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The Problem with Profit Shifting, Part 2

The Problem with Profit Shifting by Doug Darling

Mimi Song: Look at Coca-Cola. So I don’t know if you were paying attention to the specifics of the case with Coca-Cola, but they were hit with over $3 billion of adjustments per year.  

That’s over three years, that’s $9 million worth of an adjustment and true story, again, my friend called me and transfer pricing has always been one of those things… I don’t know about you, Doug, all my friends are like, “What is that? What do you do?”  

Doug Darling: Yeah. I’d like to, I think people see it as even people within the organization that aren’t in transfer pricing. They it’s the dark arts”… maybe because it all goes on behind the scenes. 

Mimi Song: That’s right. Nobody really knows exactly what you’re doing. 

Doug Darling: Nobody knows what you’re doing. And so it’s a bit, I’ll let you finish, but it’s it, it’s very simple. Once you break it down into its principles, 

Mimi Song: It is, the principles are simple.  

But my friend called me and she said, Hey, I read about Coca-Cola.” She’s in equity research. And Coca-Cola is one of her companies. And she actually asked, I saw this issue that Coca-Cola was hit with the transfer pricing adjustment, tell me about it.  

And I said, Oh, all right, I’m ready to do this!” Like I was able answer her questions  

Doug Darling: You really want to get into this…”  

Mimi Song: Yeah. I’m happy to tell you exactly what it is. And because it has implications for the market.  

Market perception of the business, it impacts their profitability. I mean, these are billions of dollars in adjustments. 

Doug Darling: It labels them as a bad corporate citizen and whether it’s true or not, you do not want to be known as a bad corporate citizen. And that gets really played up in the media a lot. That’s just been my observation. 

Mimi Song: Yeah. Well, I think, interesting aspect about the case with Coca-Cola is the challenge in terms of who was doing what and how was the allocation of profit being distributed across each of the contributors to the transaction. And so there was a question about the profitability of certain routine entities. 

Doug Darling: Right. Unusually too much. 

Mimi Song: Well… unusually profitable for…. 

Doug Darling: Unusually profitable for “routine.” 

Mimi Song:  And the general public may not grasp that fully, but I think it says they understand routine enough to at least get the gist of what’s being said.  

Doug Darling: Sure that it’s sort of every proportion is disproportionate. Exactly. And I think, I I’m, I’m curious, Doug. I mean, if you were to advise your clients, what would be some best practices for your functional analysis in this, in this postBEPS environment, any particular suggestions you might make there? 

The first thing that comes to mind is invest in frequent robust, functional interviews. I know that’s a simple answer, but you’ve got to be able to understand the profile function, risk, and asset.  

And there’s a couple ways to go about that. And I think one is just good old functional interviews and talking, asking questions about this, and about that and changes and try and pinpoint any changes. But, but there are other ways of doing that.  

And I learned this in one place I was at, it very much not just that, in addition, when you have certain metrics such as head count. When you see head countin certain areas, fluctuate in an entity like R&D

All of a sudden you see an entity with the head count in R&D drop over. That should be a signal that maybe they’re just so doing more routine functions. Now they may have been doing true R&D innovation, but this warrants a closer look, do we need to look at their profitability based on what we’re learning. 

So there’s a couple ways to go about that functional analysis. And I think we’re always focused on, I always had been on, you know, just talking to people then that’s an art form really is because people act suspicious. 

Mimi Song: Well, I was gonna say, yes, they always get a little bit defensive talking about their jobs. Don’t theyDoug? 

Doug Darling: Yes. You’re like if you’ve seen the movie Office Space, so that’s the two Bobs, they’re coming in all the time.  

Mimi Song: And I say that all the time!  

Doug Darling: And I get that a good interviewer will put that to rest and there are ways to go about it. But I also find that most people, once you get over that they like talking about themselves in their jobs. So it is an art form and not everybody’s good at it. And whether you outsource that, I think that’s a worthwhile investment when you choose your outsourcing dollarsI think that’s usually a wise area. 

Mimi Song: When I think about the functional enough office process and the need to actually get buy-in from the various stakeholders within the organization on a real-time basis, I always tell people, I always think about it as this needs to be part of the fabric of the organization.  

Transfer pricing should not be treated as a second marriage.? I don’t, well now maybe that’s not the right.  

Doug Darling: … A second class citizen? 

Mimi Song: Yes, that’s right! It shouldn’t be considered an after that. It should be part of the business activities, the normal course business activities.  

And if the stakeholders understand that this is really important to mitigating the risk for the overall organization, then they can appreciate the delicate nature of what the transfer pricing story is telling the tax authorities and really help to identify key areas, on a real-time basis, so that the functional interviews are not drawnout, lengthy, hourlong fact pattern discussions, but more so 15 minutes, right? It’s an evolution of the business. 

Doug Darling: Yeah, agreed. 

The ideal situation is where the transfer pricing team is plugged in to the different areas of the business. And that’s a relationship building that’s trustability, and then it takes time. So that functional understanding, I don’t want to say interview, but just functional understanding process. Point being it should be an ongoing thing. 

Mimi Song: It should be an ongoing exercise. 

Doug Darling: Should be give and take in a lot of ways. And that takes effort on both sides. And it takes an investment in time and in helping the business divisions, commercial, understand why it’s important and hopefully, and hopefully you’ll get some reciprocity that you’re more likely to have former understanding, accurate understanding of your functional profiles.  

If you do that – and I’ve seen it yet work, I’ve seen it both ways whereplaces I’ve been, I’m actually seeing where it’s just a real challenge, a real struggle. And a lot of that is with your BP attacks is also buys into the importance of transfer pricing. They understand the value of it and the dollars involved. And they’re not just, you know, an accountant type looking to do compliance. 

Mimi Song: Right. And in my experience, what I tend to see is that organizations that have been challenged. And one of the areas that maybe they’ve been a challenge and audit on would be the choice of the transfer pricing method that was applied. 

So when they’ve been audited like that and been picked on and by the tax authorities, you tend to see that the business then starts to focus on transfer pricing and understands the implications of not having the appropriate policies in place, the appropriate documentation in place, the appropriate level of investment from the various stakeholders internally. 

Doug Darling: Yeah, no, absolutely. A… a smack in the hand, it usually just gets your attention…. 

Mimi Song:  Yes. That’s a good way to put it.  

Doug Darling: It may be even worse than a smack in the hand, but then you’re absolutely right. I mean, those that are still kind of operating that real siloed environment where the transfer pricing group is just – I’ve worked at such a place – is, just, is not plugged in.  

Let me say they probably haven’t been hit hard with transfer pricing, penalties, questions, issues, confrontations. And usually when brought up, they, they had the typical answer I’ve always heard, “Well, our audits have been fine!”  

Okay. Well, you’ve been lucky maybe, and maybe knock on wood and maybe you have your ship in order, but I don’t think you really know whether you do, if you’re not on this constant understanding of your function and risk and asset profiles. You’re hiding your head in the sand if you’re not, and it’s only, it’s only a matter of time, unless just by chance, you’re fine. And you just, just don’t know it. 

Mimi Song: Yeah. Most tax authorities, I think their audit practices are to try to rotate through as many companies as possible and make it as random as possible while at the same time, clearly focusing on companies where they see that there’s an opportunity. Right. So certain characteristics, shall I say, of, of a business 

Doug Darling: Maybe like, IP rich? 

Mimi Song: IP rich. Yes. It may trigger an audit 

Doug Darling: The life sciences area, the whole life sciences pharma. Yeah…. 

Mimi Song: Well, especially after the pandemic. RightI think 

Doug Darling: That’s, yeah, that’s it, that’s an interesting point. What will develop there? 

Mimi Song: Exactly. And I think right now, if I’m not mistaken, the administration actually in the US for example, thinks that there’s nearly $90 billion of losses in the US alone related to, of course, once again, profit shifting in their elite…. 

Doug Darling: I see that number. And I raise my eyes, but … HeyI can’t disprove it. Right? 

Mimi Song: But it’s to your point, Doug, of IP rich companies, companies that have valuable and tangible assets I mean, what are the things you think that they should be mindful of in anticipation or knowing that the IRS is focusing companies like them and knowing that the number that the IRS is already thinking about is $90 billion of shifted profit? 

Doug Darling: Okay. Kind of circling back around is, is really thinking long and hard about any transfers of such intangibles. I mean, not saying don’t do it, but it requires much more scrutiny, much more thought, much more investigation. 

Mimi Song: There needs to be a much, a valid reason to do that. 

Doug Darling: There has to be that, that business purpose and developing that business purpose now becomes all the more critical. 

Mimi Song: You were at a medical manufacturing company before. And the reason I bring that up is there was a project I had also done for a medical manufacturer – not the same one, by the way.  

Doug Darling: I think we would have known that… 

Mimi Song: [Laughs.] But yeah, but the project I had dealt with at that time was actually the valuation of IP to, to be able to move that IP from a newly acquired company, into the caution, into the existing cost sharing structure, cost sharing was pretty prominent in this space. And during this time in that whole right. And, and I’m wonderingbecause it’s a newly acquired company to create less complexity from an intercompany dealings perspective, isn’t that a valid reason for perhaps migrating IP? 

Doug Darling: Yeah, I think it can be absolutely valid [reason]. I think you’re going to have to make it as robust as possible. I think it’s absolutely a valid [reason] mean, any gain of business, operational efficiencies, it was potentially a valid business reason. This is where our customer base really is or whatever. 

Mimi Song: Right. This is why we acquired this businessThere were certain efficiencies to be gained with this new product line that intertwines with our existing product line. And it doesn’t make sense. How are we going to like bifurcate between the two? 

Doug Darling: And this is where these functions would normally sit. So by default, why would we put them into anywhere else?  

So that’s an area that you, you, you definitely have to be focused on and invest in the time and the thought to develop that business, or that business case. And again, with all these things in place, I can check all the boxes. And I don’t know, I don’t have an issue doing itor being part of it or advising, but you have to have all those boxes checked and not halfway. 

Mimi Song: I think one of my favorite questions, at least from a transfer pricing perspective is: Why? Why did you do that, right? Or why did that happen? Or how did this actual intercompany dealing occur? It’s the simple question of why. 

Doug Darling: And, and I’ll tell you: there’s always more reasons than just, “Well, because we want the profit over there.” 

Mimi Song: And then that’s never the first reason. 

Doug Darling: Is that it’s never… I’m sure it crossed the mind. Sure. 

It’s the natural [choice], but that doesn’t mean it’s your motivation. And so I do believe to dare, like I said, supply chain now where things are manufactured. For example, one thing we experienced had kind of gave the pandemic was where I saw this all one place was computer equipment and micro motherboards and stuff that were made in China that supply dried up just because they weren’t, they didn’t go to work.

I mean, there was a time there that nobody was allowed to go to work. So that whole supply chain of getting your motherboards from there had to be changed. And so, that’s a valid business reason and you better lean on it. If it also results in some like maybe some incidental moving of profitability. 

Mimi Song: Yes. It’s incidental, but it’s much it’s necessary. 

Doug Darling: It’s necessary. It’s not just, you know, nice to have, if you want your business to survive, you have to do that. That was one consequences. And it had other domino effect consequences, but that’s certainly something you would definitely want to lean on and develop and lock down if some sort of rearranging of profitability in jurisdictions, that wasn’t the intent. 

Mimi Song:  Right. And I think the pandemic has clearly … we can’t stop talking about it. Right? Because it’s had such farreaching implications.  

And we know for example, that because of the pandemic, every government has responded differently and all these different tax authorities, they are not collecting the same tax revenue that they were historically. 

Doug Darling: Because, and we’ve seen it, I’ve seen it personally and in entities profitability are down, all over the board… 

Mimi Song: Right. And they’ve, they’ve been helping taxpayers with various programs 

Doug Darling: Grant subsidies and yep. But yeah, I think that’s right. There’s going to be some sort of rebound effect about it. I just, I can’t visualize what it is yet. I haven’t really thought that much, but for every reaction there’s an opposite reaction. So somehow that’s going to bounce back a different way.  

Mimi Song: Well, of course someone has to pay for it. [Laughs.] Somebody has to pay for it. The question is who is that? Somebody at this moment in time, and, you know, I listened to the OECD inclusive framework meeting, the 11th meeting, which happened in January.

And while the focus is on economic recovery there, all of these countries are full steam ahead on this notion of, “We all need to make sure that everyone is achieving and allocating their fair share of tax. And we need to increase multinationals tax morality.” 

Doug Darling: That’s your point tax morality. They’re the judges of tax morality. 

Yeah… I’m not a big fan of the word fair. I mean, “fair share means different things to different people. I believe it! I believe in fair share, but not how somebody else may define it.  

You know, I, I do think people should pay what they owe. This is what they’re obligated to pay, whatever it is. But that definition of fair share does it always is a knowledge that isn’t inconsistent across the board. So, you know, when you say fair share, not you personally, but when someone says fair share, I got to ask, what do you mean by that? Really? What… How are you shading that? 

Mimi Song: Well, I think that’s the challenge. Right? Cause everybody would define that fair share differently.  

Doug Darling: No, absolutely. Absolutely. And, and so, you know, I don’t think there, you know, what is fair share? I don’t think there’s a single answer. It’s that simple, but I certainly think I understand what, like the OECD thinks it is. And probably doesn’t jive with mine 

Mimi Song: [Laughs.] Just saying, that’s why you’re not at the OECD, Doug. Well, you know, yeah. 

Doug Darling: I’m not sure I’m a fan favorite thereThey haven’t invited me to many things 

Mimi Song: Well, hat may be the sentiment for a lot of different professionals in the space. I do have to say, I think the work that they’re doing is, is tremendous. And it is, there is so much communication happening. It’s impressive.  

Doug Darling: It is impressive. As quickly as they got the initial BEPS done people pick a couple of years 14 or 15 people, who were scoffing it, you’ll never get it, you know, such a consensus. And so I do believe they can move very rapidly.

And therefore the reaction time for the multinationals is consequently reduced, right? So that requires more proactivity, maybe anticipate what is coming down the pipe with them more or ability to, or try to.  

Mimi Song: Well, I’m excited to see what’s going to happen with all these new initiatives, but bringing it full circle. When we think about this, the tax justice network’s assessment of how much is happening in terms of profit shifting and the global dollar impact in your experience, do you think that this makes tax authorities even more aggressive? 

Doug Darling: I think it would. I think it has a potential to go, Hey, look, see! They said, ‘These are the experts. They know it’s, it should be $50 billion more here than we’re collecting.  

Mimi Song: Right. 

Doug Darling: So we better figure out why we’re behind. We’re behind. We’re looking bad. If these people, experts think, you know, it should be 50 billion and we’re only pulling in tinder. I take it naturally will make them aggressive. 

Mimi Song: And I think it goes back to your statement about, you know, the definition of fair, because before information was being shared before we talked about an environment of global tax transparency, many of these governments may not have been as concerned. But now they see this whole worldwide net of taxable income.

And now their definition of what constitutes a fair share has changed. And they’ve been empowered and emboldened to be able to challenge this assertion now, and let’s face it. Everyone’s after their fair share of the pie now. So, they want a piece of it.  

Doug Darling: Yeah, that’s absolutely right. And it’s not ignorance is bliss.’ That’s not the right phrase, but before they were just ignorant of it, of the total profitability making in the total chain, the total pie. And now that they’ve getting some visibility or, you know what somebody says it should be that is having that impact of “Oh, we need to get our fair share of the pie.