Documentation is expensive, and tax department budgets are finite. Therefore, tax departments face the very common economic problem of how to allocate resources more effectively, a process that starts with the determination of which legal entities need documentation and an evaluation of the type of documentation that is needed.

Some tax departments approach this issue with the preparation of a detailed risk scorecard (see my videos on building and using such scorecards), and such a risk scorecard can be very useful in many cases. However, the process of prioritizing documentation can also be approached very simply as follows.

Start by taking the sales revenues of each legal entity from the trial balance. Use your favorite visualization software to prepare a tree chart such as the one shown below, which has been populated using data from FakeCo, a illustrative company that I have created that has 297 discrete legal entities.

The size of the boxes in the tree chart reflects relative sales. Starting from the upper right hand of the tree chart, just under thirty boxes are large enough to show all or a part of the legal entity name. These top 10 percent of the legal entity population have sales that are material, and probably therefore warrant the preparation of documentation designed to mitigate the risk of a transfer pricing adjustment. Approximately an equal number of legal entities are contained in the boxes that are inside the green oval but outside of the red oval. These are much smaller, and therefore likely to represent significantly less transfer pricing risk, than the boxes containing legal entity names. The boxes within the red oval account for the remaining 230 plus legal entities, and in the bottom right many of these boxes are too small to see. These legal entities are unlikely to represent financially material transfer pricing risk from the perspective of the taxpayer, but they may be material and of substantial interest to the local tax authorities.

We can now think about how to spend our transfer pricing budget. For the sake of easy arithmentic, let’s assume a budget of $10,000 per legal entity, which comes approximately $3.0 million for the entire set of 297 legal entities. Let’s now split the budget into 4 baskets. I will use half of the budget to prepare documentation for the top 10 percent of the legal entities with boxes that are large enough to show their names (Basket 1); and then split the remaing half evenly among among Basket 2 — the second decile of companies (boxes inside the green oval but outside of the red oval), Basket 3 — all other legal entities (boxes inside the red oval); and Basket 4 — special issues that may attact tax authority interest such as loss-making companies, situations in which there has been an acquisition and subsequent IP shift, intercompany loans.

The average budget of $10,000 per legal entiy now translates into the following: $1,500,000/30 = $50,000 per legal entity for entities in Basket 1; $500,000/30 = $16,7000 fo legal entities in Basket 2; 500,000/230 = $2,100 for legal entities in Basket 3; and 500,000 for special issues. (I have rounded aggressively for arithmetic ease.)

This simple exercise accomplishes several things. First, it provides a framework for allocating budget based on risk. Second, it clearly identifies two very different types of documentation tasks: (1) risk mitigation, which is the primary goal of the spending in Baskets 1 and 4 and (2) compliance, which is the primary goal of documentation in Basket 3, and quite possibly Basket 2 as well. Finally, it highlights the point that documentation that is prepared primarily for compliance purposes, while often necessary – tax authorities in small countries think (reasonably) that they too are entitled to know why the transfer pricing arrangement of controlled companies operating within their boundaries are arm’s length – has to be prepared with focus on cost containment and the ability to scale (add additional legal entities) at a very low incremental cost. To bring this point home, increasing the per legal entity budget for legal entities in Basket 3 from $2,100 to $4,200 might require reducing the budget available to legal entities in Basket 1 from $50,000 to $33,000. Alternatively, it may require reducing the number of legal entities in Basket 3 that are documented from 230 to 115.  But this implies that the taxpayer has not even tried to meet tax authority expectations regarding documentation.

There are a number of different ways in which the above analysis could be carried out – looking at profits rather then sales; allocating budgeted resources differently. But regardless of the details, it provides an easy framework to at least start aligning costs and benefits, and getting a clear picture of the resulting constraints.

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