Legal form and economic substance are ideally aligned with each other. If this is not the case, as has historically been the case in some aggressive tax structures, this begs the question what prevails. In this blog we will explain these concepts in more detail and how to deal with this if you would like a sustainable transfer pricing policy.
Understanding legal form
When we say “Legal form” we refer to the formal and legally recognized ownership of assets within a corporate structure as well as contractual agreements, including intercompany agreements, that specify ownership, legal rights and obligations.
As an example of an historically aggressive structure in which the legal form concept is (mis)used;
- A multinational may register a brand or intellectual property in a jurisdiction with favorable tax laws.
- The legal form dictates that this entity is the official owner of the asset, enabling other entities within the corporate group to pay royalties or licensing fees to this entity.
- These payments are typically deductible from taxable income in higher-tax jurisdictions, thereby reducing the overall tax liability of the corporate group.
Another example relates to when an entity is included within the legal structure with as only or main goal to reduce withholding taxes (on dividends, interest or royalties).
The legal form is, historically, often utilized in tax planning strategies to optimize tax liabilities. However, relying solely on legal form, without keeping the underlying economic activities in mind, likely results in tax audits and related adjustments and fines and maybe even legal challenges for directors (next to the cost of the audit itself for your organization and related advisors). There has, rightfully, been quite some development in this field in the past ten to twenty years and what may have worked then does not work now.
The focus of economic substance
The concept of economic substance emphasizes the need to consider where and how business operations are conducted. This includes:
- location of core activities: Determining the geographical location where the company’s core activities are carried out.
- value creation: Assessing who is responsible for the development, enhancement, maintenance, and protection of key assets.
- management and decision-making: Identifying where the critical business decisions are being made and who is making them.
Most jurisdictions prevail substance over form but may challenge you as well if the legal form does not match the financial outcome and that outcome would be in their favor.
Sustainable transfer pricing policies
A sustainable transfer pricing policy aligns economic substance and the actual activities taking place in a certain jurisdiction with the legal form, intercompany agreement(s) and further documentation. In addition, it makes sure this matches with the financial results of the respective entities and can easily explain the related financials.
In addition, it takes account of the strategy of the respective MNE and already creates flexibility towards the direction the MNE may develop. The storyline matches with actual substance and the related financials. The policy is therefore easy to explain, even in Public CbCr related settings.
In addition, it should take account of potential custom duties and withholding tax impact and transfer pricing regulatory developments (for example Pillar 1, Amount B) as well as country differences (e.g. Brazil, China and India may require a bit different approach in comparison to western-European jurisdictions).
In contrast of aggressive tax structures, we often see that existing transfer pricing policies are non-compliant but also lead to a much higher tax burden than a compliant policy would. This is often caused by not giving sufficient attention to the topic or not having the right expertise involved.
Conclusion
As global tax regulations continue to change and grow, you must ensure that your legal structures and economic activities are closely aligned and has the appropriate substantiation. transfer pricing risks comes, for example, likely up as a topic in a due diligence and the overall cost of not being in control is much higher than organizing that all matches well.
Companies that fail to adapt their strategies may find themselves at a competitive disadvantage, facing legal challenges and maybe even financial penalties. By developing and maintaining a sustainable transfer pricing policy businesses can achieve long-term success.
Would you like to improve or check your transfer pricing policy or processes but are you not sure where to start? We offer strategic sessions for a limited fixed fee in which we examine your current situation, brainstorm with you on potential improvements / attention points and summarize suggested next steps with a related prioritization. Upon your informed decision, we can support with such steps (in a light or full manner) or you execute these with your existing resources.
Please reach out to hello@quanteragobal.com or m.verhoeven@quanteraglobal.com if you are interested in knowing more.