Tax administrations have finite resources and limited time, which means they are not able to conduct audits on all taxpayers with related party transactions. They will, therefore, need to determine the potential tax at stake to select the most promising audit cases. A core principle for selecting audit cases is the maximisation of returns on limited audit resources.
The core objective of the transfer pricing risk assessment is to identify the risk and allocate government resources to investigate it. There are four fundamental questions that every risk assessment should answer:
1. Does the taxpayer have material intercompany cross-border transactions?
2. Is there an indication of transfer pricing risk?
3. Is the case worth an audit?
4. What specific issues need to be addressed during the audit?
In 2013, the OECD published the “Draft Handbook on Transfer Pricing Risk Assessment”. It contains general guidance that tax authorities may utilise, including sources of information for risk assessment, as well as common risk areas. It also includes a practical checklist of nine important issues to be considered in a transfer pricing risk assessment, which can be used by tax administrations in organising their risk assessment processes.
We list these issues below, provide practical examples of situations that may trigger the transfer pricing audit and give advice on how to be prepared:
1. Significant transactions with related parties in low tax jurisdictions
Risk: Where transactions take place with lowly taxed and related entities there is a risk that mispricing will incorrectly attribute excess profits to the lowly taxed jurisdiction.
How tax authorities find out about the risk: information from the transfer pricing form (return), local file, other contemporaneous documentation, customs data.
Examples: sales of products to low tax jurisdictions (where goods are directly shipped to customers), purchase of services from low-tax jurisdictions, financial transactions and payments for the use of intangibles to low tax jurisdictions.
How to be prepared: Prepare good transfer pricing documentation that will specifically focus on the substance of the low tax counterparty, as well as arm’s length nature of the transactions. Put special attention to explaining how the counterparty contributes to the value chain.
2. Transfers of intangibles to related parties
Risk: Transactions of this nature raise difficult valuation questions, especially where the intangibles are unique and consequently there is a lack of comparables.
How tax authorities find out about the risk: information from the transfer pricing form (return), local file, other contemporaneous documentation, financial accounts, patent office.
Examples: transfers of trademarks, technologies and other intellectual property.
How to be prepared: Prepare good transfer pricing documentation that will specifically focus on DEMPE functions (and changes in these functions). Transfer pricing aspects of intangibles are highly complex and controversial, so the application of principles described in the OECD Guidelines Chapter VI is crucial.
3. Business restructurings
Risk: Similar to intangibles transfers, business restructurings are difficult to evaluate and price. Also, transactions that involve business restructurings often have high tax abuse potential.
How tax authorities find out about the risk: information from the transfer pricing form (return), local file, other contemporaneous documentation, financial accounts, taxpayer’s website, press reports/magazines, securities analysts’ reports.
Examples: relocation of functions, assets and risks between group entities across the border, transfers of significant tangible and intangible assets.
How to be prepared: When planning future business restructurings, consider tax and transfer pricing risks. Prepare good transfer pricing documentation that will specifically focus on the business rationale for the restructuring. It also should provide a robust transfer pricing methodology for evaluating restructuring itself, as well as post-restructuring transactions.
4. Specific types of payments
Risk: Payments of interest, insurance premiums and royalties to related parties because the underlying rights are highly mobile and consequently there is a risk that the payments do not reflect the true value being added by the related party.
How tax authorities find out about the risk: information from the transfer pricing form (return), local file, other contemporaneous documentation, financial accounts, national bank data (in some countries).
Examples: material interest payments for intragroup loans, guarantee fees, insurance premiums, royalty payments for the use of trademarks, technologies and other IP.
How to be prepared: consider transfer pricing and tax risks before arranging these payments. For financial transactions, take into account thin capitalisation rules. Strong and robust local file (and other contemporaneous documentation) is a must.
5. Loss making entities
Risk: Year on year loss making where there is no attempt made to change business operations or financing. Sustained losses may be evidence that the reported results do not reflect the true value of the business.
How tax authorities find out about the risk: information from the transfer pricing form (return), local file, other contemporaneous documentation, financial accounts.
Examples: an entity with material intra-group transactions generates losses year on year. Even a one-year loss can be an issue, if the entity’s functional profile does not assume such a possibility.
How to be prepared: this issue becomes even more relevant in COVID-19 crisis times. In general, the taxpayer has to be ready to substantiate that the loss is legitimate and arm’s length, i.e. in free-market conditions, a company with a similar functional profile can receive a loss. We will be addressing the COVID-19 impact and loss-making entities separately.
6. Poor results
Risk: Similarly, results that are not consistent with industry norms or with the functions carried on by the enterprise in the country concerned may be evidence that related party transactions have not been correctly priced.
How tax authorities find out about the risk: information from the transfer pricing form (return), local file, other contemporaneous documentation, financial accounts, commercial databases and other data on comparable transactions.
Examples: an entity with material intra-group transactions generates poor (i.e. below the arm’s length) results.
How to be prepared: similar guidance as in loss-making situation applies.
7. Effective Tax Rate variations
Risk: Significant variations between the effective tax rate reported at group level and the nominal rates to which it is subject can be the result of transfer pricing that allocates too much profit to low tax jurisdictions.
How tax authorities find out about the risk: contemporaneous documentation, financial accounts (entity and consolidated).
Examples: the local entity has a significantly higher nominal tax rate (comparing to the effective tax rate at the group level). This may potentially indicate that associated enterprises pay tax at a lower rate, and therefore transactions with such counterparties may be scrutinised.
How to be prepared: be ready to explain why an effective tax rate of the group is at the given level.
8. Poor/Non-existent Documentation
Risk: Evidence that transfer prices and the methods used to compute them are inadequately recorded casts doubt on the reliability of the prices themselves.
How tax authorities find out about the risk: local file and other contemporaneous documentation
Examples: documentation that is too high-level, does not cover all material transactions, or simply does not exist.
How to be prepared: do your transfer pricing documentation properly. Focus on the most material and risky transactions.
9. Excessive Debt
Risk: Debt that appears to be in excess of the amount that an entity could borrow if it were a free standing entity, or interest rates that appear to be in excess of market rates.
How tax authorities find out about the risk: information from the transfer pricing form (return), local file and other contemporaneous documentation, financial accounts.
Examples: debt that is too high, thin capitalisation rules triggered, interest rates that exceed appropriate arm’s length (or safe harbour) levels
How to be prepared: continuously analyse your financial transactions and debt level. Prepare contemporaneous documentation that explains both the level of debt and the interest rate applied.
What’s coming next?
Nowadays, tax authorities have even more instruments and risk indicators they can use (the Handbook was published before CbCR and master file implementation). We have mixed indications about the use of CbCR and master file data for the risk assessment; however, it is clear that these new instruments can allow tax administrations to identify transfer pricing issues and risk indicators better. For example, it is now much easier to spot suspicious presence in low tax jurisdictions, assess the substance, review effective tax rates. BEPS 13 local file and master file also enhance the disclosure of business restructurings, intangibles and financial structures. We’ve been talking about the approach that some multinationals take to proactively disclose and explain their tax positions in another blog post.
Is it relevant for the ADIT exam?
Yes! The ADIT syllabus requires candidates to know risk assessment and risk management practices, and therefore this topic is crucial for the successful exam sitting. In our transfer pricing course, we discuss the risk management and risk assessment in Module 16. We also give some interesting country examples there that are especially helpful during the ADIT exam.
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Country-by-Country Reporting (CbCR) is part of mandatory tax reporting for large multinationals. MNEs with combined revenue of 750 million euros (or more) have to provide an annual return called the CbC report, which breaks down key elements of the financial statements by jurisdiction. A CbC report provides local tax authorities visibility to revenue, income, tax paid and accrued, employment, capital, retained earnings, tangible assets and activities. CbCR was implemented in 2016 globally.