Rapid development in technology, transportation and communication has led to an increased number of multinational enterprises (MNEs) conducting their operations worldwide. These MNEs engage in transfers of goods and services, intangibles and capital within an MNEs group. Evidences indicate that intra-group trade is growing and forms a significant part of all international transactions. A big chunk of these transactions are not driven by market forces rather the common interest of the related party entities (associated enterprises). This necessitates the need to establish the appropriate price also known as transfer pricing. Transfer pricing refers to the pricing of cross-border intra-firm transactions between related parties (UN, 2017). There is an internationally agreed norm that the pricing of these transactions should be at arm’s length i.e. similar to pricing of transactions between enterprises which are not related. Tax authorities are concerned that these transactions may sometimes be mispriced or incorrectly priced leading to tax avoidance and evasion. Transfer pricing has become a major issue for Multinational Enterprises (MNEs) and many countries have come up with measures including transfer pricing regulations to curb tax evasion and avoidance in an attempt to improve tax revenue collections.
In Tanzania for instance, the Minister for Finance and Planning has recently emphasized through a budget speech that transfer pricing compliance monitoring will be intensified by the Tanzania Revenue Authority (TRA) as part of the Government measures to ensure effective tax collection. This will largely be done through transfer pricing tax audits. Thus, the understanding by taxpayers of the focus of transfer pricing tax audits conducted by tax authorities and how to manage them to reduce associated tax risks is important. When transfer pricing audits are not properly managed, they can be costly to taxpayers in terms of double taxation, interest and penalties as well as time.
Key Risk Areas of Focus by Tax Authorities
Tax authorities have been conducting risk-based transfer pricing audits to establish whether transactions with associates are conducted at arm’s length. Areas of focus include MNEs recording consistent losses, interest charges not at arm’s length, intangibles such as payment of royalties, intragroup services such as management and technical fees, cost sharing arrangements, profit shifting through new structures and restructuring particularly reallocation of significant risks during restructuring within MNEs with no evidence of economic substance and transactions with affiliates registered in tax havens etc.
Adhering to the transfer pricing documentation requirements, performing a robust functional analysis and ensuring economic substance of the transactions are some of the matters taxpayers should pay attention to in managing transfer pricing tax audits.
Transfer Pricing Documentation
The transfer pricing documentation is normally the starting point by the auditors as it provides justification regarding compliance of related parties transactions with the arm’s length principle. The documentation should result from a transfer pricing study and is normally comprised of background information, industry analysis, comparability analysis, choosing a method for determination of arm’s length price and establishment of the arm’s length price. Compliance with the documentation requirements as per the jurisdiction’s transfer pricing laws is key. In Tanzania for instance, there is a need to ensure that the documentation is filed with the final income tax return when transactions with associates during the year are of TZS 10billion (about USD 4,300,000) or more. When the transactions are less than TZS 10billion the documentation should be prepared contemporaneously (as and when the transaction occurs) and be ready for submission to the Tanzania Revenue Authority within 30 days from when it is requested. The penalty for not filing or providing the documentation is TZS 52.5 million (about USD 22,800).
Functional analysis i.e., the identification and comparison of significant activities and roles performed by the independent and related parties which affect the price charged and hence the profits reported is a key part of the transfer pricing study as it affects the determination of the arm’s length price. A robust functional analysis should be undertaken by focusing on actual functions performed not just contractual obligations to provide a basis for comparability analysis. Failure to properly characterize the transactions can lead into improper allocation of risks. The functional analysis should identify appropriate transfer pricing method to apply, value drivers etc. Tax authorities normally undertake their own benchmarking studies and can come up with issues including rejection of the transfer pricing method used which in the absence of justification can lead into additional taxes.
Economic Substance of Transactions
Demonstration of economic substance of transactions undertaken with associates is important to avoid adjustment during tax audit which can lead into additional tax. For instance, for intragroup services, there is a need to ensure intra-group services have been rendered and such services has conferred an economic benefit or commercial value to the business to improve its commercial position, for instance in terms of cost reduction, time saving, increased competitiveness, increased market shares etc. The mechanism to charge the fees will also be thoroughly examined.
Overall, taxpayers will be in a better position to manage a transfer pricing tax audit when they have proper supporting documentation for transactions, demonstrate economic substance of transactions undertaken with associates, ensure compliance with the provisions in the transfer pricing law and other tax laws of the country and ensure pricing of related party transactions complies with the arm’s length principle.
By Straton Makundi, Partner, Auditax International.