Transfer Pricing in the Digital Economy

The Digital Economy

The digital economy is comprised of economic activities that utilise digital information and knowledge for production. The digital economy is heavily reliant on the internet, digital communication networks, and data.

With the advent of the digital economy, companies are able to generate revenues in a particular market without having a physical presence. Online streaming platforms, e-commerce marketplaces, and app-based service providers are a few examples of such companies.

TP Challenges Arising from the Digital Economy

The digital economy operates both domestically as well as across borders, with services and intellectual property including data and algorithms transferred between members of an MNE in different jurisdictions. 

The digital economy poses multiple challenges to traditional Transfer Pricing (“TP”) norms and principles and it is creating both challenges and changes for tax authorities and MNEs alike. Some of the major TP challenges that MNEs face are as follows:

• Determining the Arm’s Length Price and Ensuring Local Compliance: Establishing arm’s length pricing for digital transactions, especially those involving intangibles such as software, algorithms, and complex user data. Moreover, ensuring compliance with diverse and evolving TP documentation requirements across jurisdictions adds to the burden.
• Attribution of Profits in the Absence of Physical Presence: Digital business models often generate significant value in jurisdictions where the enterprise has no physical presence. Determining how profits should be allocated to these markets, especially when value is created remotely is a key challenge for MNEs and tax authorities alike.
• Allocation of Risks, Functions, and Assets: Traditional TP relies on accurately identifying the functions performed, risks assumed, and assets used by different entities within an MNE group. In a digital business, these may be highly integrated, automated, or centralized, making it difficult to separate and allocate them for TP purposes.
• Valuation of Unique and Hard-to-Price Intangibles: The valuation and pricing of unique intangibles such as proprietary algorithms, AI tools, user-generated data, or digital platforms are inherently difficult due to a lack of comparables and the subjective nature of their value. These assets are often the main drivers of value in digital businesses, yet they challenge traditional valuation methodologies.

Potential Measures to Counteract Challenges

Given the above-mentioned challenges and the fact that MNEs are facing a rapidly changing TP landscape, it critical that MNEs must put in place measures to counteract the current challenges. Some of the measures that can be adopted are as follows:

• Review and Realign Value Chains: Regularly assess the value chain to identify any gaps between where value is created and where profits are currently booked. Ensuring alignment between economic substance and profit allocation is critical to defend TP positions.
• Align Legal Structures with Operational Realities: MNEs should ensure that their legal entity structures and intercompany agreements accurately reflect actual business operations and functions. Misalignment can lead to increased risk during audits.
• Strengthen Documentation and Functional Analysis: A robust functional analysis is essential, especially for digital business models to demonstrate how value is created, how key intangibles are developed and used, and how risk is distributed across the group. Clear and defensible documentation is key to meeting local compliance standards.
• Stay Informed on Global Policy Developments: Tax rules are evolving rapidly, particularly with the OECD’s Base Erosion and Profit Shifting (BEPS) 2.0 initiatives—Pillar One (focused on reallocating taxing rights) and Pillar Two (introducing a global minimum tax). MNEs must actively monitor these changes and prepare to adjust their TP policies accordingly.

• Enhance Cross-Functional Coordination: Collaboration between tax, legal, finance, and IT teams is crucial to gain a full understanding of the digital business model, access accurate data, and develop a defensible TP strategy.

Key Takeaways

The digital economy is fundamentally challenging traditional TP principles, particularly in areas involving intangible assets, remote value creation, and profit attribution without physical presence. As tax rules evolve, it is essential for MNEs to proactively adapt their TP strategies. This includes enhancing documentation, aligning legal and operational structures, and fostering cross-functional collaboration to ensure compliance and mitigate risk in a rapidly changing tax landscape.