With the turn of the new year and many organizations now knee deep in their own year-ends, it’s possible that tax and finance departments are once again grappling with last-minute transfer pricing adjustments.
In taxation and accounting, transfer pricing refers to the methods organizations use for pricing the transactions that take place within and between the enterprises they control. This can include the organization’s divisions, subsidiaries, holding companies, and other such entities.
Although many organizations strive to maintain fair and transparent transfer prices, sometimes these yearly last-minute scrambles can lead to inter-departmental friction. If the finance, tax, or transfer pricing department determines that retroactive adjustments need to be made to an entity’s prices for the prior year, it can throw a serious wrench into the plans that the entity’s director had already made based off a different profit and loss scenario.
Retroactively changing the prices charged by a given entity for the whole prior year can have wide-ranging impacts, so when corporate finance departments fail to sufficiently coordinate with the managers of these entities, a whole new set of problems can come to light.
Transfer pricing changes can affect employee compensation
Last-minute year-end changes can certainly throw off a subsidiary’s plans for the next year, but they can also impact the compensation that executives and operations directors receive. If decisions about transfer pricing and tax liabilities are left until the last possible moment, managers who are paid a portion of their remuneration on the basis of their division’s profitability may be disappointed with the new year-end calculations. All of a sudden, that big bonus they had planned for may be washed down the drain.
As the Association of Chartered Certified Accountants (ACCA) explains, “As well as transfer prices needing to be set at a level that maximises company profits, they also need to be set in a way that is compliant with tax laws, allows for performance evaluation of both divisions and staff/managers, and is fair and therefore motivational.”
The challenge for multinational organizations is that tax reporting and transfer pricing processes are managed centrally. But as ACCA further points out, “if divisional performance is poor because of something that the manager and staff cannot control, and they are consequently paid a smaller bonus for example, they are going to become frustrated and lack the motivation required to do the job well. This will then have a knock-on effect to the real performance of the division.”
PwC agrees that there may be a significant influence on the actions of managers who are remunerated by a bonus linked to local company operating profits: “A change in a group transfer pricing policy that fails to recognise the impact that may be felt by individual employees may not bring about the behavioural improvements management wish to achieve.”
Contributory factors to uncertainty
Two of the biggest reasons that lead to year-end uncertainty and eleventh-hour price changes are the lack of proper planning and coordination that should happen throughout the year. And it is the tools that are used that may be to blame. Many large multinationals continue to use manual methods and spreadsheets to manage their tax planning and transfer pricing. This, in turn, makes it difficult for transfer pricing teams to maintain proper visibility into how each subsidiary is tracking throughout the year against its expected profitability targets. The result is a year-end scramble once all the finance numbers are finalized.
One driver for this situation is that there is a relative underinvestment in effective software to provide visibility into how all subsidiaries are tracking against their targets so that the price updates can be made much earlier and communicated with directors. The software underinvestment is especially true when compared with expenditures on central accounting and enterprise resource planning applications.
On top of that, the often-overwhelming workload faced by tax and transfer pricing teams means that there are few spare hours in the day to undertake anything but basic transactional activities. Although an ideal approach would be to undertake monthly and quarterly trial balances in advance of year-end to gain visibility and transparency, a recent poll undertaken by insightsoftware at a webinar with tax professionals found that this strategy is often not utilized.
Most of the webinar attendees (70 percent) reported that they do not undertake pre-close provision calculations in this way. Just 10 percent carry out mid-December trial balances, while the same proportion calculate November actuals and one-month forecasts. A further 10 percent calculate October actuals and 2-month forecasts.
Another problem for tax and transfer pricing teams is that they are asked to work with constantly changing data. In an earlier insightsoftware webinar, tax professionals were asked to name their biggest challenge/concern when carrying out their duties. The responses were as follows, demonstrating the many difficulties tax teams have when receiving forecasts and reforecasts from finance:
- Confidence in the forecast effective tax rate (11%)
- Quality of the finance team’s reforecast (42%)
- Struggling to keep up with numerous forecasts (25%)
- Being able to forecast corporate liquidity requirements (8%)
- Challenges with remote access to people/data (14%)
The fact that so many tax, transfer pricing, and finance teams operate in silos means that poor communication channels between them—to say nothing of those with entity managers—intensifies uncertainty in year-end numbers. In turn, this exacerbates potential disappointment for those managers with expectations for a healthy annual bonus.
How to establish best practices
If an organization finds that its annual bonuses are often impacted by last-minute transfer pricing changes, they would do well to rectify their processes to avoid perpetuating any negative fallout among their employees. The best solution is to follow the clear set of steps below to improve transparency and visibility into P&Ls throughout the year, then having time to coordinate with all parties to set expectations. This avoids having to wait until the last moment to confirm numbers and potentially demotivate valued regional leaders.
1. Consider implementing tax and transfer pricing software
Finance, notably tax, is one area of business that can most benefit from automation, while operational transfer pricing (OTP) is a process ripe for modernization. There are many advantages of using software built from the ground up to manage tax and transfer pricing. An important one is that it increases both visibility and confidence in final numbers, so that OTP teams can coordinate with
finance and business unit teams to make well-informed decisions earlier on and throughout the year, rather than those large year-end adjustments.
2. Establish clear methodologies for how tax is calculated
With multinationals set to experience more scrutiny in the way in which they manage tax and OTP processes, there is more than one reason to set out a record of how they have been handled year-on-year—beyond reducing those end-of-year surprises for entity managers. Dedicated software, like Longview Tax and Longview Transfer Pricing, includes process maps, which make it easier to capture and track relevant data.
3. Build better relationships
Instead of just exchanging basic numbers at year-end with colleagues over email, it helps to connect more with the individuals involved in managing the different entities, including any regional finance managers. By having conversations about material events or changes that various entities have experienced, tax, OTP, and central finance teams will be better prepared for the anomalies that emerge as final numbers are calculated.
This friendly coordination can be combined with financial incentives to serve as two powerful carrots to engage and retain top performers. End-of-financial-year bonuses that are aligned with agreed-upon KPIs are important elements of those incentives, so it is vital that leadership teams remain aware of the potentially negative impact that last-minute calculations can have.
Find out more about how you could use Longview Tax from insightsoftware to reshape your tax function. Book a demo, or drop us a line.