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The recent headlines regarding losses reported and the amount of corporate tax paid by Starbucks and other multinationals illustrate not only an increasing global concern regarding the ability/practice for multinationals to shift profits for their own advantage, but also how transfer pricing practices are used to legitimately achieve this.

Taxpayers need to consider whether the results in their offshore entities reflect a commercially realistic outcome in that jurisdiction after any transfer pricing adjustments.      

In Starbuck’s scenario, their cross border transactions for royalty payments, coffee purchases and funding arrangements with other Starbuck entities in other countries, were highlighted after Starbuck’s recognized losses in multiple years, despite reports that the business was profitable.   

Commercial reality

Transfer pricing has long been viewed as being primarily concerned with establishing the arm’s length price of specific transactions between offshore related parties where revenue authorities require that loans must have arm’s length interest rates and transactions for product and services need to have arm’s length markups on costs. Arm’s length pricing, measured as the price that unrelated parties would pay for the same transaction in similar circumstances, seeks to prevent the manipulation of profits between cross border related entities. 

However Inland Revenue (IR) and a number of other revenue authorities including the Australian Tax Office (ATO’ also apply a “commercial reality” test to the taxpayer’s financial results after specific transfer pricing transactions and adjustments. The question they ask is whether the taxpayer’s results reflect the ‘correct commercial outcome’ after any transfer pricing adjustments.  

What is an appropriate commercial profit will depend on a range of factors including the key commercial contributions to a business’s performance: where the key profit drivers are; where the key functions are performed; the level of risk assumed in the different countries, market conditions etc.

The goal is to calculate an arm’s length return as measured by what profits an independent entity in the same or similar business would earn. Where there are non commercial results, IR’s view may be that there is something wrong with the transfer pricing methodology applied.    

The ATO has recently introduced anti-avoidance measures to allow it to focus more generally on profits and conditions, rather than specific transactions. The intention is to allow ATO to review the commerciality of taxpayer arrangements even though any transactions with an offshore related party are at arm’s length. This is potentially an expansion of the previously understood scope of transfer pricing rules.    

Implication for exporters

Exporters need to be aware that many offshore revenue authorities apply such a commerciality test and that the offshore business should also recognise a commercial result in the jurisdiction – while balancing the opportunity for a New Zealand owned business with offshore operations for the New Zealand business to reduce its overall tax costs as far as practical through ensuring that as much of this total tax cost as possible is paid in New Zealand rather than overseas. 

Double taxation arises if you are operating both in New Zealand and overseas and the New Zealand taxpayer is likely to be double taxed on offshore income when income tax is being paid overseas. Although it may be able to be claimed against the New Zealand tax payable, imputation credits generated in New Zealand (tax credits the New Zealand shareholders of a New Zealand company can benefit from) will be reduced, meaning the New Zealand shareholders have to pay more tax on their eventual dividends.

Often offshore operations, although important strategically, will be performing a more routine, lower risk role. Therefore other things being equal, lower profits should be reported offshore, allowing correspondingly more profit to be reported in New Zealand. This in turn should mean less double taxation.

Despite the advantages from using transfer pricing to minimise double taxation it is important to recognize a commercial arm’s length return offshore and avoid the temptation to move all profits back to New Zealand – or worse, leave the offshore entity in unrealistic losses year after year to avoid paying income tax offshore.

It follows that effective structuring of offshore operations and appropriate transfer pricing strategies can therefore mean greater after-tax returns for the shareholders. 

Given the public concerns raised by recent events, transfer pricing continues to be very high on most revenue authorities’ list of priorities in terms of tax audits. Transfer pricing can be seen as either a compliance obligation, or an opportunity to proactively demonstrate and ‘set’ the level of profit offshore based on what the overall business’s role is in that country, and hopefully at the same time minimize double taxation and ultimately put more cash in the shareholders’ pockets.   

Establishing appropriate transfer pricing policies and supporting documentation will often, of itself, reduce a business’s risk profile and minimise its chances of a full blown transfer pricing audit (in New Zealand or overseas).

Geoff Castleis national transfer pricing adviser for WHK.Email[email protected]or visit www.whk.co.nz

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