PwC's Transfer Pricing Controversy Practice
On April 30, 2013, the Steering Committee of the OECD Global Forum on Transfer Pricing (Steering Committee) released a publication entitled “Draft Handbook on Transfer Pricing Risk Assessment” (the Handbook). The Global Forum on Transfer Pricing consists of all 34 OECD member countries, over 100 non-OECD countries, and nine international organisations, and is focused on the need to simplify transfer pricing rules, strengthen the guidelines on intangible issues and improve the efficiency of dispute resolution. The Steering Committee undertakes one project per year that is generally a “best practices” overview of an important topic in transfer pricing administration that has relevance to both developed and developing economies.
The Handbook is meant to act as a supplement to prior OECD publications, including “Dealing Effectively with the Challenges of Transfer Pricing”, a report released in January 2012 which included a chapter discussing transfer pricing risk assessment. Recognising the need for practical guidance on implementing risk assessment techniques, the Steering Committee of the OECD Global Forum on Transfer Pricing undertook a project on transfer pricing risk assessment in November of 2011. The goal of the project was to provide tax authorities with a practical Handbook that offered a framework for assessing the transfer pricing risk presented by an individual taxpayer's operations. Interested parties are invited to provide comments on the Handbook by September 13, 2013.
The Handbook begins by noting that every tax administration has limited resources, and therefore tax authorities must develop practices that allow them to efficiently manage transfer pricing audits by balancing costs with expected benefits from further investigation. Transfer pricing risk assessment is a form of “responsive regulation” - the idea that tax authorities should identify which taxpayers are worthy of more detailed inspection based on the taxpayer's preliminary disclosures. With this framework, the Handbook identifies the need for tax administrations to be able to distinguish taxpayers and transactions that involve a high degree of transfer pricing risk from those which do not involve a high degree of risk. To the extent that a tax authority can distinguish between these taxpayers and transactions effectively, it is better able to allocate its limited resources efficiently, expending more resources on those taxpayers and cases most deserving of an audit.
Ultimately, the Handbook addresses five specific questions:
• What questions should the tax administration seek to answer in a transfer pricing risk assessment process?
• How can the tax administration evaluate whether a taxpayer presents a material transfer pricing risk that justifies a detailed audit?
• Where can the tax administration get the information necessary to identify and assess transfer pricing risk?
• How can the tax administration organise itself to carry out an effective risk assessment?
• How can the tax administration most effectively interact with the taxpayer in assessing transfer pricing risk?
A transfer pricing risk analysis begins with some fundamental questions, the first being whether any material intercompany transactions exist with related parties. It is important to note that the Handbook recognises that transfer pricing risk is generally directly proportional to the size of the cross-border transactions between related entities. Thus, taxpayers that engage in large cross-border transactions should be on alert that their transactions will most likely be heavily scrutinised. Furthermore, the Handbook notes that materiality is a two-way street, both the materiality of the transaction to the taxpayer but also the materiality of the transaction to the countries involved is significant.
The next question to be asked in a transfer pricing risk assessment is whether there is an indication of transfer pricing risk. The following factors generally indicate transfer pricing risk:
• high level indication that the profitability of the local entity is inconsistent with what might be expected of a similar uncontrolled taxpayer;
• whether the local member of the Multinational Enterprise (MNE) group engages in material transactions with related entities in jurisdictions that have low tax rates; and
• whether the taxpayer makes large deductible payments to related parties (e.g., interest payments, royalties, services, etc).
Naturally, the ultimate goal of a transfer pricing risk assessment is to determine whether the case should be pursued further in audit. It is also important to remember that the information gained during a risk assessment should drive the actual audit regarding issues to be further investigated and questions to be asked by the tax administration.
Transfer pricing risk generally arises from one of three factors. First, the taxpayer engages in recurring intercompany cross-border transactions. The Handbook advises tax authorities to identify the nature of payment and any likely tax attributes of the given taxpayer to determine whether further pursuit is worthwhile. For instance, items such as interest, royalties and service fees may be of less concern where they are paid to an entity operating in a high tax jurisdiction if the likelihood of a tax benefit is small.
The second factor is that the taxpayer undertakes a large, one-time transaction such as the transfer of valuable intangibles. These instances generally occur when a company engages in a business restructuring or a transfer of intangible assets. Such transactions have the potential of altering the transfer pricing relationship of many group members for the indefinite future. Thus, the Handbook advises that such transactions may require additional scrutiny.
Lastly, the taxpayer demonstrates general non-compliance with transfer pricing rules. The Handbook states that where a lack of co-operation or a low level of compliance is evident, combined with where there is evidence that sophisticated tax planning structures are in place, the risk level may be high and the case is worthy of additional investigation.
Next, the Handbook offers guidance on how tax administrations can evaluate transfer pricing risk by identifying a number or risk indicators. First, the financial results of a taxpayer as compared to potentially comparable companies are a strong indicator of high transfer pricing risk. In addition, a useful measure to test the profitability of an entity is to review the results of the company or a part of the group in the context of the whole group's performance. For instance, high profits allocated to an entity performing routine functions may be an indicator of transfer pricing risk if a related party performing non-routine functions sustains abnormally low profit margins while the business as a whole shows normal profits.
The next risk indicator is recurring losses for a taxpayer. Special caution should be given where a group as a whole makes losses. As many companies found out in 2008, losses may not necessarily be allocated in the same manner as profits. The Handbook states that losses should be allocated based on the way risks and functions are allocated among participants to any given intercompany transaction. Thus, losses should typically be borne by the entity which bore the risks associated with the materialisation of the resulting losses.
In addition, a company's financial performance over a period of time can be a useful risk indicator. Recurring losses may have economic reasons, such as start-up losses or market penetration strategies; nevertheless, tax authorities should examine recurring losses with scrutiny. As a result, taxpayers that show start-up losses or pursue market penetration strategies should document risk allocation and strategy contemporaneously under the assumption that such results will be heavily scrutinised.
The OECD built upon its business restructuring work in noting that business restructurings require a thorough transfer pricing risk audit. Business restructurings involve two aspects which deserve scrutiny: the transfer of assets and the ongoing transfer pricing after the restructuring. The first aspect is the restructuring itself, often involving a transfer of valuable intangibles. These transfers may lead to difficult valuation issues including reaching an appropriate arm's length price for such transfer, whatever the form of transfer may take. The second aspect is the ongoing transfer pricing policy following the restructuring, which generally includes new entities with different risk characteristics as compared to the prior operating model.
One of the key issues in successful transfer pricing risk assessment is finding the appropriate information to evaluate transfer pricing risk. The starting point for any risk assessment is the taxpayer's tax returns. Additional information sources include contemporaneous transfer pricing documentation, questionnaires issued to selected taxpayers, taxpayer's file and audit records of previous years, publicly available information regarding the taxpayer, site visits and meetings with company personnel, customs data, information from a country's patent office, and information obtained from the exchange of information provision under a tax treaty.
A preliminary question for tax administrations is whether risk assessment should be employed on a centralised or decentralised basis. Employing a centralised risk assessment team affords tax authorities more consistent standards as it allows the risk assessment group to develop experience and exercise practical judgment. Furthermore, it enables the best resources in a tax administration to be exposed to transfer pricing risk assessments. Nevertheless, centralisation can result in a risk assessment team that lacks resources and becomes stretched too thin. Each tax administration should evaluate its own circumstances as to which model will best suit its own needs. Taxpayers, on the other hand, should identify the form of risk assessment undertaken by the tax administrations in the countries in which they operate.
The Handbook highlights that it is imperative for a risk review process to be conducted in a regular and systematic manner. This promotes corporate respect for the tax system and enables a tax administration to devote its limited resources to taxpayers deserving additional scrutiny. Likewise, a regular and systematic risk review process allows for a system where taxpayers who deserve to be “left alone” after preliminary review are not unduly burdened by intense tax audits. This idea returns to the focus of responsive regulation - that tax administrations have limited resources and the efficient allocation of resources requires tax administrations to be able to identify cases worthy of additional scrutiny as early in the process as possible.
The Handbook notes that it may be useful to have discussions between the tax administration and the taxpayer regarding transfer pricing before a tax return is lodged. One important question to be addressed by each tax administration is whether the tax administration should share their risk assessments with the affected taxpayer before committing themselves to an in-depth audit of all identified issues.
The Handbook offers practical advice for tax administrations on transfer pricing risk assessment. The objective of the Handbook, to better allocate tax administration resources, should be welcomed by taxpayers. If the advice offered in the Handbook is followed, tax administrations will hopefully spend less time on “unworthy” audits of taxpayers who take the appropriate steps to form a prudent transfer pricing strategy. Conversely, taxpayers should closely monitor the transfer pricing risk assessment tools and disclosure requirements adopted by tax authorities in the jurisdictions where they operate. In effect, taxpayers should deploy their own risk assessment techniques in order to effectively manage risk and compliance in light of limited resources. That is particularly true considering that the Handbook seems to portend greater transfer pricing enforcement activity globally, especially given the substantial substantive overlap with the material in Chapter 8 (Audits and Risk Assessment) of the UN Practical Transfer Pricing Manual for Developing Countries. Clients operating in a multitude of jurisdictions facing ever changing transfer pricing regulations and compliance requirements have successfully performed global risk assessments, thereby reducing and more efficiently managing disputes.
The authors are members of PWC's Transfer Pricing Controversy Practice in Brussels, London, New York and Washington D.C. They may be contacted as follows:
David Ernick, Washington, D.C.
Richard Collier, London
Adam Katz, New York
Rita Tavares de Pina, New York
Isabel Verlinden, Brussels
John Cianfrone, New York
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