The transfer pricing (TP) compliance and reporting environment continues to evolve with an increasing burden placed on businesses with respect to requirements to prepare, and in growing cases, submit TP documentation as well as TP forms and disclosures.
Alongside this, there is growth in TP controversy, with tax authorities challenging businesses’ TP arrangements. TP documentation plays a key role in defending those challenges and mitigating penalties as well as helping businesses to organise and structure TP analysis.
Businesses need to balance meeting the growing compliance requirement whilst also ensuring that TP documentation is helpful towards navigating tax audits.
In this article, the changing compliance and controversy environment is explored, as well as discussing what ‘audit ready’ TP documentation could mean and considering practical approaches for tackling TP documentation in this environment.
Continued growth in TP compliance and reporting – recent developments
Since the release of the Action 13 as part of the OECD’s BEPS project, there has been an ongoing introduction of new TP compliance and reporting requirements in individual jurisdictions.
In the last 12 months alone, a new submission requirement in Denmark has been introduced (requiring the master file and local file to be submitted at the same time as the tax return for years ending December 31 2021 onwards), a revamp of the Italian TP documentation requirements (which means the master file and local file must be finalised and time stamped by the tax return deadlines for years ended December 31 2020 onwards) and, most recently, the launch of a consultation on the UK’s TP documentation requirements.
The consultation proposes to align the UK’s TP documentation requirements with the OECD’s master file and local file approach, but also considers the introduction of an evidence log, which would set out the key facts and evidence on which the technical opinions are based, and an International Dealings Schedule, which would set out cross-border transactional data.
At the OECD level, there has also been the release of guidance addressing the impact of the COVID-19 pandemic on TP, which is another area businesses will need to consider when preparing TP documentation covering 2020 and 2021.
Therefore, while the initial flurry of new requirements that came after Action 13 may have slowed, requirements are still growing and with an increased focus on submission of local files or other information to tax authorities, to support risk assessment and controversy activities.
Growth in TP controversy – why documentation is more than just compliance
The TP controversy environment has become increasingly busy and focussed.
Tax authorities are becoming more sophisticated in their approach to identifying audit cases, often using data analytics and risk assessment techniques. There is also exchange of information between tax authorities, meaning information shared with one tax authority may be shared with others.
In audits themselves, there is often very detailed fact-finding and analysis and sometimes there has been increased challenges and push for full two-sided analysis, favouring of more complex profit split approaches and granular analysis of comparables used in benchmarking studies. As a part of this, TP documentation may be considered to be evidence of the level of diligence the business has put into its TP arrangements, and a perceived lack of diligence can result in the application of penalties.
It is clear that TP documentation is truly a global compliance requirement and tackling this in an efficient manner is key for businesses. Therefore, the focus in recent years has been a shift towards centralised preparation of local files with the aim of achieving consistency in content across files where there are common transactions. This makes sense from an efficiency and risk management perspective. However, where there is greater TP complexity and risk, TP documentation prepared using this approach alone, may not put the business in the best position to navigate tax authority audits.
Businesses need to consider, in areas where there is greater TP risk, making the step up towards preparing what is sometimes referred to as ‘audit ready’ TP documentation.
What does ‘audit ready’ TP documentation mean?
‘Audit ready’ TP documentation extends the focus beyond meeting local compliance requirements and provides additional support with respect to, and provides an effective first response to, aspects of the TP analysis on which a tax authority may ask questions.
‘Audit ready’ TP documentation will likely go beyond meeting the OECD and/or relevant local TP documentation requirements. The areas of additional focus will vary depending on the nature of the facts, but some examples are considered and discussed below.
Understanding local functions and contributions to value chain
The functions and contributions to the value chain of the transacting parties underpin any TP analysis and it is becoming more commonplace for tax authorities to perform local fact gathering including interviews during audits. Therefore, it is important that there is a detailed understanding of local functions such that it is more likely that the TP analysis within the TP documentation will be consistent with tax authority views from their fact gathering.
While the use of common functional descriptions across local files is a good starting point and ensures efficiency and consistency, this could be verified with local functional analysis interviews and local file content adapted such that it is providing a bespoke and granular functional description of the local entity.
Taking this a step further, consideration of how the local entity contributes to the overall value chain, and articulating this in the local file, is also an important step for supporting the TP analysis and something tax authorities may consider during an audit.
Thorough consideration of selection and application method
Tax authorities are increasingly raising questions on businesses’ choice of TP method, particularly where there is use of the transactional net margin method (TNMM), with tax authorities sometimes seeking use of the comparable uncontrolled price (CUP) or profit split methods instead.
Therefore, carefully considering all the available methods and documenting in detail the reasons for accepting/rejecting each one, could be a key feature of ‘audit ready’ TP documentation, such that it is clearly articulated that the choice of method is the most appropriate for the specific case, and a business should not be challenged that it has defaulted to using the most commonly applied or straightforward method.
Careful application of the selected TP method could also be a key feature. The use of benchmarking studies as part of using the TNMM is popular. In an ‘audit ready’ local file, examples of detailed consideration of the benchmarking approach may include:
- Detailed consideration of the selection of profit level indicator and ensuring this appropriately reflects the functions of the tested party. For example, a common tax authority challenge in this area is the reward of sales linked services with a net cost plus mark up rather than an operating margin;
- Focus on the search strategy and evaluation of industry codes, inclusion and exclusion words, independence criteria and revenue thresholds and whether this will capture businesses with comparable functions and circumstances to the tested party; and
- Very detailed review of the search output including criteria for rejected companies and careful evaluation of the comparability of accepted companies.
This additional analysis can be captured within the local file and, for the TP method applied, careful consideration of the technical accuracy of the method application and consideration of whether a secondary corroborative method could be used, can form an important part of ‘audit ready’ TP documentation.
Consideration of external factors affecting the business
External factors affecting the business can often have an impact on the TP analysis, particularly when analysing comparability. A current example of this is the impact of the COVID-19 pandemic. Ensuring this has been considered in light of the OECD and relevant local country guidance, with the impact and any consequences on the TP clearly set in the TP documentation, could be an important additional step for preparing TP documentation with respect to 2020 and 2021.
Capturing additional evidence that supports the position
Describing many of the additional facts and analysis suggested above within the local file can be as important as doing the analysis itself, when preparing TP documentation that is ‘audit ready’ and evidencing the level of diligence that has gone into the entity’s TP. This can also be supported by evidence that is kept separately to the local file itself.
Getting the balance right
Preparation of ‘audit ready’ TP documentation could bring a number of benefits in the event of tax authority audit, in particular reduction in time/resources spent dealing with the audit (as a quicker resolution may be reached) and a reduction in penalties as TP documentation goes above and beyond requirements, and due care and diligence into supporting the TP position is clearly demonstrated.
The additional diligence involved in preparing ‘audit ready’ TP documentation may also identify issues with the existing TP arrangements that might not otherwise have been spotted and allows these to be addressed for future years.
However, for multinational businesses with a large TP compliance burden, preparing an ‘audit ready’ local file for every entity will clearly be time consuming and costly, and for some entities the benefit is unlikely to outweigh the cost.
Many businesses already take a cost-benefit approach to TP documentation, placing more focus on TP compliance in some entities than others. The process often heavily focuses on the nature of the compliance requirement. Broadening the focus and including the idea of ‘audit ready’ TP documentation as an additional layer and categorisation of entities is a good way to get the balance right and identify where the inclusion of more detailed analysis in the TP documentation would bring the most benefit. Tax authoritiesincreasingly use risk assessment techniques to identify tax audit cases and mirroring this approach, and considering some of the factors tax authorities consider, could help identify where ‘audit ready’ TP documentation could be prepared.
Focus could also be placed on transaction types and transactions that are likely to be audited in multiple countries could be identified. This may allow additional analysis to be performed and included in multiple local files, although, for the local file to be ‘audit ready’ it will also need that robust verification of the local functions, which does need to be performed on an entity-by-entity basis.
Financing transactions could be a good candidate for a more thorough review at transaction level, as these are typically less dependent on local functions from a TP perspective.
The TP compliance and controversy challenge – using the 80/20 principle
The benefits of ‘audit ready’ TP documentation in the current environment are clear, but so is the fact that this is not an approach that can be taken for every entity within the resource constraints of most businesses.
The Pareto principle states that for many outcomes roughly 80% of consequences comes from 20% of the causes, or the ‘vital few’. This likely holds true for TP for most businesses, and therefore identifying the ‘vital few’ and applying the above principles to prepare robust ‘audit ready’ TP documentation, while continuing to focus on compliance with local requirements for other parts of the business, should provide an effective approach for balancing the growing TP compliance and TP controversy demands being placed on businesses and their resources.