Why are transfer pricing tensions increasing in Asia?

The economic landscape is not looking very promising and transfer pricing audits are escalating in both intensity and frequency. Developed nations are struggling with significant debts and deficits as their economic growth stagnates, while developing nations have now latched onto the idea that they should reap the benefits associated with their low cost bases and their large untapped markets.

As a result, countries are increasingly employing transfer pricing adjustments, arguably their most effective weapon, to ensure they receive their “fair share” of the global supply chain profits. Multinational enterprises need to understand these developments as well as how best to manage their transfer pricing risks as to maintain tax efficiency on this altered playing field.

The size of recent transfer pricing adjustments clearly demonstrates that these can have a very material impact on the profitability of an enterprise.

We recently observed a significant increase in the frequency and magnitude of transfer pricing adjustments, especially in Asia, with countries like Japan and China publishing exponential numbers and Indian taxpayers facing USD 15.6 billion of tax adjustments linked with transfer pricing.

Yet, what do these adjustments really mean? In short, they mean that when two companies belonging to the same group and located in two different tax jurisdictions exchange products, services or licensing rights at prices which are considered non “arm’s length” (i.e. would not have been applied if the companies did not belong to the same group) the tax authorities of one jurisdiction may look to change the price so as to increase the taxable income of the company resident in their jurisdiction (and thereby increase the tax revenues of that jurisdiction).

The result is generally a significant increase in the tax burden of the company and, potentially, of the group. There are also likely ramifications in terms of cash flows and planning as unanticipated tax costs may also affect the business plan of a given investment.

It can get worse. Depending on the locations of the companies involved in the transactions which have been adjusted, you may not be able to obtain a corresponding adjustment in the other jurisdiction to compensate for the fact that, as a group, you have now paid tax in two jurisdictions on the same profit (what tax professionals refer to as ‘double taxation’).

Where a corresponding adjustment cannot be achieved, the effective tax rate of the group will be higher than the average corporate tax rate of the jurisdictions where your companies operate. It is as if you paid your suppliers twice for the same given product.

Tax authorities in most developed jurisdictions have powerful tools, which allow them to adjust the prices of transactions with other group companies if they are not arm’s length. And these tax authorities are using them. So what is really new? The fact that the tax authorities of developing nations are also being equipped to deal with transfer pricing.

For example, PRC tax authorities are planning to increase their core transfer pricing team from 100 to 500 in three years. However, already in 2010, the total amount of reassessments due to transfer pricing in China was RMB 2.31 billion. India has been adjusting almost every taxpayer with an exposure to transfer pricing and Indonesia has recently released its own transfer pricing rules and documentation requirements.

This happens at a time when developed nations are looking for ways to resist the migration of economic activity to the developing world and transfer pricing, often through “exit charges”, is also used as a defensive weapon.

Hong Kong, which has long been regarded as a relatively straightforward jurisdiction for transfer pricing, has now adopted specific transfer pricing guidance and has recently entered into numerous double taxation agreements. In our view, it is clearly aligning its approach to transfer pricing towards international standards.

As tensions between developed and developing nations with respect to transfer pricing intensify, Hong Kong taxpayers will be increasingly caught in the middle and are likely to face adjustments in overseas jurisdictions.

As the Hong Kong transfer pricing landscape is changing, so should the approach to transfer pricing in the region. Potentially, this may involve greater transparency and accuracy as well as the development of more robust, sophisticated transfer pricing policies, which are aligned with the operational needs of complex supply chains while providing the necessary flexibility to support the operational developments of multinational enterprises.

Transfer pricing efficiency can only be achieved through a proper process, which starts by reviewing the existing structure of the group, designing/refining a proper transfer pricing model, implementing it and monitoring it carefully while having a sound dispute resolution strategy. It’s time for Hong Kong taxpayers to ensure they are up to speed.