KPMG study: Recession provides tough stress test for global transfer pricing rules

Good documentation may no longer be enough. Advance Pricing Agreements (APA) limitations exposed by changing markets.

Many transfer pricing systems around the world are coming under unprecedented stress, as the global recession forces companies and revenue authorities to reassess their economic expectations, a new study from KPMG's Global Transfer Pricing Services group has found.

Some tax authorities, under pressure to provide revenue to their governments, may be reluctant to accept that formerly profitable companies are now incurring losses, and therefore paying less tax.

This means that, to meet increasingly stringent tax authority requirements, taxpayers may have to find new ways to demonstrate that prices charged for inter-group transactions are appropriate.

A similar trend may be noted in Romania as well. There has been a substantial increase in the number of transfer pricing audits in the past few years against a background of shrinking tax revenues for the state budget. As the number of tax audits has increased, tax inspectors have been looking particularly closely at intra-group transactions. They have developed sophisticated methods for enforcing transfer pricing rules, but interpretation of the rules varies from one part of Romania to another. Consequently, taxpayers now need to make special efforts to provide the proper transfer pricing documentation, and to demonstrate to the tax authorities that they have applied correct transfer prices.

In particular, the tax authorities' approach to comparability procedures varies significantly from one county to another. For example some tax inspectors do not accept as comparables companies registering losses, while others insist on having comparable Romanian companies even when there are differences between the functional profile of the companies in question and the tested party.

"Start-up investments and losses are rarely accepted by the tax authorities. This is a problem for companies which have incurred such start-up losses in the past few years, especially because the recession may lengthen the loss making period." says Niculae Done, Senior Tax Partner at KPMG in Romania.

A common problem highlighted by KPMG's research has been the lack of comparable transactions to act as benchmarks for intra-group commerce, as economic activity around the world has slowed.

"For example, the problem has been felt acutely in the area of related-party loans. It has become more difficult to make a distinction between loan financing, granted in preferential conditions, and equity financing in these times." says Dr Teodora Alecu, Senior Manager, Transfer Pricing Services, KPMG Romania. Teodora Alecu continues: "Activity in the financial services sector fell to low levels towards the end of last year and the beginning of this, so it has been difficult to find similar but unrelated transactions to determine what the open-market rate of interest might be. Details like creditworthiness of the borrower, country of the borrower, amount and currency of the loan and even security features and covenants have become much more important in determining supportable loan rates."

Advance Pricing Agreements (APAs), often thought to be a clear solution to transfer pricing issues, also appear to have come under strain.

APAs are binding contractual agreements, the terms of which are fixed while the agreement is in force. So companies wanting to change agreements because markets have changed, prices have fallen, or even where the business is losing money, may find it difficult to adjust or get out of APAs that no longer match business realities.

Some tax authorities, including the US Internal Revenue Service, and the Canada Revenue Agency, have not proved to be as flexible in agreeing to changes in APAs, as some companies might want them to be.

"The economic events of 2008 and 2009 are really testing the APA process, and indeed the whole transfer pricing system," says Steven Fortier, Global Leader of KPMG's Global Transfer Pricing Services practice, and partner in the US firm.

"This is a system that has been developed over a period of increasing globalization and prosperity. Now, it has to adjust rapidly to new, much more difficult conditions. Companies worldwide should take a careful look at the guidance from tax authorities, as well as what they do in practice, to help redraw their transfer pricing policies for a very different world economic climate."

"They should also think beyond the present situation and try to make sure their pricing policies can meet their long term objectives in good times as well as bad."

In the current economic climate, an APA may, in theory, be an appealing solution for transfer pricing issues in Romania too, as it appears to respond to companies' need to reduce uncertainty related to the increased risk of the tax authorities making transfer pricing adjustments.

However, as Alecu points out, "in Romania the possibility for gaining greater stability through APAs is limited. It seems that the Romanian tax authorities' intention is to consider APA applications only if they cover transactions which have not begun before the request for an APA is submitted."

As Niculae Done says: "It has also proved impractical for many companies in Romania to apply for an APA, as the procedure currently takes on average 12 to 18 months and sometimes even longer. Interest in APAs has been quite low, and has diminished even further as some taxpayers have abandoned their applications in the early stages because they have found the process too time-consuming and costly, bearing in mind that the expected benefit is highly uncertain."

The study cited in this release is "Planning for the recovery - examining transfer pricing in the current environment and beyond".It is a collection of articles from leading transfer pricing professionals from KPMG member firms around the world, following on from the very successful "Meeting of Minds" study which was published in 2008. "Planning for the recovery" should be of particular interest to tax and finance corporate executives of multinational companies.