Key aspects of Transfer Pricing audit
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Key aspects of Transfer Pricing audit
A Transfer Pricing audit is an examination conducted by tax authorities to ensure that transactions between related entities or subsidiaries of a multinational enterprise (MNE), often across different countries, adhere to arm’s length principles. These principles require that the pricing of goods, services, or intellectual property transferred between related parties should be consistent with the pricing that would have been agreed upon by unrelated, independent parties in similar circumstances.
To be fully prepared for the audit, the following points should be considered:
- Comprehensive and reliable information:
Transfer Pricing analysis requires collecting reliable information to not only complete the study but also to ensure an accurate understanding of the economic substance of each transaction, which is in line with the transfer pricing rules of each country. The more comprehensive and reliable the data, the better prepared a company will be for an audit.
For Transfer Pricing purposes, a strong functional analysis is essential, as it forms the foundation for comparing intercompany transactions with those involving independent parties. This analysis must account for the economically significant activities and responsibilities carried out, the assets employed, and the risks assumed by the parties involved.
A thorough functional analysis should determine the key value drivers, identify the appropriate Transfer Pricing method, and highlight other relevant opportunities for the company. For instance, in defending against a tax audit, it may be important to analyze the situation from the perspectives of multiple tax jurisdictions, be responsive to auditor inquiries, and strategically manage communication. Almost every part of a Transfer Pricing study relies on the accuracy and detail of the functional analysis.
- Proper methodology:
Transfer Pricing methods play a key role in Transfer Pricing audits as they determine how prices for intercompany transactions are set and justified between related entities of a MNE. These methods provide the framework for evaluating whether transactions are conducted at arm’s length, which is the central principle of transfer pricing.
During a Transfer Pricing audit, tax authorities examine the methods used by the company to ensure compliance with local and international regulations, such as the OECD Guidelines and local tax laws. The correct application of Transfer Pricing methods helps avoid disputes, adjustments, penalties, and double taxation.
The primary objective of Transfer Pricing methods is to ensure that intercompany transactions are conducted as if they were between unrelated parties in similar circumstances. The methods used help auditors determine whether the company’s prices are aligned with what would be expected in the open market. Tax authorities will assess whether the selected method is appropriate given the nature of the transactions and whether it has been applied consistently. If the pricing does not align with the arm’s length principle, authorities may propose adjustments to the taxable income of the related entities.
Different Transfer Pricing methods are suited for different types of transactions, and tax authorities evaluate whether the company has chosen the most appropriate method for its intercompany dealings. The methods can generally be divided into traditional transaction methods and profit-based methods.
Traditional Transaction Methods –
These methods are more common as they are direct and focus on comparing actual transaction prices. Among traditional transaction methods, you can find the Comparable Uncontrolled Price (CUP) method, Resale Price Method (RPM), and Cost Plus method (CPM).
Profit-Based Methods –
These methods focus on the overall profitability of transactions or entities. Among the common profit-based methods you can find Transactional Net Margin Method (TNMM) and Profit Split Method (PSM).
Transfer Pricing methods are central to a Transfer Pricing audit because they form the basis for evaluating the arm’s length nature of intercompany transactions. The correct selection, application, and documentation of these methods allow companies to demonstrate compliance with Transfer Pricing regulations. When done properly, this can reduce the risk of audit adjustments, disputes, and penalties. Conversely, poor application or lack of documentation can lead to significant tax authority challenges and potential financial and legal consequences.
- Thorough documentation:
A critical issue for taxpayers across various tax jurisdictions is maintaining proper documentation and evidence for each transaction conducted by MNEs. Taxpayers should retain various documents (such as invoices, contracts, records of services provided, policies, accounting records, and certificates of tax residency when treaty benefits are applied). These should be preserved according to the statute of limitations in each jurisdiction and must meet local requirements (such as formal agreements, translations, apostilles, and notarizations) to be accepted as valid evidence for the tax treatment of each transaction.
In conclusion, effective transfer pricing audits hinge on comprehensive data, proper methodology, and robust documentation. By ensuring a thorough functional analysis, selecting appropriate transfer pricing methods, and maintaining meticulous records, MNEs can demonstrate compliance with arm’s length principles and mitigate the risk of costly adjustments, penalties, or disputes. Preparedness and alignment with international standards, such as the OECD Guidelines, not only protect against tax authority scrutiny but also streamline audit processes, ensuring smoother operations for global entities.
If you need assistance in finding the right comparables or selecting the appropriate method for your benchmarking analysis, consider exploring the solutions provided by RoyaltyRange here.
Sources:
https://www.oecd.org/en/topics/taxation.html
https://assets.kpmg.com/content/dam/kpmg/ua/pdf/2016/12/UN_Manual_TransferPricing%20(6).pdf