparency, so tax authorities can more easily discern if transfer pricing is being used to shift profits.

To use the low/no tax haven example again, the new reporting regulations require both country-by-country reporting and maintenance of a transfer pricing master file. If the tax haven company reports that it’s generating 30% of the profit but only lists two employees, and there are several hundred employees in the country where the development of the IP asset took place, it becomes readily apparent to tax authorities that profit shifting is taking place.

The goals outlined in the Pillar One and Pillar Two blueprints recently issued by the OECD will create further challenges, particularly for digital companies that generate profits in countries where they have no physical presence. For example, Facebook has millions of users in many different countries where the company maintains no offices or infrastructure. The company generates profits from advertising to users in those countries, but allocating profit is difficult because no intercompany transaction is involved and there is no local entity with a tax presence.

Best Practices For Managing BEPS And Transfer Pricing Risks

While the already adopted BEPS guidelines pose challenges for compliance with reporting requirements—and the goals outlined in the Pillar One and Pillar Two blueprints will pose additional challenges for many businesses—multinational companies can follow several practices to reduce risks associated with BEPS and transfer pricing:

1. Review transfer pricing policies to ensure they are aligned with BEPS guidelines. Conduct a review to verify that all intercompany transactions satisfy the arm’s-length principle, and where they may be questionable, bring pricing into compliance by applying one of the accepted arm’s length pricing methods.
2. Create a work plan for compliance with BEPS reporting requirements. The three-tiered approach adopted by BEPS requires more reporting in more jurisdictions than was required under the previous guidelines; it can be a challenge to juggle the requirements for each jurisdiction while ensuring that all deadlines are met. Getting organized with a work plan can help keep everything on track. For this reason, Valentiam has created a free work plan template that can be downloaded and followed to ensure compliance.
3. Review and compare all transfer pricing reports before submission. Be sure to verify that local files are in agreement with the values reported in the country-by-country report. Discrepancies between the local file and country-by-country report are a red flag for tax authorities and increase the likelihood of audits.
4. Assess the potential impacts of the OECD Pillar One blueprint on your company to determine whether restructuring or changes to your transfer pricing policy might be necessary.
5. Assess the potential impacts of the OECD Pillar Two blueprint on your company, focusing on your activity in low tax jurisdictions to estimate how the cost of “topping up” the rates to a certain minimum will affect the business.

The OECD Pillar One and Pillar Two blueprints are only in the review and comment phase of adoption. Many of the details (such as minimum tax rates and what constitutes a “consumer-facing business”) are still undefined—but it is not too early to begin assessing potential impacts. The OECD hopes to reach final agreement on Pillar One and Pillar Two regulations by mid-2022; by doing a review now and estimating the impacts of the various regulations under consideration, you will be ready to make any necessary changes to business or transfer pricing structures before the new regulations are adopted.

We’ll help you navigate transfer pricing and policy changes.

Transfer pricing can be complex and confusing, but it doesn’t have to be that way.

Valentiam’s world-class transfer pricing specialists deliver innovative, thoughtful, and 100%-supportable strategies you can actually implement. It’s our goal to design economically-sound strategies that your company can also easily administer. With the help of one of our seasoned experts, you can maximize company profits and minimize audit risk. Let’s talk about your unique transfer pricing challenges and how Valentiam can help solve them—schedule a free discovery call today.