This article was first published by Bloomberg Tax on 31 March 2021. Reproduced with permission from Copyright 2021 The Bureau of National Affairs, Inc. (800-372-1033) www.bloombergindustry.com.
The Covid-19 pandemic has created an unprecedented challenge to people’s way of life across the world. The economic and social disruption caused by the pandemic is devastating, with significant impact on lives and livelihoods.
A significant number of enterprises face an existential threat, resulting in a large part of the global workforce being at risk of losing their income streams. Informal economy workers are particularly impacted, as they generally lack social security protection and access to quality healthcare and have lost access to productive assets.
The economic response of various governments to the crisis has also been unprecedented. Over $10 trillion has been announced by way of various stimulus packages to provide financial assistance to people and businesses across the world. Governments have included all forms of financial assistance in these packages, including cash transfers to individuals and organizations, guarantees, loans, deferrals, and equity investments. In many cases, the stimulus packages by governments have ranged from 10% to 20% of their current national gross domestic product (GDP), whilst they brace themselves for a significant fall in GDP going forward. It is a vicious circle that may lead to recession and even depression in the years to come.
Most of the Covid-related stimulus financing has come from increased government borrowings. Such significant borrowings will have the impact of widening budget deficits and a consequential increase in the public debt-to-GDP ratio. More significantly, there will be questions around how governments plan for repayment of these debts. It is likely that tax (both direct and indirect) will have an important role to play in connection with governmental efforts to repay their public debt.
Whilst tax will remain a significant avenue for reducing public debt, governments will be concerned that a significant hike in tax rates may not do the trick, especially from a direct tax perspective. With enterprises struggling to stay afloat, the profits on which the taxes are to be imposed will in any event be limited or non-existent. Separately, significant tax rates hikes would lead to fresh investments being diverted to other, more “tax friendly” jurisdictions. Hence raising of tax rates may not be the immediate response by many governments.
Nevertheless, the pressure to collect additional tax revenues will remain an imperative. Coupled with the difficulty in doing so through an increase in tax rates, we are likely to see a trend towards an increase in tax disputes around the world. One area where such disputes may be rather glaring will be in the area of transfer pricing, where the dispute is often between two tax administrations, over which one has the right to tax certain income.
Transfer Pricing Aggression
Transfer pricing has been given special attention by tax authorities since it is often perceived by them to be a tool used by multinationals to shift profits overseas.
Considering that transfer pricing concepts are ever-evolving, with perspectives themselves being largely “gray” in nature (with differing interpretations of the arm’s-length price), and also considering that a taxpayer’s transfer pricing position is only as strong as the documentation they maintain, tax authorities worldwide find transfer pricing adjustments relatively easy to target.
That apart, since transfer pricing adjustments result in a restatement of transaction values (which could run into millions of dollars), even a minor restatement/adjustment in transactional values could result in significant tax collection. With this in mind, tax authorities have been increasing their focus on transfer pricing matters, resulting in transfer pricing audits and controversies becoming the largest and most contentious tax disputes in the world.
Over the last few years, several jurisdictions, many of which are key trading partners for Singapore, have taken focused measures to bring about efficiencies in their tax and transfer pricing audit approaches. The intent, globally, is to move to a risk-based assessment system which would allow optimal collection of taxes with minimal efforts.
Examples of such measures include:
- formulation of the risk differentiation framework by the Australian tax authorities, wherein taxpayers are assigned different risk ratings based on the perceived level of risks that they carry. This approach allows the Australian Tax Office to determine the intensity of scrutiny to be adopted for different types of taxpayers on their transfer pricing positions;
- a move towards a risk-based audit/assessment system by the Canada Revenue Agency, wherein taxpayers are prescribed a risk rating—high, medium, and low risk. The audit intensity would be determined by the risk profile of the taxpayers;
- China has recently issued several circulars that require taxpayers within China and even overseas to provide significant data and information to enable conduct of tax and transfer pricing audits in a more informed manner;
- the Indian tax authorities have implemented general anti-avoidance rules to review and disregard transactions that are perceived to have been designed with an intent to avoid taxation within the country. Further, the Indian tax authorities have set up separate transfer pricing cells across the country to focus on a review of transfer pricing arrangements;
- the U.S. Inland Revenue Service has introduced and commenced joint transfer pricing audits (along with tax authorities in other jurisdictions) of multinational corporations (MNCs) and has also moved towards a risk-based audit system with a view to bringing efficiencies to the audit process.
The above measures indicate an intent to review tax and transfer pricing arrangements on a more informed basis and to target taxpayers in a more efficient manner. This trend is likely to continue, considering the pressures on tax collection, and an intent to protect each jurisdiction’s tax base.
Expected Areas for Target
Some of the expected areas where future transfer pricing aggression is likely to be focused include:
- Challenging management fee payments—management fees have often been viewed as a profit repatriation tool by tax authorities, especially tax authorities within Asia. These payments are often challenged on account of the taxpayer’s inability to demonstrate/substantiate (through documentary evidence) the receipt of a service, or inability to articulate/quantify the benefits emanating from such services.
- Challenging royalty pay-outs—brand or technology owners within an MNC group usually charge their affiliates royalties for the exploitation of trademarks or know-how. Often these arrangements have a perpetual existence. It is anticipated that tax authorities will tend to challenge such royalty payments that have been ongoing, for extended periods, on the argument that, over time, know-how or brands, tend to get “absorbed” by the licensee entity and such royalty payments are, therefore, no longer justified.
- Characterization of service providers—it is often observed that MNCs structure their subsidiaries in low-cost, high-tax jurisdictions to operate as contract service providers (e.g., contract research and development service providers, contract software developers). These structures could be challenged from a substance perspective, including challenges on the conduct of the contract service providers. Where the conduct is found to be inconsistent with its characterization, such contract service providers may be recharacterized as entrepreneur service providers (leading to a higher income being attributed to such operations).
- Location savings or location rent—many MNCs are relocating their manufacturing operations to low-cost jurisdictions to leverage the low cost of resources (such as raw materials, labor) and thereby save costs. Tax authorities may allege that the cost savings realized by the MNC (as a result of relocating the manufacturing operation from a high-cost to a low-cost jurisdiction) results in “location savings” to the MNC (i.e. additional profits to the MNC as a result of savings in cost due to relocation of manufacturing operations). Accordingly, some portion of the location savings realized by an MNC could be attracted to the low-cost jurisdiction.
- Deeming of exit charges in the case of business restructurings—MNCs undertaking internal restructurings—for example, converting an entity operating as a full-fledged manufacturer to a contract manufacturer, or restructuring an entity operating as a full-fledged distributor to a marketing service provider—are susceptible to challenges from a transfer pricing perspective. Such restructurings often entail the transfer of valuable intangible assets (e.g. customer contracts) or involve significant renegotiation of contractual terms. In such cases, transfer pricing authorities could deem an “exit charge” in the hands of such entity undergoing restructuring. The exit charge represents a compensation for such restructuring, since the restructuring has an element of limiting future revenue flows.
Such transfer pricing aggression would result in MNC groups facing significant litigation in multiple jurisdictions leading to significant costs and efforts on such litigation. Whilst tax authorities can make transfer pricing adjustments, based on preconceived notions and presumptions, within a few months (through the audit process), it takes a taxpayer many years and a significant amount of money to finally get relief on such adjustments. The alternative for the MNC would be to accept economic double taxation on the same income.
Whilst the Singapore transfer pricing regulations are relatively new, some of Singapore’s trading partners have had transfer pricing regulations and practices in place for several years now.
Many countries that seem to adopt aggressive transfer pricing approaches also happen to be key trading partners with Singapore. These jurisdictions have well-developed transfer pricing regulations, contemporaneous documentation requirements and well-defined transfer pricing audit regimes. That apart, the transfer pricing regulations in these jurisdictions often impose significant penalties on transfer pricing adjustments as well as providing for secondary adjustments (where additional income determined through the transfer pricing audit process is not remitted back into those countries).
The risk for Singapore in such cases would be one of compromising its fair share of profits as it gets caught in the middle of such transfer pricing aggression. Because of the draconian regulations in many jurisdictions, coupled with their aggressive audit approach, MNCs often tend to take conservative positions when operating in them. This would typically result in a higher attribution of the MNC group’s profits to these high-risk jurisdictions.
Singapore, with a relatively relaxed view on transfer pricing and a rather pragmatic penalty regime, may end up having to part with revenues/profits rightfully belonging to it. This could have disastrous consequences in Singapore considering a large part of its corporate taxpayers are part of MNC groups. To ensure it is able to attract its fair share of income and consequently collect its fair share of taxes, it would be prudent for Singapore to remain vigilant on this front.
Given that Singapore is viewed as one of the more attractive investment and business destinations within Asia, it may not be prudent for the government to take drastic measures to mitigate potential profit shifting measures. However, some reasonable measures that could be adopted could include:
- putting in place a transparent transfer pricing audit program clearly indicating the basis on which transfer pricing cases would be selected for transfer pricing audit by the Inland Revenue Authority of Singapore;
- enhancing and building awareness of the advance pricing agreement machinery within Singapore to attract taxpayers to seek proactive clearance on their transfer pricing arrangements over extended periods;
- reviewing the present penalty limits with respect to non-compliance with transfer pricing documentation provisions as well as for adjustments made to transfer pricing arrangements not found to be at arm’s length. The present penalty limits are extremely low (compared to the penalty limits among its trading partners) and do not seem to deter MNC groups from taking aggressive positions as regards their transfer pricing arrangements for Singapore.
Such pragmatic approaches would ensure that Singapore is not compromised in respect of its fair share of tax revenue while at the same time maintaining itself as an attractive investment destination.