An accounting concept called transfer pricing is gaining more attention from foreign governments seeking to regulate and tax multinational corporations (MNCs) to increase revenue. Transfer pricing is the pricing of goods, intangibles, financial instruments and services transferred within an organization across borders. As a result of this increasing interest, E&P companies are moving this issue higher on their list of concerns.

Ernst & Young’s global transfer pricing surveys over the past 10 years show that governments recognize transfer pricing as a field ripe for revenues and regulation. But much work remains to keep up with audit trends. This is particularly true for energy companies. Historically, they have had primarily tangible product intercompany transactions that are simpler to price and defend if they are audited.

That tax authorities are evolving in their approaches to transfer pricing may be a mixed blessing for MNCs. On the one hand, as governments take a wider look at companies’ overall operations, hone methods for audit case selection, and increase the nuance with which they are able to view specific types of transactions, the assumption is that companies with sound transfer pricing policies will go unscathed. However, high audit rates in 2010 (68% of parent companies) suggest that MNCs have plenty of reasons to remain vigilant.

Indeed, the growing likelihood of an audit has influenced energy companies’ behavior. Three of five energy companies responding to Ernst & Young’s 2010 Transfer Pricing Survey indicated that tax audit activities by governments have a high degree of influence on their companies’ transfer pricing compliance and documentation strategies. Some 95% of companies cited tax audit defense as a highly important objective when preparing transfer pricing documentation.

As the rate of transfer pricing audits increases, energy companies will have to present documentation that covers a wide view of their business and satisfies the competing demands of different tax jurisdictions.

Furthermore, as authorities expand their transfer pricing knowledge and resources, they also develop more specific expectations for taxpayers. Companies have seen record penalty rates, which have reached one in two for every adjustment among respondent companies, or for which the outcome of the examination is still pending. This indicates that authorities are growing more earnest about enforcing the regulations and specifications that they publish. More stringent requirements for comparables have turned profit-based methods, which were once considered “methods of last resort” in many jurisdictions, into preferred methods across a number of regimes. In fact, the profit-split method was cited as the most frequently applied method by taxing authorities when making adjustments.

Similarly, authorities have developed different expectations for local and regional comparables sets, and MNCs should increasingly expect to prepare both for robust documentation. Although authorities are cooperating more with one another, this does not mean that they have agreed on how to enforce transfer pricing. This disconnect creates complications for MNCs.

Multinational energy companies certainly have taken notice of this growing complexity. Ninety-four percent of energy companies surveyed by EY in 2010 believe that transfer pricing is very or fairly important. Three of four recognize transfer pricing as the single most important tax issue faced by their company. Four out of five believe it will be absolutely critical or very important in the next two years.

It is no surprise, then, that energy companies have responded by increasing investments in internal and external transfer pricing. For example, almost half of respondents report plans for a modest or significant increase in internal headcount associated with transfer pricing in the next two years. Regular assessments of transfer pricing-associated risk are more prevalent as well, with 72% of 2010 survey respondents conducting a transfer pricing policy risk assessment in the last four years.

In summary, high audit rates, as well as rapid change and development within tax regimes, mean that MNCs will need to be nimble in their approach to transfer pricing. They will have to present documentation that covers a wide view of their business, and satisfies the competing demands of different tax jurisdictions. Accomplishing this in an environment of economic turmoil and business change is no small feat.

Documentation

When the U.S. first issued the temporary and final Section 6662 regulations in the mid-1990s, it was the only country requiring MNCs to document their intercompany pricing methodologies. Today, almost 50 countries have documentation requirements. Over the last 10 years, tax authority rules and expectations for documentation have shifted as more governments have evaluated what they expect to see in transfer pricing documentation. These changes are most relevant in terms of the methods and the comparable sets that tax authorities prefer.

In the early 2000s, many countries endorsed transactional methods, which evaluate individual intercompany exchanges of goods, services, or intangibles and compare them to similar exchanges between unrelated parties. Authorities often believed these to be more reliable than profit-based methods, which evaluate intercompany transactions based on the financial results of the parties involved.

However, the problem with transactional methods lies in the availability of data on third-party transactions that are sufficiently similar to the transactions under review. Companies rarely make the details and terms of their pricing public, and throughout the decade, tax authorities that had been reluctant to use profit-based methods started to turn to them as a result of the dearth of transactional data. In fact, by 2010, the profit-split method was employed by taxing authorities to make adjustments more often than the cost-plus method, a switch from survey results of just three years ago.

As authorities have questioned which methods are the most reliable, so have they raised new concerns about the selection of comparable data. With the use of profit-based methods on the rise, focus has shifted to how local comparable sets must be. Tension on this issue first became evident around 2007, when about a quarter of respondents indicated auditors had required more local comparables.

As most parent companies have opted for pan-regional sets in some form since 2007, this presents a significant area of exposure for MNCs. Even so, jurisdictions differ in their requirements for regional or local comparables. The lack of local comparables was the most common reason that auditors rejected parent MNCs’ documentation in 2010, and almost 33% of audited parents were required to augment their analysis with a local set of companies.

Therefore, MNCs may find it necessary to maintain both regional and local sets for the foreseeable future.

Integrated oil and gas companies have historically documented their transfer prices for crude and gas using public indices, which have been readily accepted by taxing authorities as market prices, and have not been subject to much controversy. However, oil and gas companies are focusing more on services, intangibles (such as intellectual property) and financial transactions when they put together documentation.

Documentation efforts are complicated in the energy industry because energy companies are increasingly working in new-frontier countries where comparable pricing benchmarks may not exist. As such, comparables from countries with widely available benchmarks (with adjustments for the economic and political risk in the new-frontier countries) is an approach that has been used very successfully by oilfield service companies.

Given the international nature of the energy industry, transfer pricing coordination is a must. The larger companies in the energy industry have put together documentation in 30-plus countries, while the smaller companies have documentation studies in five to 30 countries, depending on their global footprint.

Documentation strategy among energy companies reflects the importance of risk management and preparation for transfer pricing controversy. Survey respondents indicated that their top three priorities in preparing transfer pricing documentation are risk management (81%), audit defense (62%) and the consistency of local country documentation reports (40%).

Audit activity

In keeping with the growing level of attention that tax authorities are paying to transfer pricing issues, audit and adjustment rates have risen since 2001. At the beginning of the decade, 59% of MNCs reported that they received an audit somewhere in their organization. By 2010, 68% of parent companies reported undergoing transfer pricing examinations. What’s more, the penalty rate had risen fivefold since 2005, from one in 25 adjustments to one in five.

The types of transactions most commonly audited have also shifted with tax authorities’ perceptions. Tangible assets, measurable against public indices, have historically constituted the largest volume of intercompany exchanges for MNCs and were the most commonly audited until 2005. After 2005, audit rates for services, intangibles, and technology cost-sharing started to rise.

In 2010, MNC parents perceived administrative and managerial services, intercompany financing, technical services, and the licensing of intangibles as the most susceptible to audit. By this point, audit rates for service transactions had climbed from 55% in 2007 to 66%. The reason for the shift in audit attention is twofold; the facts surrounding transactions for services and intangibles make them appear more suspicious to governments, and MNCs tend to lack robust documentation for these transactions.

While the most-developed transfer pricing regimes once posed the greatest audit risk, MNCs increasingly find themselves beset from all sides. Mature transfer pricing regimes, particularly in the U.S. and Germany, still have the highest rate of audits, but countries with newer regimes, such as China and India, have quickly ramped up their audit levels. Recent surveys with worldwide tax authorities confirm that most governments have been expanding their transfer pricing resources, and young regimes are no exception.

Energy company survey respondents indicated a host of countries have examined transfer pricing in the last five years. Though exams have become more frequent and occur in more countries, taxpayers have had good outcomes. Slightly more than half (55%) of companies with audits have come out with no adjustment. Among companies that have faced adjustments, penalties have been imposed in about half the audits and interest in two-thirds.

In the oil and gas industry, the transactions which are seeing a lot of audit scrutiny are the provision of services and the transfer and use of intangibles. In fact, three of four companies reported management/administration services as the most significant transaction subject to examination, and just over half cited intangible licensing or cost-sharing.

The oilfield service companies have been under audit in a number of global jurisdictions. The primary issues tend to be the profitability of the affiliate providing the service in the various countries, the lease rate charge for tools, the mark-up over costs for the manufacturer of the tools, and the royalty rate used for the license of technology (if priced separately from the value of the tool).

The drilling companies are undergoing audits in relation to bare-boat charter rates and the return to the rig owner compared to the operator. One of the drilling companies is in tax court over a transfer pricing issue.

Cross-border complications

Governments’ growing sophistication in the area of transfer pricing has given MNCs reasons for concern as well as possible sources of relief. While governments are coordinating transfer pricing examination efforts, they are not reaching a consensus on how to enforce transfer pricing. However, dispute resolution processes are becoming more efficient.

More countries are also connecting their tax and customs administrations, albeit with varying levels of clarity and agreement about priorities. Similarly, multilateral initiatives compel tax authorities to cooperate and share data across borders. Taxpayers will face increasing visibility into their operations and, likely, more and conflicting guidance from a variety of authorities.

Fortunately for taxpayers, authorities’ increased attention to transfer pricing has also resulted in a greater investment in controversy-management procedures. Both advance pricing agreement (APA) and competent-authority processes have been streamlined, and satisfaction levels with APAs remain high. These and other mechanisms allow MNCs to work with tax authorities to set transfer pricing policies up front and dispute adjustments retrospectively.

Energy companies are facing more scrutiny from tax authorities around the world, and companies are responding by compiling more detailed transfer pricing documentation. This trend of increased audits is growing for all MNCs, as governments worldwide are trying to raise their tax revenue through transfer pricing adjustments.

Mark Camp is Ernst & Young LLP’s Southwest sub-area transfer pricing leader. Purvez Captain, Ph.D, is Ernst & Young LLP’s Americas leader for transfer pricing and economics. Both are based in Houston. Carrie Patel was a senior staff member in Ernst & Young LLP’s international tax and transfer pricing practice at the time the article was written. (The views expressed in this article are those of the authors and do not reflect the views of Ernst & Young LLP or any other member of Ernst & Young Global Ltd.)