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Transfer Pricing Red Flags and How to Avoid them

Corporate tax audits are on the rise—and if your corporate income taxes are being reviewed, you can bet your transfer pricing will be under a watchful eye, too. With country-specific regulations in play—and each jurisdiction adhering to its own version of transfer pricing rules—transfer pricing compliance is trickier than ever. In fact, many tax executives think it’s more a matter of when, not if, a multinational company will come under audit.

So, why wait for an information document request (IDR) to start defending your transfer pricing against audits? Identifying the red flags that often trigger audits—and producing documentation that safeguards against them–can be a real gamechanger for any MNE. Tax advisor at the OECD Centre for Tax Policy and Administration, Manuel de los Santos agrees. So, we caught up with him to find out exactly what those red flags are and what you can do about them.

Red Flag: Losses

Even for MNEs with legitimate operating losses, the chance of a transfer pricing audit may be heightened. Tax authorities want to ensure that losses are not a result of base erosion and profit shifting. According to de los Santos, if an MNE has reported losses–particularly over a long period of time–tax authorities will want to know why. They may fear that losses have been shifted into high-tax countries to avoid paying exorbitant tax there.

In order to prove that losses are legitimate, MNEs must demonstrate that losses have nothing to do with their transfer pricing—maybe there was a tsunami that shut down plants in Indonesia, or maybe there was a virus that curtailed traveling (imagine that!), so hotel occupancy plunged. All kinds of circumstances can cause downturns, but it’s important document the facts and circumstances that contributed to the situation, and of course, provide concrete analyses throughout your report that show that transfer prices are .

Red Flag: Profit Volatility

To CFOs, annual changes in profits may be a normal occurrence thanks to fluctuating markets, but to tax authorities? Not so much. Tax authorities think that companies that perform the same function year over year should expect to earn the same returns. Volatile profits could signal that an MNE group is manipulating transfer prices.

To avoid raising suspicion, MNEs must be able to show that their volatility has nothing to do with their transfer prices and the first line of defense is documentation. Conduct an economic analysis that clearly defines market conditions. Explain circumstances that may have caused profits to fluctuate. Clearly explain the company’s distribution of functions, assets, and risks, so tax authorities can see that profits—volatile or not–have been allocated appropriately.

Red Flag: Management Fees

It’s no secret that management fees raise eyebrows with tax authorities. Not only do tax authorities expect to see documentation that services were provided and received by the related party—but they also want to know that if the service weren’t available through a related party, it’s so necessary that the MNE would have to outsource to a third-party to get it. In other words, it would have to pass the benefits test. Even the most above-board outsourcing could trigger suspicion because the allocation of costs can be subjective.

“The most important point for the taxpayer in those situations is to explain the business and to explain the commercial rationale behind those decisions,” says de los Santos. Why is the service needed? Did you demonstrate that the management fees are arm’s length?

Red Flag: Transfer Pricing Documentation

Transfer pricing documentation that is robust and accurate is the key to successful compliance. However, if information is missing, documentation is late, or your report doesn’t adhere to country-specific rules, then instead of a defense, it becomes an easy tip-off to tax authorities that something isn’t right.

“Transfer pricing documentation is key,” says de los Santos. “When you are facing a transfer pricing audit with any tax authority, the starting point is really trying to get into the business model and understand what the MNE’s policies and commercial reasons are that drive the MNE in allocating profits to different jurisdictions in different ways.”

Producing iron-clad documentation is imperative. MNEs should not rely on generic information, but instead maintain specific and thorough details of intercompany transactions. These details must also be consistent in all forms of documentation—your transfer pricing policy, your master and local file, and intercompany agreements, as well.

Recording transfer pricing in real time, and being proactive about avoiding suspicion altogether, puts MNEs in a strong tax position and allows them to shape the narrative of their transfer pricing practices. Should an audit occur, strong documentation and reports that support the facts and circumstances will help ease the examination process and, maybe even, have tax authorities wondering what they were so worried about in the first place.

Want to learn about more red flags for transfer pricing audits? Hear from the OECD’s Manuel de los Santos on The Fiona Show: Red Flags for Audits.