Enhancing Shareholder Value: Startups should plan their transfer pricing policies well

Enhancing Shareholder Value: Startups should plan their transfer pricing policies well

Startup

Over the last decade or so, start-ups have created a significant buzz globally, creating disruptions across various business sectors. There are start-ups across industries, with a large number in technology-driven areas such as payment solutions, edtech, big data, data analytics, e-commerce, etc. Typical characteristics associated with start-ups include a significant emphasis on intellectual properties (IP), global nature of business with operations spanning multiple jurisdictions, significant losses in earlier years, substantial spurts in revenue during the subsequent years and reliance on external funding to manage the business.

Getting The Policy Right

These attributes can create transfer pricing implications across jurisdictions. Therefore, it becomes imperative for businesses to ensure that they design their operating model and plan transfer pricing policies at an early stage to optimise shareholder value. Failure to get the transfer pricing policies correct could lead to impairment of shareholder value.

Considering that start-ups typically operate in multiple jurisdictions, non-planning on transfer pricing aspects may lead to inequitable revenues being retained in some high-tax jurisdictions. While this may not be an issue in the early years due to business losses during these periods, such losses tend to get wiped out quickly once the business becomes profitable. This leaves behind significant profits in high tax jurisdictions, leading to a considerably high effective tax rate for the group.

Further, any attempt to structure the operations (to optimise group profits) at a subsequent stage could be viewed as an afterthought by tax administrators across jurisdictions. Hence, any such initiatives to restructure operations, especially once the business starts making profits, could lead to challenges by tax authorities, entailing multiple taxations on the same income (double taxation) and penal consequences. The resulting litigation is usually cumbersome and costly. Besides this, the business could also face exit charge/exit tax issues which could lead to significant tax costs.

Adopting The Right Operating Model

It is worth noting that while entrepreneurs put in significant efforts to grow their businesses, it is important to keep an eye on the tax and transfer pricing aspects to ensure that the benefits of entrepreneurship are not lost through tax leakages. Entrepreneurs operating start-up ventures can enhance their shareholder value by taking certain steps.

Organisations must develop an appropriate operating model to ensure the revenues and profits/ losses from the operations are attributed across group entities judiciously, based on their relative contribution to the overall business. The model should be designed to optimise group profits while also ensuring a well-defined and consistent flow of revenues, costs and profits across the group. While the operating model would be designed based on the fact patterns peculiar to the operations, three models have been quite commonly applied within the start-up space.

Distributor/ marketeer model - This model is based on a central entrepreneur entity owning IP as well as all critical decision-making rights. The local entities (in the customer jurisdiction) are appointed by this central entrepreneur entity to solicit customers/ market the group’s solutions to potential customers. In such a model, the pricing arrangement usually revolves around the local entities retaining a routine return from their customer contracts while the residual revenues are swept back to the central entrepreneur entity either by way of service fees or royalties.

Decentralised model - This model involves the base IP being developed and owned centrally. Local entities in customer jurisdiction operate as entrepreneurs. These entities own customer relationships, take business decisions and exploit the base IP to provide customised solutions to their customer. The pricing arrangement would typically involve a royalty/service fee payment made by the local entrepreneur entities to the central IP owner. The entrepreneurial profits/ losses would remain with the local entrepreneur entities.

Partnership model – This model typically involves various highly interdependent entities within the group operating towards a common purpose (e.g., crypto traders, carbon credit exchanges, etc.). The pricing model for such operations would usually be designed to split the overall profits based on the relative contribution of the participating entities.

These are a few examples of typical operating models within the industry. One must, of course, take into consideration specific fact patterns before determining the design for an operating model.

Once the operational structure design is in place, it is prudent to set the transfer pricing policies for potential intercompany dealings (within the operational structure). This entails determining appropriate transfer pricing methodologies for rewarding the group entities within the organisation and determining appropriate transfer pricing arrangements (through third-party benchmarking exercises). This would ensure a consistent approach towards intercompany dealings across loss-making years and years when the business starts making profits. Such an arrangement would provide a strong defence against challenges by tax administrations across jurisdictions.

Intercompany arrangements should be consummated within intercompany agreements, which would act as the first line of defence against potential transfer pricing questions raised by the tax administrators.

To conclude, while start-ups are focused on growing their business, they should not neglect the tax and transfer pricing aspects of their operations. Business and tax planning should go hand in hand to ensure maximum value from operations.

Source: Money Control