By Kash Mansori
A client recently asked me to explain the “Master File / Local File” (“MF/LF”) system of transfer pricing documentation that is being adopted by an increasing number of countries. So I thought that there was no time like the present to put together a basic overview of this increasingly common format for assembling and organizing an MNE's transfer pricing reports.
The OECD’s BEPS project (see this post for additional background) resulted in the publication by the OECD of fifteen Action Items that were intended to form the basis for new laws, regulations, treaties, and administrative practices that would be adopted by the participants in BEPS. The final report for Action 13, “Transfer Pricing Documentation and Country-by-Country Reporting”, recommended the following: “countries should adopt a standardised approach to transfer pricing documentation… [based on] a three-tiered structure consisting of (i) a master file containing standardised information relevant for all MNE group members; (ii) a local file referring specifically to material transactions of the local taxpayer; and (iii) a Country-by-Country Report containing certain information relating to the global allocation of the MNE’s income and taxes paid together with certain indicators of the location of economic activity within the MNE group.”
As MNEs consider the impact of this BEPS recommendation on their compliance activities, many Frequently Asked Questions arise. What exactly is involved in the MF/LF system of transfer pricing documentation? What are the formal requirements related to it? How urgently do multinationals need to consider adopting a MF/LF system of documentation? What is the process for doing so? What are the potential advantages and pitfalls of the system? Well don't worry, we've got you covered.
(Note: for more information specifically about the Country-by-Country (“CbC”) report, please refer to this post.)
What is the MF/LF system?
For the typical MNE, it essentially means separating their transfer pricing documentation into two pieces: one portion (the MF) that they will share with any and all tax authorities that ask for it, and another portion (the LF) that contains information specific to a particular country. So the MF will generally contain descriptions of
Meanwhile, a LF will be prepared for each country in which the MNE does business, and each one will contain:
Note, however, that this is just a general guideline; each individual MNE must decide for itself (perhaps in conjunction with their transfer pricing service providers) exactly what information belongs in the MF and what in the LF, based on its specific facts and circumstances.
What are the formal requirements related to the MF/LF system?
The BEPS final reports do not have any legal authority, but numerous countries have incorporated the BEPS recommendations into their regulatory or legal frameworks. As of the time of this post, approximately 25 countries have now formally adopted the MF/LF system, and therefore will expect taxpayers to prepare transfer pricing documentation in that format going forward. Some of these early adopters of the MF/LF system include Australia, China, Germany, Japan, Mexico, Netherlands, and Spain, and many of these will impose penalties on taxpayers that do not comply with their new requirements. For additional details on how specific countries are treating the BEPS recommendations for transfer pricing, Deloitte has prepared a handy quick reference guide.
How urgently should MNEs switch to the MF/LF system?
Naturally the answer to this question will depend a lot on the specifics of each company’s situation. But generally speaking, MNEs that have significant activities in one of the countries that now require transfer pricing documentation to be in the MF/LF format should probably be thinking about converting their transfer pricing documentation this year. Other companies would probably be well advised to plan to change the format of their transfer pricing documentation over the next couple of years, as the list of countries requiring the MF/LF format will continue to grow.
What is the process for switching to the MF/LF system?
Converting current and comprehensive transfer pricing documentation to the MF/LF format should not be too onerous. The primary difficulties are (i) deciding which pieces of information belong in the MF and which in the LF, and (ii) making sure that the documentation contains all of the specific elements required in each country’s definition of the LF. Note that it is particularly important to carefully evaluate all of the information that could potentially be included in the MF to ensure that none of it will create unintended problems down the road with the various tax authorities that may have access to it. The perspective of a transfer pricing specialist can be very useful in this regard.
On the other hand, if an MNE’s transfer pricing documentation is not up-to-date or is incomplete, then developing the proper MF/LF system of documentation will obviously involve some additional work, and could in fact become fairly time consuming. In those cases it is particularly important that the company begin thinking ahead and planning appropriately. Once a tax authority asks to see an MNE’s transfer pricing documentation, it will likely be too late to cobble something together in a timely manner that meets the MF/LF requirements, and the MNE will have given the tax authority a tremendous advantage in imposing adjustments that increase taxable income in their country – putting the company at risk of double taxation and incurring non-deductible transfer pricing penalties.
What are the potential benefits and pitfalls of the MF/LF System?
Many companies have traditionally maintained numerous voluminous transfer pricing reports with repetitive information across reports. The MF/LF system has the potential of streamlining the documentation development and update process to remove the burden of updating information across numerous reports through a single MF. The MF can be leveraged as a robust document to tell the company’s story about its value chain and transfer pricing policy. Moreover, the MF/LF system can be structured in a way that promotes efficiency in the process. The key will be to develop an index within the LF that cross references the local country requirements to the components of the MF/LF transfer pricing documentation. The MF/LF system structure should be carefully thought out or risk creating an inefficient process that does not provide a compelling analysis evidencing that the company’s intercompany transactions complied with the arm’s length principle.
For additional information and perspectives, please see our BEPS Action 13 Update posted Nov 14, 2017.