Are you ready for an audit of your company in key jurisdictions? Will this result in double taxation, interest, and penalties? This PwC article deals with some of the most common threats to taxpayers in transfer pricing audits.
International taxation issues have been a top priority in the political agenda in recent years. The integration of economies and national markets has increased substantially, threatening the tax systems of countries. Several governments have agreed to a comprehensive package of measures that require coordinated implementation through domestic legislation and international treaties, and these will be enhanced by selective monitoring and increased transparency. Many of the traditional strategies that enable double non-taxation will be restricted if widespread adoption of such measures is achieved, particularly the alignment of national standards with best practice guidelines.
In order to initiate a tax audit procedure, tax administrations are planning and programming their reviews by considering the types of transactions companies engage in, including intercompany transactions, level of revenues, treaty shopping indicators, restructurings, recurring losses, and types and quantity of assets, among others. During such reviews, tax administrations’ request information and documentation to support that income has been properly recognised and that deductions comply with the requirements established by the relevant provisions.
Frequent challenges by tax authorities
An important aspect to consider among multinational enterprises (MNEs) from a transfer pricing perspective is business reorganisations and restructurings within a corporate group. The reviews are based on different angles, including exit tax, existence of permanent establishments, and substance. From a tax administration perspective, the reallocation of significant risks of a business derived from a restructuring between associate enterprises without supported economic substance, will be challenged. Based on the above, taxpayers must consider that a restructuring cannot be supported solely by contractual terms, but must also be consistent with the conduct of such enterprises as concerns the allocations of risks, which must comply with the arm’s length principle. In that sense, a company’s business restructuring must be planned and monitored not only from an economic and accounting approach, but also from a legal, tax, and transfer pricing perspective. This article deals with some of the most common threats to taxpayers in transfer pricing audits.
Another aspect to be considered by MNEs involves intercompany management fees, which are challenged by tax administration on the basis that the taxpayer has not demonstrated in supporting documentation (contracts, deliverables, and appropriate allocation of expenses in the case of allocation agreements, among others) that such services have been effectively rendered and a benefit obtained. Further, in some countries, including Mexico, allocated expenses are routinely disallowed.
Finally, the process of assessing the consistency of a taxpayer’s risk allocation with the arm’s length principle can be burdensome and costly. However, it is a good practice for taxpayers to implement a process to establish, monitor, and review their transfer prices, taking into account the size and complexity of their transactions, the level of risk involved, and whether they are performed in a stable or changing environment. Where an MNE detects a possible risk through a review of its transfer prices, it is preferable that a voluntary self- correction be made by the enterprise before a tax audit is initiated.
In addition, certain payments among related parties such as interest and royalties, back-to-back loans and expense allocations, including for research and development (R&D), will be closely scrutinised. For such activities, MNEs must consider not only the generation of a possible source of wealth and withholding tax rules in a specific country, but also the specific rules and requirements of each tax jurisdiction that allow the deduction of the expense. If these rules are not considered, such disallowance could result in economic double taxation, interest and penalties.
Some of the issues observed by tax administrations regarding passive income include the thin capitalisation rules, back-to-back loans, and interest rates that comply with the arm’s length principle, along with maintaining documentation that proves a loan is necessary for the business and that the entity can obtain the necessary cash flow to pay the loan balance in accordance with its contractual obligations.
Similarly, purported ownership or migration of intangibles to low tax jurisdictions involving ongoing local expenses to advertise and promote brands and trademarks are closely reviewed, as well as allocated expenses (including R&D), payments for technical assistance versus know-how, and royalty-free agreements, among others.
Another aspect to be considered by MNEs involves intercompany management fees, which are challenged by tax administration on the basis that the taxpayer has not demonstrated in supporting documentation (contracts, deliverables, and appropriate allocation of expenses in the case of allocation agreements, among others) that such services have been effectively rendered and a benefit obtained. Further, in some countries, including Mexico, allocated expenses are routinely disallowed.
Finally, the process of assessing the consistency of a taxpayer’s risk allocation with the arm’s length principle can be burdensome and costly. However, it is a good practice for taxpayers to implement a process to establish, monitor, and review their transfer prices, taking into account the size and complexity of their transactions, the level of risk involved, and whether they are performed in a stable or changing environment. Where an MNE detects a possible risk through a review of its transfer prices, it is preferable that a voluntary self- correction be made by the enterprise before a tax audit is initiated.
Preventive measures – defence files
Many times, audits are conducted long after transactions take place, and several factors can affect the availability and reliability of information, as well as the defence of tax positions, when evidence is not prepared prior to or contemporaneous with the transactions.
…TO BE CONTINUED
