Feeling the heat: Transfer pricing controversy is on the rise, and prudent taxpayers are taking steps now to manage risk of future audits

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

 John Ridgeway and Kristina Kulle, Ernst & Young LLP, Washington, DC and Chicago

John Ridgeway and Kristina Kulle are Senior Managers

Transfer pricing controversy is on the rise, and prudent taxpayers are taking steps now to manage risk of future audits

Transfer pricing continues to claim the attention of tax authorities around the world. Not only should taxpayers expect more transfer pricing examinations, but they should also expect those examinations, along with efforts to resolve them, to be more difficult and prolonged. Tax authorities have become increasingly sophisticated in their understanding of transfer pricing issues, and they are becoming more discerning in their selection and development of cases. Going forward, transfer pricing examinations will focus more and more on industries and transaction types perceived to pose a greater compliance risk and that thus carry a higher potential for controversy. This substantive focus will be complemented by increased tax authority resources and new administrative strategies and tools intended to increase taxpayer transparency and improve tax authority collaboration. No doubt, the examinations will be influenced by fiscal and political pressures that followed the global downturn and have led some tax authorities to apply versions of the arm's-length standard that frequently lead to conflicting results and instances of double taxation.

Multinationals should anticipate transfer pricing controversy somewhere in the world. As transfer pricing examinations increase, so too will international disputes and the need for effective dispute resolution. EY's 2013 Global Transfer Pricing Survey (the "2013 EY Survey") shows that companies are feeling the pressure. Most notably, 66 percent of companies identified "risk management" as their highest priority for transfer pricing, a 32 percent increase over the responses to the EY surveys conducted in 2007 and 2010.

To effectively manage this risk, companies need to develop a strategic approach to transfer pricing design, implementation, documentation, and defence. Being proactive can prove successful for limiting uncertainty, minimising the potential for significant controversy, and avoiding double taxation.

l. Temperatures are rising
A. Increased IRS resources and co-ordination

In the United States, the Internal Revenue Service (IRS) has initiated various improvements to transfer pricing enforcement capabilities. Recent changes include:

• Realignment and renaming of the former Large and Mid-Size Business Division, now known as the Large Business and International (LB&I) Division, to centralise international tax enforcement resources within a single function to improve co-ordination, information sharing, training, and consistency.

  • Establishment of the position of Director of Transfer Pricing Operations (TPO) to co-ordinate and oversee all IRS transfer pricing enforcement.
  • Creation of the Transfer Pricing Practice (TPP) and International Practice Networks (IPNs) within TPO to assist IRS examiners in the selection, development, and resolution of transfer pricing audits.

The expertise, experience, and resources provided by the TPP and IPNs are intended to increase the number and quality of transfer pricing audits. Under the new TPP, a group of transfer pricing specialists has been assembled to consult with IRS examiners on individual transfer pricing audits. The goal of the TPP is to focus IRS transfer pricing expertise on the highest risk taxpayers and transactions, to develop defensible approaches to difficult issues, and to facilitate greater audit uniformity and consistency.

Internet search for "transfer pricing" yields 60,000,000+ results  

There are currently 18 IPNs, with two having primary responsibility with regard to transfer pricing. The IPNs are internal communication networks where international examiners, district counsel, and other IRS personnel can share experiences, exchange information, and learn from each other. The IPNs were created to break down communication barriers, serve as an information gateway for issue development and training, and increase technical expertise in the field, with the goal of increasing the consistency, efficiency and effectiveness of transfer pricing examinations. Each IPN has a steering committee that serves a facilitating role, gathering and disseminating information on cases, developing and arranging training, and placing pertinent information in an IPN database accessible to all transfer pricing functions within the IRS.

B. Increased global scrutiny and forthcoming guidance

In an effort to increase transparency and provide tax authorities with information from which they can develop accurate transfer pricing risk analyses and assessments, the Organisation for Economic Co-operation and Development (OECD) issued, in mid-2013, an "Action Plan" for analysing and developing common tax authority approaches to base erosion and profit shifting1 as part of the so-called BEPS project, and a "White Paper" on transfer pricing documentation.2 The Action Plan is a framework to update the substantive international tax rules to combat instances of perceived abuse where taxpayers have taken advantage of the current rules to produce double non-taxation or less than single taxation. The Action Plan lists 15 different items requiring further study and action, along with a detailed timeline identifying next steps and possible approaches to implementation. Four of the action items deal directly with transfer pricing (i.e., Actions 8-10 and 13). The White Paper introduced a two-tiered approach to transfer pricing documentation known as the Co-ordinated Documentation Approach. Under this approach, the OECD would require a more uniform global approach to documentation where multinational entities (MNEs) would provide information on their global operations (a Master File) as well as prepare local, jurisdiction-specific files or reports on controlled transactions in or subject to the laws of that jurisdiction. In effect, the Master File would be a high-level overview of the MNE compared to the local files' more targeted discussion of intercompany transactions between related parties.

The Master File would be available to all relevant governments and would include information on the MNE's global allocation of income, economic activity, and taxes paid among countries. The Master File would seek to elicit a reasonably complete picture of the global business, financial reporting, debt structure, and tax situation of the MNE to enable tax authorities to identify the presence of significant transfer pricing compliance risks. Identified risk factors include:

1. Significant transactions with a low tax jurisdiction
2. Transfers of intellectual property to related parties
3. Business restructurings
4. Specific types of related party payments
5. Year on year loss making
6. Poor or non-existent documentation
7. Excessive debt

The local file portion would supplement the Master File, analyse material transactions between the local affiliate and foreign related parties, provide financial information, and apply the most appropriate transfer pricing method to the relevant transactions.

The goals of increased transparency and accessibility of information for the benefit of tax authorities are balanced against the costs and burdens of global compliance on taxpayers. The impact on MNEs could be significant in terms of document preparation and retention, the volume and breadth of local and foreign information to be collected and provided, the possible disclosure of such information to the public along with increased taxpayer exposure to reputational risk that any public disclosure would entail, and the possible use by tax authorities of certain taxpayer financial metrics not only to assess risk, but to test results in a formulaic application of the arm's length standard.3

On the national level, countries are increasingly exploring local transfer pricing measures in response to the OECD's initiatives. For example, the French Parliament recently adopted a bill that expanded taxpayer reporting obligations and entails a second contemporaneous documentation requirement. Developing nations are also imposing documentation requirements where none existed before (e.g., Angola now requires documentation beginning with the 2013 tax year), and are clarifying audit procedures and expectations (e.g., Indonesia's issuance of guidelines during Autumn 2013).

C. Transfer pricing goes mainstream

As recently as a few years ago, readers would have been hard-pressed to read about transfer pricing in the mainstream media. Today, an Internet search for "transfer pricing" yields over 60,000,000 results, including hundreds of online videos, some of which target the transfer pricing of individual companies. Transfer pricing - more specifically, whether or not companies are paying their "fair share" of tax -- frequently appears not just in the financial press, but in daily newspapers, television shows, and popular magazines. With transfer pricing "gone viral", an MNE now faces a newly significant, non-tax, economic risk that threatens the MNE's reputation and has the potential of adversely affecting the MNE's brand, relationships, revenues, and market value.

The convergence of transfer pricing and mainstream popular media has also garnered attention from elected officials and other government authorities. In the United States and United Kingdom, large multinationals have been called to testify before legislative committees to discuss their transfer pricing and other international tax planning in detail. The public hearings and the media coverage that followed often holds taxpayers to a vague, non-legal standard based on some notion of "fairness" that is at odds with generally accepted applications of appropriate pricing under the arm's length principle.

ll. Taxpayers are feeling the pressure

With increased scrutiny by tax authorities and the public alike, taxpayers are looking to mitigate risk. The results of EY's 2011-2012 Tax Risk and Controversy Survey indicated that 77 percent of companies surveyed said they anticipated managing tax risk and controversy would become more important in the next two years. The 2013 EY Survey finds ample evidence that the tax authorities' emphasis is, in fact, having an effect on taxpayer behaviour.

Documentation requirements are being strengthened and more frequently enforced. Indeed, the frequency of transfer pricing documentation being deemed adequate by a tax authority on audit declined for MNEs in 22 of the 26 countries covered in the 2013 EY Survey. Respondents also reported a significant increase in unresolved examinations as compared to prior years.

Double taxation continues to be a common concern for MNEs. Approximately 47 percent of respondents to the 2013 EY Survey reported experiencing double taxation as a result of transfer pricing adjustments. Of the 25 countries surveyed, occurrences of double taxation were reported by taxpayers in 18 countries, including Germany, France, Italy, the UK, and the United States.

lll. Managing risk via best practices

In response to increasing pressure, taxpayers are employing a number of tactics to proactively mitigate their transfer pricing risk.

A. Improving documentation and adding resources

One approach is to increase compliance: only four percent of respondents to the 2013 EY Survey reported that they left the preparation of transfer pricing documentation until requested on audit. Preparing documentation is becoming increasingly burdensome as the number of countries requiring documentation continues to grow. Taxpayers are expanding the scope and depth of their documentation, leveraging existing documentation prepared for other transactions where possible. Taxpayers accustomed to relying on a Master File to satisfy documentation requirements are re-examining whether they are in compliance with jurisdiction-specific documentation requirements and/or returns.

Another common approach used by taxpayers to manage tax risk is to invest in internal resources by adding personnel and modernising internal information systems. Many companies are increasing headcount to proactively monitor, maintain, document, and prepare to defend their intercompany pricing. Others are investing in new systems designed to replace legacy manual processes and outdated technology. Improved systems and technology can yield greater transparency while improving internal controls and automating processes.

B. Risk assessments and audit preparedness

With audit frequency on the rise, some companies are conducting their own risk assessments and mock audits to identify and mitigate key risks before they arise under exam. These risk assessments are designed to uncover inconsistencies, errors, key areas of potential challenge by tax authorities and transactions (or results) that may expose the taxpayer to increased reputational risk. Using the information gathered via these assessments, companies can remediate (or develop better support for) their transfer pricing policies in a proactive manner and on a reasonable timeline, rather than being forced to rush to develop or amend documentation when faced with the tight deadlines and competing priorities that often arise during an exam.

C. Co-operative resolution with tax authorities.

Taxpayers are increasingly taking steps to proactively eliminate transfer pricing risk by securing advance pricing agreements (APAs) for key transactions and jurisdictions. APAs provide certainty on intercompany pricing by eliminating the risk of audit adjustments and penalties, provided that the taxpayer abides by the terms of the agreement. The 2013 EY Survey indicated that taxpayer satisfaction with the APA process remains high at 79 percent. In the United States, APA activity has increased significantly. During 2012, the IRS's Advance Pricing and Mutual Agreement ("APMA") programme executed a record-high 140 APAs. While the 2013 statistics have not yet been published, IRS APA activity during the year appeared to track the 2012 activity, and it is possible that the APMA programme's final tally for 2013 may even exceed its 2012 results.

One way that taxpayers have been maximising the value of an APA across multiple jurisdictions is by securing "anchor" APAs in key jurisdictions. In doing so, a company can pursue an APA in a given country, typically due to a combination of the size of the company's operations/transactions in that country as well as the local tax administration's proficiency with the APA process and overall transfer pricing enforcement. This APA, while not technically binding on any other jurisdiction, can represent a benchmark for the other jurisdictions and often helps to mitigate transfer pricing risk in the other countries.

lV. Awareness and preparedness are critical

The current level of governmental (and public) focus on transfer pricing is unprecedented, and it is unlikely to subside in the foreseeable future. Key to mitigating the increased risks created by this environment is an awareness of the transactions and jurisdictions likely to be scrutinised and a preparedness to defend those transactions against challenges by the relevant tax authorities. Taxpayers willing to invest resources in advance of an examination will find themselves in a far better position than those who employ the "wait and see" strategy of days gone by.

John Ridgeway is a Senior Manager with Ernst & Young LLP Transfer Pricing Services in Washington, DC. Kristina Kulle is a Senior Manager with Ernst & Young LLP Transfer Pricing Services in Chicago. They may be contacted by email at:

The views expressed in this article are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or any other member of Ernst & Young Global Limited.  



1 White Paper on Transfer Pricing Documentation, OECD, July 30, 2013 (accessed via www.oecd.org/ctp/transfer-pricing/white-paper-transfer-pricing-documentation.pdf, Jan 14, 2014).


2 Memorandum on Transfer Pricing Documentation and Country by Country Reporting, OECD, Oct 3, 2013 (accessed via www.oecd.org/tax/transfer-pricing/transfer-pricing-documentation-country-by-country-reporting.htm, Jan 14, 2014).


3 For additional information on OECD BEPS, see alsoEY's portal on the BEPS project at: www.ey.com/GL/en/Services/Tax/OECD-base-erosion-and-profit-shifting-project.

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