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4 strategies for avoiding transfer pricing audit shocks

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From Graphene Economics: Transfer pricing audits are on the increase, and pose a risk for multinational entities (MNEs) as they arrive years down the line, creating surprise exposure, says Graphene Economics founder and director, Michael Hewson.

Hewson, who heads specialist African transfer pricing advisory firm, Graphene Economics, believes that MNEs need to actively seek to manage the risks that transfer pricing audits can pose – sometimes several years down the line, when exposure may have mounted.

“Transfer Pricing relates to the setting of the price for goods and services that are sold between controlled (or related) legal entities within an enterprise,” he explains. “Transfer Pricing principles govern how all cross-border related party transactions are accounted for, and how profit is distributed, depending on the contributions made by each entity. As revenue authorities, particularly in Africa, look to maximise collections, corporate tax and specifically transfer pricing is increasingly coming under the spotlight. We’re seeing an increasing number of transfer pricing audits.”

These may result in a tax amount payable, plus interest and penalties, which is often a substantial financial blow.

Hewson says the increased focus on transfer pricing from revenue authorities is driven by the increasing capacity of tax authorities in specialist areas like transfer pricing, coupled with the increase in levels of transparency of MNEs’ business. He recommends a four-pronged approach to managing transfer pricing risk:

  1. Prioritisation of transfer pricing

Hewson says that managing transfer pricing risk is not simply about compliance and that avoiding shocks will require prioritising transfer pricing. “What I mean by that is that MNEs need to allocate sufficient budget and resources, and support their tax teams,” he says. “Executives need to be engaged in the process of internal price setting and management so that they can be aware of, and help to mitigate the risks that may arise from cross-border transactions.”

  1. Operationalisation

The second strategy is to operationalise. Transfer pricing involves price setting, which Hewson says needs to be embedded into an MNE’s operations, down to the level of unit pricing, determining pricing for goods and services, or the setup of operations. “It also sometimes involves the setting of targets for sales targets or pricing targets for profitability,” he adds. “Every aspect has transfer pricing bearing and implication.”

There are also legal considerations. For example, legal agreements, and an understanding of which party will take the risk in certain transactions. For example, during the two weeks of unrest in South Africa in July 2021, if an MNE had goods in transit to another country and those were destroyed, the question becomes, “With whom does that risk rest?”

Hewson adds that MNEs cannot think about transfer pricing in isolation, but need to see it in relation to real-world issues. “COVID-19 has shown us this,” he says. “It we look at how it’s accelerated remote working and digitisation, we start to realise that it’s affected value creation in different countries, which has transfer pricing and tax implications. MNEs may have people living in one country and reporting into another, and that creates complexity from a tax perspective.”

Monitoring is also critical. “MNEs need to monitor the transactions and contributions of all their parties and entities to decrease the likelihood of needing to make a significant adjustment or large correction payment at the end of the year, which may be called into question,” Hewson says. MNEs should leverage the monitoring capabilities of their internal audit teams to assist with this.

  1. Communication

Hewson says communication is critical internally to avoid transfer pricing risk. “Communication facilitates the proper prioritisation of transfer pricing and understanding of the relevant principles,” he says. “But communication is also critical beyond internal structures, for example with external auditors and the board of directors. We’re seeing more CFOs proactively presenting how they’re structuring cross-border transactions and managing their transfer pricing so there are no surprises at year-end. We’re seeing more MNEs publishing tax and economic contribution reports, aimed at external stakeholders, where they proactively communicate what they’re doing, where they’re making money, what contributions they’re making to local communities, etc. The idea is to proactively help manage the perception of their brand.”

  1. Defence

“Companies need to be able to defend their transfer pricing from various perspectives,” says Hewson. “With the advent of country-by-country reporting and additional disclosures required in many countries, transparency continues to increase and there’s more and more exchange of information between revenue authorities. This, coupled with digitalisation, means that MNEs can be queried on many different fronts. They must be comfortable that will be able to satisfy those queries – to defend and substantiate their pricing.”

This means having the required evidence available of contributions made by the different parties, as well as the extent of the value of those contributions.