How enterprises can manage rising transfer pricing disputes in Asia-Pacific

Multinational enterprises can adopt best practices to reduce disputes while managing the increase in transfer pricing audits.

With the number of transfer pricing audits in Asia-Pacific steadily climbing over the years, it has now become even more pertinent that multinational enterprises consider how best to manage such disputes. What are the factors contributing to the increased focus on transfer pricing and the best practices that companies can undertake to manage transfer pricing disputes should these arise?

Transfer pricing under the spotlight

The growth in the number and complexity of cross-border intragroup-related party transactions is a key factor that contributes to the spike in transfer pricing disputes in Asia-Pacific — but there are other factors at play. These include:

Information disclosures and spontaneous sharing amongst tax authorities

Multinational enterprises in Asia-Pacific are now expected to have a higher level of transparency on their transfer pricing matters, allowing tax authorities to access a treasure trove of information to assist in initiating transfer pricing audits. This can take the form of:

• Master File–Local File concept: Many jurisdictions in the region now implement the Master File–Local File concept of transfer pricing documentation where a significant amount of extraterritorial information is shared with local tax authorities.
• Country-by-Country-Reporting (CbCR): Information at the group and country level are submitted and shared amongst tax authorities.
• Action 5 of the Organisation for Economic Co-operation and Development’s (OECD’s) Base Erosion and Profit Shifting (BEPS) project: This involves spontaneous sharing of information on unilateral rulings with other tax authorities.
• A resurgence in exchange of information requests based on existing tax treaties.

In fact, in the EY 2019 global survey on transfer pricing and international tax, increased information sharing amongst tax authorities was identified as one of the three most important factors contributing to tax risk today.

While many tax authorities do not make it known publicly how they will specifically use the information they receive, it is generally expected that the information will serve as a means of assisting authorities to identify cases for initial audit.

For example, in India, the Central Board of Direct Taxes has outlined the approaches to use the information received by the India tax authority from the spontaneous exchange of information under Action 5 of the OECD’s BEPS project. The India tax authority will use the information on the taxpayer’s unilateral Advanced Pricing Agreements (APAs) concluded with other jurisdictions to ensure that there are no mismatches with the taxpayer’s tax filings with India and that no profits remain untaxed. This shows that such information would almost certainly be used by India in its transfer pricing audit processes.

What this means for businesses

Businesses should consider the impact of the information shared with the various jurisdictions and pre-empt the likely responses of each jurisdiction upon receipt of the information, as part of its transfer pricing risk management strategy. Consistency in definitions and presentation of facts and circumstances is paramount, particularly when responding to queries to similar business arrangements.

Rising revenue pressures

With the current pandemic affecting most nations in 2020, the International Monetary Fund expects growth in Asia-Pacific to stagnate at 0% this year - the worst performance in almost 60 years, including during the Global Financial Crisis in 2007-2008 (4.7%). The forecast for 2021 is still uncertain and highly dependent on the response of individual countries to subsequent waves of virus infections.

While there are mounting pressures on tax authorities to collect more revenues to fund stimulus packages, revenue collection remains a challenge given that many businesses are not expected to do well or even be profitable during this period.

The growing pressure to collect more revenues means that tax authorities will likely focus their tax audit efforts on areas that will reap more rewards – the “low-lying fruits” so to speak. Transfer pricing, which is often said to be an art rather than a science, is thus a prime target. The functional and economic analyses of entities are often subject to debate, and the arm’s length outcome of related party transactions arguably within ranges rather than specific points.

What this means for businesses

Sectors that are likely to do well during this pandemic would be at higher risk of having their transfer pricing come under intense scrutiny by tax authorities. Sectors affected by the pandemic will also have to grapple with a higher transfer pricing audit risk if their financial performance suffers significant fluctuations.

Businesses should therefore identify such risk early on and establish a defence strategy before a potential transfer pricing audit arises. If changes to the transfer pricing policies are needed, such adjustment should be made throughout the financial year as opposed to a one-time adjustment, given limitations in numerous countries in dealing with such issues as well as in building up legal, accounting and transfer pricing documentation that evidences the need for the change.

Four best practices to manage transfer pricing disputes

1.    Identify risk areas

Identifying risk areas early on is crucial to preventing as well as managing transfer pricing disputes. This can be a challenge as tax authorities in Asia-Pacific have diverse areas of focus. Having said that, some common risk areas are:

• Financial indicators
  • High volumes of intercompany transactions
  • Persistent operating losses, low profitability or fluctuations in profitability
  • Less tax paid compared to industry standards
  • Large “transfer pricing adjustment” entries
• Nature of transactions
  • Transactions involving intellectual property, including outbound royalty payments
  • Outbound service payments
  • Intercompany financing transactions
  • Cost-sharing arrangements
• Others
  • Business restructurings resulting in material fluctuations in related party transactions
  • Transactions with affiliates located in tax havens

Guidance issued by the local tax authority is useful in identifying risk areas for some jurisdictions. For example, the Australian Taxation Office (ATO) has adopted a “prevention before correction” strategy to encourage a change in taxpayer behaviour. A number of Practical Compliance Guidelines (PCGs) issued by the ATO in recent years focus on specific transfer pricing aspects, such as offshore hubs, related party financing transactions and inbound distribution arrangements. Taxpayers are to self-assess their transfer pricing risk profiles and take appropriate measures to ensure that they avoid scrutiny from the ATO. The PCGs provide the framework to be used by the taxpayer to determine the risk zone it falls within: low (green), medium (yellow) or high (red).

2.    Build and maintain a defence strategy

The defence strategy adopted should be aligned with the level of transfer pricing risk assessed for the related party transaction. All available options should be considered, including the use of domestic recourse, APAs and Mutual Agreement Procedures (MAPs).

For instance, the use of bilateral APAs could be considered for relatively high-risk and high-volume transactions, where both jurisdictions concerned have a good track record in concluding BAPAs.

On the other hand, for transactions assessed to be of lower risk, the taxpayer could contemplate documentation as the strategic means to communicate the taxpayer’s transfer pricing policies, should a dispute take place.

3.    Adopt a centralised and consistent control

Should a transfer pricing dispute take place, ensuring a centralised and consistent control in responding to tax authorities is often key to resolving the dispute successfully.

Transfer pricing disputes are cross-border issues and can even involve multiple jurisdictions if the same type of transaction and its transfer pricing policy are applied in multiple jurisdictions. Very often, poor coordination between related parties results in lack of oversight and an inconsistent presentation of information to tax authorities. This results in a prolonged and painful dispute resolution process, which may not yield a satisfactory outcome.

The use of technology to manage dispute processes is a recent trend given the frequency of queries from authorities and the need to manage multiple deadlines.

4.    Stay connected

In today’s world, economic conditions and government responses, including tax policies, are evolving at a fast pace. Managing transfer pricing disputes is not a stagnant process and the strategy adopted may need to be tweaked as circumstances evolve. Keeping abreast of developments and being flexible in adapting to these developments are vital.

Circumstances can also evolve because of changes to the business itself. Certain related party transactions can become less or more relevant, as business models, product lines or markets change. Consequently, it will be worthwhile examining if the transfer pricing dispute management strategy in relation to these transactions should be changed.

While there is no one-size-fits-all strategy when it comes to managing transfer pricing disputes, the best practices above provide a framework that taxpayers can adopt to better achieve their desired outcomes. Perhaps first and foremost is the need to embrace a mindset change — that managing transfer pricing disputes should start even before any disputes take place.

The co-authors of this article are Luis Coronado, EY Global Tax Controversy Leader; EY Asia-Pacific Transfer Pricing Leader, and Jow Lee Ying, Director, International Tax and Transaction Services from EY Corporate Advisors Pte. Ltd.