Implementing transfer pricing (TP) policies can be complicated enough when done solely for income tax purposes. Segmentation can be tricky. There is risk for each counterparty jurisdiction. Regular monitoring and true-up processes are often necessary. But the TP challenge transcends tax: TP policies may also need to be squared with management books to suit a business’s internal reporting needs.
A simplified example: USCo, a multinational engineering software company, adopts a transfer pricing policy in which its Australian limited risk reseller subsidiary, AusCo, earns a fixed 5% return on its local sales. For tax purposes, implementing a single “lever” such as a residual platform/license fee may be acceptable.
Meanwhile, USCo management tracks profitability by project, and ties AusCo personnel’s key performance indicators (KPIs) - and compensation - to metrics such as operating margin.
The Company prefers not to keep two sets of books. But if the TP policy is applied without nuance, KPIs would be distorted and incentives for improvement among AusCo personnel would be blunted - regardless of performance the 5% operating margin is guaranteed.
One possible solution is for the company to “disaggregate” the transfer pricing policy into constituent transactions: in this case, perhaps charge a cost-plus management fee for support received from USCo HQ, a royalty on net sales of the software product, and a residual true-up/true-down to achieve the target margin. The first two are considered in KPIs, while the third is not. Such transfer pricing policy suits both tax compliance (arm’s length allocation of income) and management books (operating P&L tracking).
There are many variations, but the principle stands: when designing TP policies, transfer pricing advisors should not stop at providing a benchmarking study for tax purposes. They must understand the Company’s business requirements and develop a methodology that fits both business and tax needs.
