Deloitte: Transfer pricing among the challenges of cross-border expansion for IT start-ups

Opinion by Ionuț Alexe, Manager, Transfer Pricing, Deloitte Romania, and Mircea Farcău, Managing Associate, Reff & Associations | Deloitte Legal

Expanding a business across the border of the state in which it was developed is a complex process with multiple implications, which requires careful planning and increased attention to previously unseen aspects, such as the tax regime applicable to transactions between the parent company and the affiliated entity. And while issues like this are relatively easy for large companies to manage, for small ones they can be real challenges. Moreover, start-ups interested in expanding their activity in advanced foreign markets (especially those in IT targeting the United States market) face specific difficulties, generated by the fact that they operate in jurisdictions with completely different tax regimes. What are the essentials for compliance?

A crucial concern in this scenario is the strategic management of capital flow from the parent company through various mechanisms such as service contracts, management agreements, intellectual property transfers and intra-group loans. All these mechanisms are based on the concept of transfer pricing, which must be applied correctly to ensure tax compliance and operational efficiency. Consequently, it is essential that these transactions comply with legal standards and the principle of market value, to provide the guarantee that the terms of the agreements are similar to possible transactions between independent parties.

Difficulties in establishing the market value of services

For start-ups in general and for those in IT in particular, the road to compliance and efficiency is all the more complicated. One of the challenges such entities face is determining the fair market value of services provided and loans contracted, processes often complicated by the particularities of technology services and the lack of terms of comparison. The complexity is accentuated by the significant differences between the tax regulations in the two jurisdictions (USA and Romania in this case), which impose different approaches and provide for penalties for non-compliance. With regard to intra-group loans, particular importance must be given to the establishment of interest rates and the observance of conditions specific to usual commercial practices.

The tax authorities carefully analyze such matters and act promptly to correct any discrepancies, which may result in additional tax liabilities or penalties being imposed on the taxpayers concerned. Thus, IT start-ups must carefully approach capitalization strategies and debt structures and document them properly to justify the contractual terms and interest rates, valid both at the time of financing and during their lifetime, thus so that it can be demonstrated that both market volatility and interest rate fluctuations over the life of the loans have been taken into account. Also, the taxpayers involved must pay more attention to loan repayment plans, especially given that the tax authorities tend to consider non-deductible interest expenses related to unpaid loans or converted into contributions to the social capital (shares or shares).

Last but not least, local companies providing services to group entities must constantly assess compliance with the market value principle, as the tax authorities expect the profit margins obtained by companies in this field to be quite high, given historical performance of the IT industry. On the expenditure side, the documentation of the services received by local companies from external affiliates must also be carried out promptly during their reception, as the subsequent retrieval of relevant documents can prove to be an arduous exercise with the passage of time.

The cost of non-compliance

In case of non-compliance, the companies concerned can suffer severe consequences, with a significant impact on liquidity and financial stability, essential aspects for start-ups, which, by definition, are at the beginning of the road, and even more so for those in the IT sector , recognized for its high competitiveness, but where investments in research, development, qualified personnel and expansion are not only consistent, but also prioritized to ensure market survival. At the same time, in many developed markets, taxpayers can resort to mechanisms provided by the tax legislation, through which to reduce these risks. The main tool that can be used in this regard is the advance pricing agreement (APA). It also works in Romania and involves the advance establishment of the prices at which cross-border transactions are to be carried out, together with the tax authority, so that, during subsequent controls, the tax inspectors cannot impose transfer price adjustments and, implicitly, additional amounts of payment for the taxpayers concerned.

The existence of such mechanisms in the target market for expansion can therefore represent an important criterion that a company must take into account when making such a decision. In conclusion, an effective approach requires preventive planning, initiated even from the preliminary stages of the business expansion strategy. In this regard, it is recommended that start-ups invest in the development of coherent transfer pricing policies supported by robust legal documents, which authentically reflect the value of the transactions they carry out with affiliated entities. This approach involves conducting thorough comparability studies, detailed assessment of non-compliance risks, the use of applicable fiscal tools to mitigate them and rigorous documentation, so that all legal and fiscal regulations in force are respected.