Transfer Pricing Issues for SMEs

Transfer pricing is an important issue for any business working across international borders. While it is usually thought of in the context of large multinational corporations, recent changes to the Australian definition of SME means it is just as important that smaller-scale businesses are aware of their transfer pricing obligations to ensure they avoid any messy and (potentially costly) situations down the track.

So just what is transfer pricing? Put simply, transfer pricing is an income tax acronym for how to set prices between two or more international related parties. The most important element of transfer pricing is that the prices set must be “arm’s length” – i.e. a fair price that might have been reached even if the parties weren’t related. The reason transfer pricing exists is to ensure that a business or group of related businesses aren’t “double taxed” by having to pay two or more tax authorities if trading in two or more countries. Transfer pricing involves a sometimes complex mix of accounting, tax consulting, and economic review.

SME is short for Small Medium Enterprises and means different things in different countries depending on the context it falls in. In Australia, for transfer pricing purposes it is defined by the Australian Taxation Office (ATO) as any business enterprise with an annual turnover of $250 million or less. This level of inclusion changed in the last 6 months, as the previous cut-off between a small and large business was a turnover of $100 million. This change of cut-off means a different team in the ATO now does the tax audit / risk review of those businesses in the 100 – 250 range. This team is focused on international tax issues such as transfer pricing, controlled foreign companies, and withholding tax deducted from dividends, interest and royalties and is well trained. It has been tasked to review businesses in the 100-250 million turnover range that have not seen a tax review for some years. It looks for international tax risk – is Australian tax paid, less than it could be if there were no international tax dealings?

In doing a review the ATO will ask for a transfer pricing documentation report prepared in respect of the years under review. Back in 1998 the ATO issued income tax ruling TR 98/11 that set out in detail what it expected to see in a transfer pricing documentation report and what it would do with it if it needed to review one.

The ruling created the concept of the “4 step process” (some could say the new tax tango!) and outlined how it would score documentation in a risk review to determine if the ATO should proceed to an audit. The 4 steps set out 4 key processes that must be discussed in a transfer pricing documentation report. They are:

• a functional analysis of how the company and its group does business globally including a description of products services and royalties and market conditions;
• the methodology used to set prices for goods, services or royalties between related parties and why it was chosen;
• the testing of the outcome of using the method(s) – so called benchmarking analysis; and
• a description of management steps taken each year to review transfer prices as the business changes.

The scoring process has a checklist which reviews the 4 steps and ranks the company on a scale, from having no documentation coverage through to adequate coverage. The process also has an economist review the company’s annual profit and loss with an ABC score that ranks it from industry normal profit to continuing loss. A score of “no documentation coverage” and “continuing losses” is the trigger for a tax audit. The audit then seeks to ascertain if the pricing the company has with its overseas related parties has shifted profits out of Australia and hence lower Australian tax has been paid.

An adequate documentation score, paired with industry consistent profits will indicate no transfer pricing tax risk worthy of an audit. If the ATO happens to find other issues and proceeds to audit, in the event that transfer pricing is an issue then adequate documentation gives a level of penalty protection if a transfer pricing adjustment is made.

The message is clear – a document on the table when the tax office calls is better than no document – more so if accounting losses are earned. Other triggers that point to a need for having documentation are management fees, royalties, transfers of capital tangible and intangible assets and significant dollar levels of goods and services between related companies.

Our experience is that documentation once started is straightforward to maintain year on year – a big first time report can be updated without re-writing the whole report or doing new benchmarking for at least 3 and maybe up to 5 years, amortizing the cost. So long as the 4^th step of the annual review is done at tax time and a minute of what was determined is annexed to the main report, it continues to be relevant and current.

The old idea that the ATO does nothing on transfer pricing has changed – don’t be caught out. Think of it as insurance and getting to know your business better by doing it.

Author: Chris Bowman, March 2008

Chris is a new member of the Grant Thornton Team. Based in Sydney he is the National Lead Director of our transfer pricing team

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