As you scale internationally, transfer pricing often emerges as a critical yet overlooked component of your company’s financial strategy. Having a clear understanding of the different transfer pricing mechanisms and how to effectively implement them will be key to your ongoing success.
That’s why CP’s Head of Tech & High Growth, Steve Leith, and Head of Tech & High Growth Tax, James Peck, hosted a one-hour webinar to answer scaleups’ questions and tell you how to get your transfer pricing diligence-ready.
We’d recommend watching the whole thing back, and you can do so here:
If you’re pressed for time, we’ve summarised some of the key takeaways below. And if you have any questions about the specifics of your transfer pricing, don’t hesitate to get in touch.
TRANSFER PRICING: THE BASICS
At its core, transfer pricing examines the economic activities and locations of various entities within a corporate group. By analysing these functions, businesses can determine appropriate remuneration for each entity, ensuring that intercompany transactions reflect an arm’s length, fair market value. This approach not only maintains compliance with tax regulations, it also ensures that profits are allocated appropriately across jurisdictions.
WHY & WHERE TO START?
For scaling companies, assessing the relevance of transfer pricing is crucial. Different countries have varying thresholds that dictate transfer pricing requirements. In the UK, for instance, if your company exceeds 250 employees, and one of or both of the following criteria:
- Over €50 million in turnover; or
- A balance sheet total exceeding €43 million
You’ll likely fall within the scope of transfer pricing regulations. These thresholds are calculated on a Group consolidated basis for a Group of companies.
Even if you don’t meet these thresholds and are classified as an SME, there are scenarios where implementing transfer pricing becomes necessary:
- Different Jurisdictions: If you’re conducting business with group companies in countries that lack a double taxation agreement with the UK, such as Brazil, transfer pricing rules may still apply.
- HMRC Notices: Medium-sized businesses might receive a notice from HMRC requiring them to file transfer pricing documentation, though this is relatively uncommon.
- Patent Box Transactions: Engaging in transactions involving the Patent Box regime can prompt HMRC to mandate computations aligned with transfer pricing principles.
Proactively addressing transfer pricing for your business, even when it’s not explicitly required, can prevent premature taxation in multiple jurisdictions and demonstrate strategic foresight to stakeholders and potential investors. Contrary to common misconceptions, transfer pricing doesn’t always prompt exhaustive documentation. Well-crafted intercompany agreements, tailored to your business’s size and complexity often suffice.
COMMON PITFALLS & RED FLAGS
Embarking on transfer pricing without a holistic view of its tax implications can lead to costly mistakes. Some of the key things to consider include:
- Tax Residency: Ensure clarity on where the central management and control of your entities reside. Missteps here can render transfer pricing efforts ineffective.
- Permanent Establishment (PE) Risks: Unintended creation of a PE in another jurisdiction can complicate tax obligations and potentially lead to double taxation.
- Transferring Contracts: Shifting contracts across borders from one entity to another can trigger exit or migration charges. For example, transferring contracts from a UK entity to a US subsidiary without proper consideration might result in HMRC viewing it as an asset leaving the UK tax net, triggering unforeseen tax liabilities.
To navigate these challenges, we’d recommend adopting a proportionate approach, aligning transfer pricing policies with your business’s scale and ensuring they are replicable across jurisdictions.
DEVELOPMENT CENTRES VS. SALES ENTITIES
Understanding the differences between development centres and sales entities is another key element in transfer pricing:
- Development Centres: These are entities, often overseas, dedicated to R&D on behalf of the parent company. It’s crucial to establish clear licensing agreements to ensure intellectual property (IP) resides where intended. For instance, setting up a development centre in Romania would involve creating a local subsidiary that hires developers. A licensing agreement between the Romanian entity and the UK parent ensures that IP developed remains under UK ownership. Pricing for such arrangements typically follows a cost-plus model, with margins varying by country.
- Sales Entities: These entities handle direct sales to third-party customers. The degree of autonomy and risk they assume influences their profit margins. A limited risk distribution model, where the sales entity operates under strict guidelines from the parent company, might yield an operating margin between 2.5-5%. In contrast, a fully-fledged distribution model, where the entity undertakes significant commercial management and marketing functions, could result in higher profits or even losses, reflecting its entrepreneurial role.
Maintaining simplicity in these structures helps prevent complications, such as unintentionally relocating IP, which can lead to internal conflicts and tax inefficiencies.
THE KEY FACTORS DRIVING PRICING BENCHMARKS
Determining appropriate pricing involves:
- Proportionality: For SMEs, transfer pricing policies should be sensible, scalable, and aligned with the business’s complexity.
- Benchmarking Analysis: Utilising OECD guidelines and conducting benchmarking studies can help establish a reasonable pricing range. Collaborating with advisers ensures that chosen rates are justifiable and defensible during audits or due diligence.
- Materiality: As transactions grow in significance, obtaining formal benchmarking analyses and maintaining comprehensive documentation becomes increasingly important to show the reasoning behind your transfer pricing positions.
PREPARING FOR DUE DILIGENCE
In the lead up to due diligence, especially during funding rounds or potential exits, there are a few key elements that investors or buyers will be looking for:
- Documentation: You’ll be expected to maintain a master file and local files for each relevant subsidiary, showing in-depth analyses of functions, risks, and pricing methodologies. SMEs, while not required to produce extensive documentation, should have functional analyses that evaluate the risks and rewards of each group entity. This includes assessing IP licensing, financial arrangements, and management charges.
- Intercompany Agreements: Legal agreements should mirror the established pricing mechanisms, ensuring consistency between documented policies and actual practices.
- Diligence Challenges: Common issues during due diligence include the absence of transfer pricing policies, application of inappropriate models (e.g., using cost-plus for sales entities), and unaddressed PE and / or corporate residency risks. Addressing these proactively can prevent potential deal disruptions and tax exposures in the future.
Implementing transfer pricing isn’t just a compliance exercise. It shows your commitment to sound financial management and international growth. And if you don’t already have it in place, you’re going to end up with disproportionate levels of profitability for sales entities.
Transfer pricing makes simple commercial sense, but you need to make sure it’s sensible, scalable and proportionate to the size of your business and its requirements.
As always, if you have any questions about transfer pricing in your business, don’t hesitate to get in touch with our Tech & High Growth team.
