The word ‘Policy’ although a simple word to understand is a tough nut to comprehend. What comes to your mind when to narrate this term? For me, the first thought is economic policy, fiscal policy, monetary policy and nothing less than a very heavy weight document which could have the power to steer the course of an economy or at least an institution. In short, light but yet a heavy word to use.
When this word is used in combination with yet another complicated subject (TP) with perceived value, it converts itself into a language which could be understood only by beings with superpowers. In reality, a transfer pricing policy is a document which is used to make life easy for a Multinational corporation.
A policy is a set of guiding principles or rules on which machinery of a concept or situation is pillared. As the name suggests, a transfer pricing policy is a document which highlights how an MNE would look at a specific international transaction from a group pricing point of view. It may or may not include a benchmark, depending upon the preference of the MNE management. It definitely includes and highlights a price setting model, which is used to price similar types of a transaction through a remuneration model.
For a step by step understanding of how to draft a transfer pricing policy, the following sequence and conceptual terms need to be understood.
- A walk through of the MNE – For the preparation of a policy document for any situation, one needs to understand the scenario very well. Therefore, while you are preparing a policy document for the transactions that would be entered cross border within the MNE group, it is essential to understand the MNE group itself. Such an understanding and data gathering may include knowledge of business, business segments, industry, holding structure, types of products or services offered by the MNE group, geographical locations, past history in terms of transfer pricing and tax litigation etc. This may not be an exhaustive list, however, one may choose to make their own checklist of a gathering of information from the company. Such an analysis may also give you comfort to compare the business models with other business models that you may have seen in your experience. Businesses could be unique, however similar business models could be used by companies in a particular case.
- Industry analysis – Once we have understood the subject well, it is essential to perform thorough research on the industry to which the MNE belongs. As mentioned, there could be certain business models that could be used in industry at large and you do not want your MNE to follow a unique pattern which could be later on challenged by the tax authorities. Further, the performance of industry analysis would also give you ready documentation when the transfer pricing documentation needs to be maintained.
- Undertaking a supply chain analysis – A transfer pricing professional has coined a beautiful name of this step. We call it FAR [Function, Asset and Risk] Analysis. What it actually means is an analysis of the functions undertaken by the respective Associated Enterprises (AEs) in the group, assets employed by such AEs and respective risks associated with the transactions. Now ideally a legal inter-corporate agreement is a starting point to FAR analysis followed by management interview, but considering that you are looking at making a planning document in the nature of policy, most likely the intercorporate agreement would not be available and that is something that you may have to draft after you get the policy up to speed. FAR could be of various types and the format and examples could be available online, but it is the quality of FAR matching to the exact scenario of the company is all that matters. FAR compulsorily involves two or more AEs and therefore cannot give only a unilateral view.
- Characterisation – The whole motive of undertaking a FAR is to characterise the transaction in one or more buckets which would help us in the determination of remuneration model. Example of characterisation for a distributor could be High-risk distributor, a Licensed distributor, Low-risk distributor, commission agent etc. One would be able to characterise a transaction only when an appropriate FAR is undertaken.
- Remuneration model – Once you characterise the entity, the remuneration model is something that is closely liked to such characterisation. For example, if you are a distributor, you get a margin as remuneration; if you are a broker, you get brokerage or commission as your remuneration. In transfer pricing study one often refers to 5-6 types of transfer pricing methods of benchmarking. It is important to note that these methods are not the only methods to test but also fixation methods. The remuneration model could be fixed via a cost-plus method, yet tested through a TNMM analysis. Such a remuneration model is the final output and heart of the transfer pricing policy. The reason for the selection of a remuneration model also needs to be justified through appropriate business rationale and commercial substance.
Now that we know the basics of preparation of a TP policy document, it is imperative that such a document is easy to comprehend with use to the business at large and to non-technical personnel at the MNE group. Also, such a document needs to be implemented or else such a Transfer pricing policies would be well drafted only on papers and not in reality.
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