Startups are usually set up with an objective of developing solutions to existing or potential issues. A key attribute of startups is the endeavour to take the solutions or products to global markets.
In their hurry to go to market and socialise their solutions, startups tend to ignore potential tax and transfer pricing issues that could have a serious impact on their businesses, leading to significant litigation and multi-point taxes across jurisdictions.
Some of the common transfer pricing issues that impact startups include:
IP licence/ monetisation
Startups, by their very nature, are set up to provide innovative solutions. Intellectual property (IP) developed by startup entrepreneurs forms a critical business driver for the startup group. IPs may include technical IPs such as know-how, patents, etc., as well as commercial IPs such as brands, trade names, vendor or customer relationships, etc.
Often, a startup group operating across multiple jurisdictions fails to identify the IP within the group. Since the IP itself is not identified, its location, legal and economic ownership, its usage by other members within the group, etc. are not identified and documented by the group as well. This often leads to the IP being monetised by various members within the startup group without any royalty or license fee payments to the IP owner.
This could lead to the following consequences from a transfer pricing perspective:
(i) The group continues to ignore the IP and its exploitation by members/ group entities until one or more members of the group are selected for transfer pricing audits/ assessments. At such a stage, it is likely that tax authorities in multiple jurisdictions would try and attribute the IP to the member located in their respective jurisdictions and, consequentially, deem royalty income in the hands of such taxpayers. This would lead to multiple-point taxation of the same income without any corresponding tax breaks.
(ii) The group entity, at a subsequent stage, identifies the IP within the group, attributes the ownership and decides to charge royalties to other group entities exploiting the said IP. Often, tax authorities would tend to view such subsequent charges of royalties as an afterthought. The argument would be that IP usage is usually at its most intensive at the beginning of the business cycle. Considering there were no royalty charges at that stage, the subsequent charge of royalties could be construed as a profit extraction or repatriation tactic with a view to reducing the group’s effective tax rate.
Both options could lead to potential transfer pricing issues and significant economic double taxation.
To avoid such risks, it becomes imperative for the startup group to identify and determine the economic ownership of the group IP at the very onset. This should be immediately followed by designing an appropriate royalty or licence charge model (covered by a licensing agreement). If the startup group decides to provide support to its group entities by not charging the royalties or licence fees in the initial years, a moratorium for a specific tenure can be structured within the arrangement to showcase that the subsequent charge of royalties is not an afterthought or a profit repatriation strategy.
Funding of operations
In the startup world, fundraising is mostly centralised. Often, the entity raising and receiving the funds from investors or banking institutions is a holding company located in a tax- and regulatory-efficient jurisdiction. The need for these funds is often at the operational company levels which may be spread across multiple jurisdictions. In such cases, it is observed that the holding company often lends the funds to the operating companies – either interest-free or at interest rates determined arbitrarily.
Interest-free loans are usually frowned upon by tax authorities and could lead to deeming of interest in the hands of the lending entity (without the consequential tax break in the hands of the borrowing entity) resulting in economic double taxation. In the case of interest rates arbitrarily agreed upon, these are usually challenged by tax authorities in both the lending company’s jurisdiction as well as the borrowing company’s jurisdiction. This leads to multiple-point transfer pricing adjustments.
To mitigate such issues, startups could consider conducting a scientific transfer pricing analysis to determine arm’s length interest rates at which such transactions can be concluded. Alternatively, the group could consider other funding routes such as equity/ preference shares, etc. to avoid such transfer pricing issues.
Management functions
Often, the founders or key management personnel driving strategic matters relating to the startup’s operations are seen to be in different geographies (and housed in different legal entities). This could be either based on personal reasons (nationality, family reasons, etc.) or business/ tactical reasons (technical personnel located at the production site, while marketing and sales heads at the customer location).
The management personnel across various locations provide strategy, guidance, and services to multiple entities within the group, often not charging for these services or charging fees in an arbitrary manner. The non-charge of the services would certainly be challenged by tax authorities in the respective jurisdictions and lead to transfer pricing adjustments (and the consequential double taxation).
Ideally, it would be prudent to develop a management fee policy at the onset to ensure management services are appropriately rewarded. A central management charge is usually preferred to avoid having multiple locations charge such fees across the group. A centralised charge helps avoid maintaining a cumbersome tracking and monitoring exercise and mitigates tax leakages on account of multiple-point withholding taxes.
Restructuring of operating model
Startups usually commence operations without factoring in potential tax costs as they anticipate losses during the initial years. However, as operations grow, and the group starts becoming profitable, there is a propensity to restructure operations to optimise the group’s effective tax rate. The restructuring usually involves re-shuffling the functionalities within the group to attribute profits in a tax-efficient manner. Often, such restructuring is done without considering the consequential exit charges or exit taxes that could impact such re-alignment of functionalities and could create significant tax implications across jurisdictions.
It would be prudent for startups to design their operational model optimally right at the onset to avoid frequent restructuring and tax leakages on account of exit charges.
In a nutshell, promoters of startups often are so focussed on the business and innovation side of things, that tax and transfer pricing are often ignored. To avoid tax leakages and economic double taxation, a robust tax and transfer pricing strategy, right at the onset, is imperative and non-negotiable.
Munjal Almoula is Partner and Leader - Transfer Pricing, BDO India. Views are personal.
