Managing Transfer Pricing Audit Risks

Article excerpt

Transfer pricing continues to be the number one international tax concern of multinational enterprises (MNE), according to a 2001 Ernst & Young LLP biennial survey of more than 800 tax and finance directors. Interviews with various revenue authorities around the globe indicate that tax authorities also view transfer pricing as a top audit issue, scrutinizing MNEs' pricing for intercompany transactions to make sure the arm's length standard is followed.

As MNEs grow and use advanced communications and management information systems, the volume of intercompany, cross-border transactions has increased, along with the uncertainty of the tax treatment for such transactions. This uncertainty is compounded by the revenue authorities' increased scrutiny and sophistication in reviewing intercompany transactions. Moreover, taxing authorities are implementing conflicting interpretations of the arm's length standard. This ambiguity and inconsistency, fueled by changing business models, is keeping corporate tax departments on heightened alert.

According to the survey, the number of NINE parent companies ranking transfer pricing as the most important international tax issue grew from 78% in 1999 to 85% in 2001. Among subsidiaries, 94% rate transfer pricing as their top priority, up from 85% (1999). Double tax relief comes in a close second to transfer pricing concerns (Exhibits I and 2), apparently because transfer pricing adjustments often result in double taxation.

Increased Tax Authority

The survey indicates that more governments are focusing legislative, regula tory, and enforcement efforts on MNE's transfer pricing. Many governments are issuing additional transfer pricing legislation, regulations, or other guidance, as well as penalty provisions.

This trend is global. Countries that have had no prior formal transfer pricing rules are establishing such rules, and countries with formal rules in place are seeking greater enforcement. For example, in November 2001, U.S. Senator Byron Dorgan (D-N.D.) released a report that MNEs operating in the United States avoided $45 billion in federal income taxes in 2000 by moving profits earned in the United States to other countries through abusive transfer pricing schemes. Senator Dorgan, who chairs the Senate Appropriations Treasury and General Government Subcommittee, included $2 million in the 2002 Treasury General Appropriations bill for a new study to determine how the IRS can collect these unpaid taxes. The IRS will likely step up its audit activity and propose transfer pricing adjustments.

Fiscal authorities worldwide have taken many transfer pricing enforcement initiatives, such as requiring additional tax return disclosures, hiring more international tax examiners, and initiating more audits. Tax authorities have increasingly turned to specialists to help analyze complex transfer pricing issues and develop arguments for proposing adjustments.

Many of the tax and finance directors interviewed for the survey also said that revenue authorities from different countries are communicating among themselves more frequently about transfer pricing, discussing topics such as:

* Key issues (e.g., migration of intellectual property);

* Arm's length standard concepts;

* Industry practices (e.g., automotive, financial, medical and pharmaceutical);

* Exchange of taxpayer transfer pricing information; and

* joint government training classes.

Not surprisingly, respondents to the 2001 survey indicated that when a revenue authority has audited them, transfer pricing issues have been raised approximately 60% of the time. For the twelve largest countries surveyed (Australia, Canada, France, Germany, Italy, Japan, Korea, Netherlands, Sweden, Switzerland, United Kingdom, and United States), the rate of transfer pricing audits rose to 65%.

MNEs headquartered in Switzerland and Finland are audited most frequently (88%). …