International growth and transfer pricing: corrections, obligations and opportunities

When your company expands its operations to other countries, there are several ways you can do business. You could, for example, simply supply products or services to foreign customers from the Netherlands. Or you could establish a foreign legal entity and do business with foreign customers from that entity. Business activities sometimes lead to an intermediate situation without a legal form: the permanent establishment. When a foreign entity or permanent establishment is involved, it is essential to determine which portion of the profits are taxable in the Netherlands and which portion in the other country. You need to set an arm’s length price for the transactions between the Dutch company and the foreign permanent establishment or legal form. This is done using transfer pricing.

Transfer pricing: correct profit allocation

In commercial transactions with third parties, arm’s length prices and terms and conditions are generally agreed automatically. It is not in any of the parties’ interests to grant discounts not in line with arm’s length pricing or to pay an excessively high non-arm’s length price. The situation may be different for affiliated parties. To a certain extent, you are able to determine for yourself the price at which you supply a product to your foreign sales entity or the interest rate you apply when granting commercial credit to your foreign permanent establishment.

Without transfer pricing (TP), it would be possible for a company to unilaterally determine where the profits are realised. A company could then opt to report expenses in a country with a high tax rate and all the profits in a country with a low tax rate. Yet this would not reflect economic reality. For this reason, tax authorities require profits to be determined at arm’s length: as if the two parties unaffiliated to each other.

Transfer pricing aims to determine what an arm’s length price would be for transactions based on an analysis of the facts and circumstances. What price would an independent third party charge? Under which terms and conditions would you borrow or lend money? By applying transfer pricing, you calculate the arm’s length stand-alone profits of a Dutch or foreign group company. This enables you to establish which profits belong to which company based on the transactions and function and risk profiles.

Make sure you are clear about transfer pricing in advance

It is especially important to be clear about your transfer pricing position when your company is growing and you are expanding your operations to another country. The arm’s length principle has long been enshrined in Dutch law, with the international TP guidelines acting as a template. Additional obligations have recently been introduced at both a national and international level.

The first step is to determine the ‘function’ of your Dutch company and of the foreign permanent establishment or legal form. Which activities take place there and how much discretion does the local management have when it comes to decision-making? Where does the tactical management lie and where the operational management? The division of authorities and risks will contribute to determining the function and risk profile of the Dutch and foreign business. It is advisable to consider these aspects carefully in advance and record the decisions - and arguments supporting them - clearly.

The actual activities of the foreign company also play a role in determining the transfer pricing method. Does the local entity only make sales, receiving a percentage of these sales as remuneration? Or is contract manufacturing involved, with the Dutch company in fact issuing instructions and bearing the risks itself? In this case, a different price is often appropriate, for example a fixed percentage on top of the costs (cost-plus method).

Make sure you have comprehensive documentation

Once the division of functions and risks is clear, it is possible to determine which transfer pricing method is appropriate for each type of transaction. For limited riskers (entities that only run a very low entrepreneurial risk themselves, such as internal service providers or certain sales offices), a premium on top of the costs or sales-related agreement may be an appropriate general method: the entity receives a percentage of the costs or external sales as remuneration. In other cases, it might be necessary to determine an appropriate price for each individual transaction. For instance, by performing a benchmark to determine the interest rate and terms and conditions of intragroup loans. It is important to record these decisions and the arguments supporting them carefully. Make sure you document, for example, the function description with regard to the risks that need to be managed. Also make sure that there are contracts to enable classification of money flows, such as loans or commercial credit lines. The most appropriate profit allocation method can be determined based on this documentation.

For smaller businesses, there is no prescribed format for transfer pricing documentation in the Netherlands. It is usually enough simply to demonstrate the reasonableness of the decisions and methods used. However, if you are unable to provide the Dutch Tax Authorities with this documentation within a reasonable timeframe when requested to do so, they may adjust the profits. This can result in a higher tax payment and occasionally even double taxation. The division of the burden of proof means that it is often difficult to appeal successfully against such adjustments.

Additional obligations apply to larger groups. It may be mandatory to provide a Local File and a Master File that describe and substantiate all the classifications and TP methodology. Groups with a consolidated turnover of €750 million or more must also submit a Country-by-Country Report.

Is your company growing? Keep reviewing your TP!

There may come a time when the activities in the other country take on a different form. For example, when you open an actual branch or when the local management is given greater responsibility. This can have implications for taxes, such as VAT, wage taxes and corporate income tax, but transfer pricing also plays an important role here.

What happens to existing customers who used to be served directly from the Dutch business? Are they transferred to the new location? If so, this may involve a transfer of value and you will also need to consider the arm’s length aspect and tax implications for pricing and profit determination. The tax authorities are extremely alert to these matters, just as they are on the transfer of intellectual property (IP) rights within the group. Although this may appear to be an internal matter, it is important to ensure the arm’s length nature of such transactions.

Logistical changes may also impact your transfer pricing position. Switching from the external warehousing to storage in your own warehouse in another country may lead to a shift in risks. This may mean that a higher payment is appropriate for the foreign entity.

You will also need to consider transfer pricing aspects if local management is given more or different functions. Does this alter the established function of the foreign entity and does this have implications for the transfer pricing methodology and profit determination?

Even minor changes can have implications for your TP position or even offer opportunities for streamlining or optimising operations. By keeping a close eye on your transfer pricing, you ensure that the profit allocation is correct and keep discussions with the Dutch and foreign tax authorities to a minimum.

The right set-up for your administrative systems

The application of transfer pricing should result in the correct profit allocation. If the prices used within the group are not arm’s length prices, retrospective corrections may be required. Using logical invoicing and money flows from the start, in line with the applicable TP methodology, will result in few or no corrections to the transactions recorded in the books being required at the end of the year. General corrections may however be necessary if the profit level deviates from what may be expected based on the documented function and risk profile.

How can we assist you?

Our transfer pricing specialists would be happy to help you map your transfer pricing obligations and explain how to document the applicable methodology. Based on a thorough analysis of your business, including your plans for the future, we can help you maintain a clear view of your position. This may also lead to valuable insights into your business operations, such as potential business and finance-related risks and opportunities for optimisation. Wherever necessary we work together with trusted advisors within our global Baker Tilly International network to make sure you can remain in control of local compliance as well.

Would you like to know more about the importance of transfer pricing in relation to international growth? Please do not hesitate to contact our Transfer Pricing Desk!

The legislation and regulations in this area may be subject to change. We recommend that you discuss the potential impact of this with your Baker Tilly advisor.