I wrote the below blogpost last year but I thought it may be worth while to share it on this blog as the old blog does not exist any longer.
As many of you know the OECD published its “Public Consultation: Draft Handbook on Transfer Pricing Risk Assessment” on 30 April 2013 (hereon referred to as “draft handbook”). The purpose of this handbook is to provide practical resources that can be used by tax administration seeking to develop/improve its risk assessment procedure, methods and practices. However, this will also be useful for taxpayers to ascertain what exactly tax administrations may look at to determine whether a taxpayer and his current/planned cross boarder related party transaction may be at risk for further investigation.
The draft handbook is divided into the following six different sections which are discussed in more detail below:
- Introduction to transfer pricing risk assessment
- Questions to be answered in a transfer pricing risk assessment process
- Assessing when transfer pricing risk exists and when it does not
- Sources of information for conducting a transfer pricing risk assessment
- Risk assessment process – selecting cases for transfer pricing audit
- Building productive relations with taxpayers – the enhanced engagement approach
The following subsections are a summary of the sections within the draft handbook. Please note, in order to get a full understanding of the sections and problems discussed below, it is advisable to read the actual draft handbook.
Introduction to transfer pricing risk assessment
The first section provides objectives and the rational of the draft handbook. Then it describes what a transfer pricing risk assessment is and how it progresses. This section also highlights some sensitive points such as “occasional losses are a genuine feature of business life and may not necessarily be the result of transfer pricing manipulation”.
All-in-all the first section provides a high-level overview as to how the OECD believes a transfer pricing risk assessment should be performed.
Questions to be answered in a transfer pricing risk assessment process
This section deals with the fundamental transfer pricing risk assessment questions to be answered before an actual risk assessment is performed. The draft handbook states that before starting a transfer pricing risk assessment the following questions should be answered:
- Are there material controlled transactions?
- Is there an indication of transfer pricing risk – i.e. potential of shifting income and erode the local tax base – the types of payments that raise such issues could include:
- Large royalty payments
- Large rental payments
- Large management fees
- Large insurance payments
- Financial derivative contracts
- Large payments of deductible interest
- Is the case worth an audit?
- What specific issues need to be addressed during the audit?
Assessing when transfer pricing risk exists and when it does not
The first part of this section deals with the types of transactions in relation to transfer pricing risks and the second part deals with risk indicators. The whole section is the crux of the draft handbook.
The different types of transactions can be summarised as follows:
- Risk arising from recurring transactions: For example, if a local taxpayer in one of the extraction industries sells all of its local country output to related parties, small pricing discrepancies in each individual sale can add up to large reductions in the local tax base. Accordingly, recurring related party transactions will be one key risk factor. Certain types of transactions (as listed above) may create more cause for caution than others.
- Risk arising from large or complex one time transactions: A different type of transfer pricing risk can arise in connection with certain types of large and/or complex one time transactions such as business restructurings or transactions involving the creation/sale of intellectual property.
- Risk arising from taxpayer behavior in governance, tax strategies or ability to deliver compliance: This risk factor stems from the taxpayer’s behavior rather than the nature of its transaction. I.e. is the taxpayer compliant?
In addition to the different types of transactions identified above a quantitative evaluation of the amount of potential tax at stake should form part of the risk assessment process. What is the point of performing a long lasting audit if the outcome may only provide a few bucks to the tax administrations?
The following is a summary of the risk indicators observed from related party transactions that may indicate higher transfer pricing risk, and therefore, in the opinion of the OECD support a decision to conduct a thorough audit:
- Profitability/Financial results: The following points may indicate a higher transfer pricing risk in relation to profitability/financial results:
- If the profitability/financial results of the company under review substantially differ to:
- those of industry standards or potential comparable companies
- its related party of the tested (i.e. same) transaction in the other tax jurisdiction
- the whole of the group’s performance
- If the company under review is a consistent loss maker, or if the company under review makes recurring low profits or low returns on investment.
- If the profit trends of the company under review are contrary to market trends.
- If from a group’s perspective of the company under review, a large portion of the overall income is allocated to a lower tax jurisdiction where few economic activities take place.
- If the profitability/financial results of the company under review substantially differ to:
- Transactions with related parties in low-tax jurisdictions: Even though there may be commercial reasons for trading with or in low-tax jurisdictions any sizeable transaction has a high potential for non-arm’s length pricing.
- Intra-group service transactions: Intra-group service transactions may be one of the most frequently occurring transfer pricing issues. Depending on the nature of these service transactions and the charges made for them, the issues can have either large or limited significance.
- Royalty, management fees, and insurance premium payments, particular to entities in low tax jurisdictions: These payments can be used to erode the local company’s tax base and as such these payments are always seen as more risky.
- Marketing or procurement companies located outside countries where manufacturing takes place: There is a risk in these types of transactions in the sense that the taxpayer is strategically accumulating income in such marketing/procurement companies in excess of the income that can be justified by the economic activity in those companies.
- Excessive debt and/or interest expense: Excessive debt can be used to erode the tax base, particularly when the interest is paid to related entities in low tax or conduit jurisdictions.
- Transfer or use of IP to/for related parties: This is a topic on its own but in short when transferring an income-producing intangible, determining its arm’s length value is crucial. This process is very difficult and as such poses risks in relation to miss pricing of the IP.
- Cost contribution arrangements: Similar to IP this is a difficult subject especially when creating unique or valuable IP. Cost contribution arrangements are seen as complex and as such pose a greater risk to tax administrations.
- Business restructurings: This topic has been a hot topic around the world for quite some time. Transfer pricing issues arising with regard to business restructurings can be very complex and require a thorough transfer pricing audit.
Lastly the second part of this section gives a brief description of non-tax factors that may distort pricing and the importance of contemporaneous transfer pricing documentation.
Sources of information for conducting a transfer pricing risk assessment
This section illustrates the information sources available to conduct a transfer pricing risk assessment. The following is a list of sources that may be available to different tax administrations:
- Specific tax return disclosures – information returns
- Contemporaneous transfer pricing documentation
- Questionnaires issued to selected taxpayers
- Taxpayer’s file and audit records of previous years
- Publicly available information regarding the taxpayer (such as internet searches, commercial databases, press reports & trade magazines and security analysts’ reports
- Site visits and meetings with company personnel
- Customs data
- Patent office
- Exchange of information under tax treaties
- Necessary legal provisions to facilitate access to information
- Obtaining information relating to foreign associated enterprises
- Obtaining information relating to domestic potentially comparable businesses
It is important to note that even though tax administrations may not use every available information source, none of the information sources available to the tax administration should contradict each other – be it through supplied information or publicly available information. For example taxpayers may provide tax authorities with low profit margins (or even losses) due to inefficiencies or a downturn in the economy, however, when looking at publicly available information, such as financial statements or websites, the information available may depict a different story as this information is mainly trying to please stakeholders (i.e. show a good investment).
It is important to note that tax administrations do not only look at tax returns.
Risk assessment process – selecting cases for transfer pricing audit
This section outlines the procedures and steps that a tax administration should follow to conduct a risk assessment. It is important to note that a risk assessment process should be consistent and regular and that all personnel involved must have a clear understanding of that process. Common steps in the risk assessment process may include the following:
- Assembling quantitative data from tax returns, transfer pricing forms and contemporaneous documentation provided by the taxpayer
- High level identification of possible transfer pricing risk by analysing processed quantitative data
- High level quantification of potential risk
- Reviewing qualitative information in contemporaneous information and gathering of additional intelligence from public sources
- Tentative decision as to whether to proceed
- More in depth risk review including analysis of functional and comparability descriptions in contemporaneous documentation
- More detailed quantification of potential risk
- Initial interactions with taxpayer personnel
- Preparation of draft risk assessment report
- Decision as to whether to proceed with an audit, including decisions regarding issues to target in the audit
- Internal review and quality control processes, including central committee review if such a committee is used
- Prepare final risk assessment report
Additional to the above process tax administrations use transfer pricing specialists or if needed industry specialists within their risk assessment process.
Building productive relationships with taxpayers– the enhanced engagement approach
The last section of the draft handbook mentions that several countries have adopted programmes intended to increase the amount of real time engagements with taxpayers on transfer pricing issues. The objective of such programmes is to increase communications between taxpayers and tax administrations to avoid long audits and save costs for both. Examples of some of the programmes are summarised within the draft handbook.
The above is merely a summary of the draft handbook on transfer pricing risk assessment with a few examples. If you have any questions, concerns or recommendations please feel free to comment below. My personal view is that such a handbook is great for both tax administrations and taxpayers alike as it helps tax administrations to follow a simple process in their risk assessment and it provides full disclosure for taxpayers as to how a tax administration will assess risk.
On 23 September 2013 the OECD published comments received on the new Draft Handbook on Transfer Pricing Risk Assessment, which you can find here.