Strategic Insights into Transfer Pricing: Unveiling Common Audit Red Flags (Part I)
This blog is the first of our two-part series calling attention to some easily avoidable perils we encounter in Transfer Pricing (“TP”) documentation. These item are also the “red flags” that stand out for tax authorities during TP audits. Though there is no such thing as a “bullet-proof TP strategy”, avoiding these red flags can alleviate some pressure from the audit procedure. In general, being prepared with the requisite documentation and engaging proactively with the tax authorities makes the process less stressful. In our view, tax audits should be viewed as an opportunity to be transparent and forthcoming with the tax authorities. To help companies prepare for tax audits and questions from the tax authorities, we are sharing our experience with tax audits, specifically pointing out some pitfalls to watch out for while developing TP policies and compiling TP documentation.
04 Mar. '24 Neha Mohan
1. BIG SWINGS IN PROFITS
Large fluctuations in a company's profits one year to the next naturally draw the attention of the tax authorities. In every such case, there is bound to be a discussion. Hence, it is critical to understand the reasons behind profit fluctuations to assess the appropriateness of the TP model and its alignment with the company’s actual operations and market conditions. In the absence of a clear and reasonable explanation, tax authorities may propose an adjustments to the taxable profits, assuming that the variance is caused by a deliberate attempt to shift profits.
Surely, big swings in profits could well be caused by an external commercial factor, such as a decrease in demand for the company’s products or a supply chain issue. However, if the variance in profits reported is not clearly explained in the TP documentation and linked to a verifiable external commercial factor, tax authorities will definitely take a closer look into the internal transactions to verify the cause of the variance. This is particularly true if profits appear to be shifted from a jurisdiction with a higher tax rate to a jurisdiction with a low tax rate.
This could imply that there has been a cross-border re-location of functions, assets and/or risks (“FAR”). In such case, the tax authorities will want to inspect the related inter-company transactions and check whether the FAR have been transferred at arm’s length. They will want to confirm whether the party that has given up some profit-generating FAR has been proportionally compensated.
