Transfer Pricing Audits: Challenges and Best Practices

In the face of increasing state transfer pricing audits, companies will want to evaluate and update their policies and documentation. Taking action such as establishing arm’s length prices, recording them, including them in accounting systems and intracompany legal agreements and paying into intercompany accounts on an ongoing basis will enable businesses to mitigate risk and avoid the burden of global taxes.

Challenges

With state departments of revenue looking to shore up their budgets in response to the Covid-19 pandemic, transfer pricing audits may increase significantly. Therefore, companies must have strong documentation and proactive defense strategies in place in order to minimize risks and defend against increased scrutiny.

Companies who are unprepared for these audits could face significant tax adjustments, penalties and interest penalties that result in double taxation or reduced corporate tax deductibility.

As part of its defense against an audit, companies should conduct an in-depth transfer pricing study encompassing their company, transactions, functions and assets. This analysis allows case teams to respond effectively to revenue agent reports as well as prepare for pre-presentations of adjustments or assessments by revenue agents.

Best Practices

Transfer pricing methods, when carefully selected, applied and documented can greatly decrease audit adjustments, disputes and penalties. A key aspect of any effective transfer pricing study is gathering accurate data demonstrating arm’s length transactions between intercompany entities; to do this effectively requires conducting an in-depth functional analysis that takes into account economically significant activities, responsibilities performed, assets employed and risks assumed by both parties as well as issuing separate transfer pricing reports for each fiscal year under review instead of consolidating them together into one report.

Step two in an audit process involves comparing transactions to market data – an often difficult feat for multinational enterprises that rely heavily on intellectual property such as software. A comprehensive study can reduce transfer pricing disputes as well as support major corporate events like M&A deals by providing documentation which counteracts overly generous tax assessments.

Implementation

As more and more transfers are subject to audits for transfer pricing risk, businesses should consider their transfer pricing risks and strengthen documentation and defences in advance of cases like Cassation 17824-2023-LIMA. As such, maintaining the right combination between generous tax Administration time quotas and due consideration for legal certainty and rights of the taxpayer remains an essential balance.

No matter if an MNE pursues an advance pricing agreement (APA) with tax authorities or is subject to audit, functional analysis should always be used by all companies to identify economically significant activities, responsibilities, assets and risks between related parties and non-related parties. This approach allows a business to create an arm’s length transfer price that reflects its economic substance.

Kovacev notes that transfer pricing audits may take years to complete due to their comprehensive nature, which often involve billions in transactions at stake. He further remarks on how accessing market data for intellectual property transactions may slow the process.

Monitoring

As state tax authorities increase transfer pricing audits, companies need to assess and enforce their policies and strengthen defenses accordingly. To do this effectively, organizations may conduct risk analyses in order to ascertain their likelihood of audits, while also creating comprehensive documentation.

Gathering reliable information for an extensive functional analysis that encompasses transactions, functions, assets and risks is crucial to providing accurate comparisons of transactions compared to what would occur between independent parties and must abide by each country’s transfer pricing rules.

TPGenie equips companies to provide tax authorities with all of the detailed information they require by simplifying validation for local files and expediting discrepancy identification, helping companies complete documentation more quickly while entering audits with confidence.