Look at any of the largest tax audit and litigation cases of the last few years and it is more likely than not that some form of transfer pricing (TP) sits at – or very near – the heart of each one.
It is therefore of little surprise that transfer pricing has again been confirmed as the leading source of risk to tax departments globally, according to 1,265 respondents to the 2021 EY Tax risk and controversy survey. This marks the fourth survey in a row where TP has come in at the top.
But that simple headline belies the very breadth and depth of impacts that the TP discipline continues to have on regulators, tax authorities, taxpayers, and advisors alike.
Emerging technical issues (not to mention evolving tax authority interpretation) are by no means the only areas of challenge within the discipline of TP. The form, costs and approaches to audits have changed, as have the approaches of taxpayers and tax authorities everywhere in trying to secure more effective dispute prevention and resolution approaches, collectively hoping to reduce the incidence of – and mitigate the time, monetary and trust impacts – of major disputes.
Here, all parties realize that the endgame of litigation is best avoided and replaced with tax certainty instead. But approaching the tax controversy lifecycle from the very final phase – that of litigation or audit/dispute (irrespective of tax type) – is perhaps not optimal. Change takes time, and although the Organisation for Economic Co-operation and Development (OECD)'s efforts to drive more tax certainty are welcome, there are still issues to be worked through. That doesn't mean there is nothing for business to do – indeed, as well as providing valuable input to the OECD on where problems are occurring – businesses should actively consider how they can focus their efforts earlier in the TP controversy lifecycle, doing more to try and reduce the incidence of disputes before they occur.
Assessing the risks
While respondents to the survey note that TP is their key tax department risk, rather like an iceberg, it is what is under the surface that is more enlightening.
Specific TP risk areas identified by respondents closely mirror the accelerating globalization of the decade or so preceding the first G20/OECD Base Erosion and Profit Shifting (BEPS) recommendations. They include tax authority challenges to how headquarters and management services transactions are priced between different entities of a company (viewed by respondents as the TP issue most likely to attract further scrutiny). Second, issues related to the ownership and control of risk around Intellectual Property (the second most selected result) reflecting both the importance and mobility of such assets, not to mention their relationship to licensing fees and/or royalties issues that are so often involved in many major litigation cases). And third, intra-company financing transactions – further illustrating the dramatic effect that such rapid globalization has had on cross-border taxation.
Limitations on the deductibility of costs by a revenue authority that bases its interpretation on domestic rules in lieu of TP adjustments register fourth place. This is a rapidly growing trend, in my opinion, and one that every taxpayer should continue to assess and monitor.
A further survey question asked respondents to name the most significant "unilateral" tax measures causing risk to their business in the last three years. Ask any group of almost 1,300 senior tax leaders this question and one might expect the answer to be "Digital Services Taxes" (DSTs).
But that is not the case – far from it, in fact! "Transfer pricing interpretations that differ from OECD guidance" secured the highest number of first ranked votes to this question, collecting a third more votes than the second placed option – which again, was not DST, but instead Withholding Taxes – further reflecting the very shift in behaviors of countries.
The COVID-19 global pandemic also delivered – and continues to deliver – a series of unexpected TP outcomes. Primary among experiences of survey respondents were risks experienced as a result of mobile workers becoming stranded abroad due to travel and/or immigration lockdowns, creating both personal tax (and social security) obligations and permanent establishment (PE) risk – including, of course, subsequent profit allocation issues. Overall profit volatility also impacted many companies in 2020, and the difficulty of creating TP benchmarks (comparables) acceptable to a tax authority in 2020 is now coming into sharper focus as scrutiny plays out.
Look more broadly and across a longer timeframe though, and the issues affecting TP controversy compound. It used to be that the two key sources of tax risk – the legislation published by a government and its enforcement were by and large the only things that were outside a taxpayers control. Today, that simplicity has been turned on its head – and nowhere more so than in the area of TP. Global trade disputes, for example, have caused upheaval in multiple regions, driving supply chain reconfiguration and resultant new scrutiny of global value chains by revenue authorities.
Even more deeply impactful, shifts in the definition of value creation for tax and TP purposes – historically allocated to activities performed primarily by representatives of a corporation, but now increasingly to end users – are already impacting how revenue authorities expect enterprises to allocate profits, sometimes in advance of global consensus on the issue.
Managing the risks
It is not only specific TP risks that shift and flex over time; so too do the ways in which revenue authorities administer their countries' TP regimes. The survey describes how converging trends such as automatic information exchange (through which a clearer picture of a company's value chain is established), digitalization of the tax administration (especially in the area of predictive analytics, machine learning and Artificial Intelligence) and a further acceleration of multilateralism and collaboration among tax authorities (through which they share ideas and information) together mean that revenue authorities are already well on their way to becoming far more empowered, sophisticated and connected, and tax audits are becoming increasingly forensic, multi-sided and whole-of-group-focused.
Couple these themes with trends yet to truly arrive: a post-COVID-19 landscape where both tax policies and their enforcement will both be used for fiscal consolidation efforts; the possibility of criminal sanctions within audits and changes to the cross-border tax architecture, where the broad effects of the BEPS 2.0 may go well beyond "digital". All things considered; it is hard to misinterpret the perceptions of almost two-thirds (65%) of the largest companies in the survey1 who say they expect the global tax enforcement landscape to become more challenging in the coming three years.
Future proofing, now
It is concerning – but not necessarily surprising – that only a subset of survey respondents may be both fully aware of the shifting enforcement landscape and fully executing the necessary response to protect their businesses. I say not surprising, as 76% of respondents told us that the pace, complexity and volume of national-level tax reforms that have occurred in the last three years have increased their tax risk exposure. But concerning it is, when you consider the following:
- 76% say they don't have full visibility globally of all open tax audits and disputes
- 61% don't follow a well-defined, proactive strategy to secure Advance Pricing Agreements (APAs)
- Just 39% use the Mutual Agreement Procedure (MAP) to resolve disputes wherever and whenever possible
- Less than half (47%) have a clear protocol defining the circumstances in which they will invoke litigation
More can and should be done if these respondents want to weather the storm without experiencing more double taxation, a greater number of unexpected disputes, the greater risk of financial penalties; interest and surcharges, and increased reputation risk. And of course, those factors ignore what might occur within the tax department itself – including too much time being spent on managing incoming enquiries, and potentially decreased C-suite confidence in the tax function.
A better way forward
Organizations that recognize these risks and want to be able to manage tax disputes effectively in the future need to make investments – in people, processes and technology – that span the tax controversy lifecycle, identifying and adopting leading practices across tax risk assessment, tax risk management and tax audit management activities.
Addressing tax risk assessment early and across all tax types and geographies can help stop controversy before it arises. That happens via top-down governance, systems and processes that enhance monitoring, compliance and dispute resolution. Effective tax risk management, meanwhile, can help mitigate the impact of controversy by having a full picture of risks and a comprehensive strategy to manage them. Where such issues are cross-border in nature, that includes both the use of dispute prevention and resolution processes – such as APAs, MAP or even the multilateral International Compliance Assurance Programme.
Tax dispute/audit management – should it be required – focuses on securing quick and effective resolution, allowing the company to move forward. All three processes, if executed fully, should also contain feedback loops back into both tax operations and tax advisory within the enterprise.
Every enterprise is unique – each will have its own cultural and management values, appetite for tax risk and tax litigation, as well as an internal structure that defines how, where and by whom tax issues are managed. Against such a rapidly changing landscape – for not only TP, but all tax types – it is imperative the tax leader considers how the tax controversy department of the future can be built – immediately. Now, not once a new breed of TP disputes start to occur.
1. Those in the $50-$100bn annual revenue range