In the globalization era, Economic Groups no longer only operate locally but internationally, thus facing significant tax challenges in several jurisdictions. Hence, Transfer Pricing audits became an essential element of international taxation, given that Tax Administrations worldwide aim to ensure that multinational companies pay fair taxes in each jurisdiction they operate.
Consequently, Transfer Pricing mismanagement may lead to financial penalties and expensive disputes.
Therefore, we will explain herein the importance of Transfer Pricing audits, the proceeding that Tax Administrations employ to determine the risk profile of the taxpayer to be audited, the progress of Transfer Pricing audits, the Country-by-Country Report function in a tax audit process, and the preparation and effective approach of companies for Transfer Pricing audits.
We will start with simple questions as a basis for understanding a complex and interesting issue:
What Is a Tax Audit?
Tax Administrations can determine the correct tax obligation and audit the truthfulness of the information declared by taxpayers.
What Is Transfer Pricing?
Transfer Pricing refers to prices collected due to related-party transactions within an Economic Group. These transactions may include the sale of products, the rendering of services, the provisions of intangible property licenses, or any other kind of business transaction. These prices must be comparable to prices collected among unrelated companies (Arm’s Length Principle).
Risk Profile Determination for Taxpayers to Be Audited
- Through risk assessment:
- Assessment of structured and non-structured information sources.
- Assessment of sensitive transactions recorded by taxpayers, such as payments abroad and intragroup services.
- Analysis of the methodology employed by taxpayers. For example, a change in the methodology based on the results of the enterprise’s profitability is a red flag for Tax Administrations.
- Analysis of the origin and destination of goods. In order to identify triangulations mainly recorded by traders.
- Assessment of the value chain: It considers the kind of activity recorded by the enterprise and its current phase to analyze the necessity of received services.
- The main indicator matrices (scoring) of Tax Administrations:
- Minor results to the sector: They assess financial and management ratios, asset rates, and others.
- Materiality: Potential evaded tax.
- Recurrence: There must be no other tax audits in progress.
Progress of Transfer Pricing Audits
As stated by Clara Inés Ramírez, Deputy Director of the DIAN (Dirección de Impuestos y Aduanas Nacionales – National Tax and Customs Directorate), in her presentation at the Virtual Forum: “Perspectives and Trends in International Taxation,” the progress in Transfer Pricing audits in Colombia went from compliance with formal obligations to substantive audits.
The recent rulings of the Colombian high courts involve a comprehensive view on Transfer Pricing and especially focus on the evidentiary means both by the taxpayer in its defense phase on the argumentation of the methodology applied and the information provided to the Tax Administration and by the latter when it disagrees with the study initially submitted by the taxpayer or intends to controvert it.
The Colombian Tax Administration aims to promote other solution tools for controversies presented in the tax audit process, such as:
- Promotion of a greater implementation of APA (Advance Pricing Agreements),
- Participation by the International Compliance Assurance Programme – ICAP,
- Implementation of the Mutual Agreement Procedure (MAP), where analyze discussions affecting some of the controversies that the Colombian Tax Administration had with the taxpayers.
Main Concerns of the Colombian TAX ADMINISTRATION
- Distribution activities.
- Commodities operations: The hydrocarbon and mining sectors are very important for the Colombian Tax Administration, especially the Comparable Uncontrolled Price (CUP) method or the discarding thereof to implement methodologies based on profitability.
- Analysis of the supply chain for the CUP method implementation.
- The participation in the supply chain of related parties, especially those located in non-cooperating jurisdictions with low or no taxation.
- Identification of harmful practices: In order to identify the cases in which the Tax Administration deals with a recharacterization of the transaction, determination of a new margin or comparability, or abuse in tax matters, which would have a specific procedure.
Country-by-Country Report Functions in Tax Audits Processes
The Country-by-Country Report is not a report for tax audits but to measure risks. Conversely, according to Fernando Becerra, Manager of International Taxation and Transfer Pricing at the SUNAT (Superintendencia Nacional de Aduanas y de Administración Tributaria – National Customs and Tax Administration Superintendence), in his presentation at the Virtual Forum: “Perspectives and Trends in International Taxation,” it may be used as an input for Tax Administration audits to corroborate the hypothesis, in addition to allowing the activation of information exchange mechanisms.
Preparation and Effective Approach of Companies for Transfer Pricing Audits
An adequate Transfer Pricing management can reduce contingencies before eventual tax audits that may result in financial penalties and expensive, long, and tedious litigations against Tax Authorities.
The preventive and timely preparation can be carried out from the two facets to be complementary: Internal management with external advice.
- Constant review of the electronic mailbox for warning of possible notifications from the Tax Administrations in time, given that timely detection will allow requests for extensions in case of short deadlines.
- Identification and adequate characterization of the intercompany services rendered. Likewise, the identification of significant transactions with non-cooperating territories of low or no taxation.
- Especially for material operations, search for external advice on the proposed profit margin to be collected, according to the market range.
- Intercompany financing transactions should be monitored along with external advice, enabling the evaluation of the market rates to be considered within each contract, according to the special characteristics of each case.
- Timely compliance with the reporting required by the Tax Administrations within the scope of the Transfer Pricing regulations: Local Report or Technical Transfer Pricing Study, Master File, and Country-by-Country Report.
- The financial information segmented by each operation reported must have the support of the selection criteria of drivers used for the correct allocation of costs and expenses, reflecting the effectiveness of the transaction.
- For the Peruvian case, it must have the documentation supporting the compliance with the Profit Test.
- Preparation of a risk matrix identifying likely, possible, and remote cases.
- Generation of supporting folders enabling the accreditation, necessity, and opportunity of the expenses incurred for services received from related parties (contracts, addendums, reports, appraisals, pricing documents, and/or tariffs, etc.).
- Monitoring of recurring losses at the operating level and searching for supporting evidence explaining them.
- Monitoring of intercompany tax projections.
- Changes in the selected methodology.
- Payments for foreign services.
- Identification of the supply chain and value chain by business line.
- Establishment of Transfer Pricing policies at the Group level.
- Active and collaborative support of the parent companies concerning the information requirements of their related parties.
Transfer Pricing audits play a crucial role in the inspection of international transactions of multinational companies by the tax authorities. They ensure tax equality, transparency, and compliance by taxpayers. Thus, companies must be prepared and maintain accurate records and proper documentation to comply with tax regulations and avoid penalties. Cooperation and consultation with Transfer Pricing experts are essential to successfully comply with these evolving regulations and ensure the integrity of the company’s international transactions.