Rethinking your transfer pricing approach under Pillar Two: A focus on operational transfer pricing

The new Pillar Two regulations have introduced additional challenges for multinational enterprises (MNEs) when it comes to managing and pricing their intercompany transactions. To avoid complex calculations and potential double taxation, it is crucial for MNEs to upgrade and enhance their operational transfer pricing (TP) processes.

Year-end TP adjustments under Pillar Two

MNEs often make year-end TP adjustments to align their transfer prices with the ‘arm's length’ principle, ensuring compliance with TP policies and international tax regulations. These adjustments are typically made after the closing of consolidated financial statements. Several factors can cause delays in the consolidation process:

1. Timing mismatches
   Local GAAP profit is usually finalised after the consolidated financial statements are closed. This can prolong the pricing process, especially when using methods like the Transactional Net Margin Method (TNMM) to achieve a targeted operating profit percentage.
2. Reflecting operational and economic changes
   Delays may occur due to the need to account for operational and economic changes that were not anticipated at the time of the transaction.
3. Internal process inefficiencies
   Delays can be caused by inefficient internal processes, such as finance and tax departments requiring extra time to gather data and calculate adjustments.

Despite some TP adjustments not being included in the consolidation process, they are typically included in local statutory accounts and tax returns for the given year. This often leads to discrepancies between the data used for consolidated statements and local statutory results. Such discrepancies can pose significant challenges in the context of Pillar Two, some of which are detailed below.

Additional compliance burden

Pillar Two relies on calculating an Effective Tax Rate (ETR) on a jurisdictional basis using income and covered taxes derived from the accounts used for consolidated statements. Year-end TP adjustments that are not included in the current year consolidation process can impact the Pillar Two calculations, potentially resulting in compliance difficulties. There is no clear guidance on how to treat year-end TP adjustments under Pillar Two, but it is possible that MNEs may need to reopen calculations from previous years in jurisdictions where there are significant decreases in prior period covered tax. This adds complexity to an already challenging compliance task.

Risk of double taxation

Year-end TP adjustments can also trigger double taxation under Pillar Two, depending on the evolving interpretation of the rules. If not properly addressed, a TP adjustment made in one country could lead to additional taxes in another country, resulting in double taxation. We have included an illustration of this scenario at the tail-end of this article.

Country-by-Country Reporting (CbCR)

CbCR data is now at the heart of Pillar Two's transitional safe harbour qualification, calculation and outcomes (as explained in the following article). As such, the approach an MNE adopts to CbCR compilation, including the processes identifying and gathering the necessary data elements, could have significant implications for qualification and outcomes under the Pillar Two CbCR safe harbour.

‘Late’ TP and related tax adjustments are often posted through the group accounts in the following year. This raises the question of whether the incorporation of those year-end TP adjustments into the current year CbCR figures derived from the consolidation process could undermine the CbCR's eligibility for the safe harbour. In particular, it is still unclear whether the incorporation of figures pertaining to the subsequent years' consolidation may be considered as not adhering to the principles of qualifying financial statements, and could prevent the group from benefiting from the CbCR safe harbour. It is, however, worth noting that a definitive position on this matter and on what exactly constitutes a ‘qualifying CbCR’ is yet to be established.

Would you like to know more?

We discuss the issues raised in this article in more detail on our TP Talks podcast. We also recently delivered a webcast focussed on Pillar Two preparation more generally, provide your details to access the session recording here.

If you would like to hear more about how we are helping our clients in this space, or discuss your organisation’s Operational TP requirements please get in touch with us directly, or speak to your usual PwC contact.

Double taxation - illustrative example

In Table 1, an example is presented where a multinational enterprise (MNE) has a low-tax jurisdiction (Country Alpha) with a principal and a high-tax country (Country Beta) with a limited risk distributor (LRD).

The LRD's target arm's length return is 4% on sales, achievable through a transfer pricing (TP) adjustment of GBP3,000 from the principal to the LRD. Without TP adjustments (Panel A), Country Alpha would have a Pillar Two top-up of GBP1,000. However, including the TP adjustments (Panel B) reduces the top-up to GBP970 (Panel C).

If no refund is granted for the excess top-up tax previously paid (GBP30), double taxation could occur, as the TP adjustment would first face a top-up in Country Alpha and then local corporate income tax at 25% in Country Beta.