February 2002

Managing Transfer Pricing Audit Risks

By Robert E. Ackerman and John Hobster

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 MNE 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 1 and 2), apparently because transfer pricing adjustments often result in double taxation.

Increased Tax Authority Activity

The survey indicates that more governments are focusing legislative, regulatory, 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%). Dutch companies continued to have a high incidence of audit (80%). Other countries with a high incidence of transfer pricing audits included Denmark (85%), Sweden (84%), Germany (84%), the United Kingdom (78%), and the United States (74%).

Due to continually escalating scrutiny by revenue authorities, 75% of MNEs expect that transfer pricing issues will be raised in examinations over the next two years. Exhibit 3 shows the countries with the most aggressive tax authorities, where MNEs expect transfer pricing audits to occur.

In cases where a tax authority challenges an MNE's transfer pricing practices during an audit, a proposed transfer pricing adjustment often occurs. Exhibit 4 shows the percent of transfer pricing audits that resulted in a proposed adjustment. The increase in proposed adjustments is alarming, more than doubling between 1999 and 2001 in several countries.

Primary Transactions Subject to Transfer Pricing Adjustments

Services (particularly technical services), transfers of intangibles, and technology cost-sharing arrangements were primary transfer pricing risks in 2001. Because of the high incidence of adjustments for these transactions, MNEs desire competent authority relief to mitigate the extent of resulting double taxation (Exhibit 5).

At 42%, technical services gave rise to the highest incidence of adjustment, followed closely by administrative and managerial services at 38%. Services are easy to audit on a stand-alone basis, and proving that a benefit has been received can be difficult for MNEs, whereas tax authorities can easily determine whether payments have been made. In addition, fiscal authorities often contend that the delivery of technical services to a related party should be characterized as an intercompany transfer of intangibles, resulting in a higher valuation than the typical "cost plus" charges.

Other arguments on which tax authorities typically base adjustments to intercompany service fees include the following:

• Whether fully loaded costs (direct and indirect) are used in the allocation;
• Whether the allocation factors employed have a rational basis to the benefit being conferred by the service; and
• Whether "headquarters" or "home office" centralized services should be charged at cost or at fair market value.

Many fiscal authorities are expanding the definition of "intangible" to include items MNEs do not typically treat as such, including computer networks. In doing so, such items come under the country's transfer pricing rules, thereby becoming eligible for a adjustment. Another argument involves reclassifying the owner of certain intangibles for tax purposes. For example, certain marketing intangibles, such as trademarks and trade names legally owned by a parent company, may be attributed by the tax authorities to a subsidiary distributor that uses the intangibles or pays for advertising and promotion of the trademarks and trade names in a specified geographic market. By reclassifying the distributor as an owner of such intangibles, tax authorities require a higher return to the tax owner, often resulting in adjustments to the transfer pricing between parent and the subsidiary.

Finally, fiscal authorities often challenge the valuation method selected by the MNE. Because of the nature of intangibles, they can often be difficult to value, and different methods can result in different valuations. With technology cost-sharing agreements, the issues usually involve determining the following:

• The most reliable valuation method for the buy-in and buy-out payments;
• The most reliable cost allocation method among the cost-sharing participants.

Double Taxation

After transfer pricing, the risk of double taxation ranks second as a major international tax concern. Of those MNEs suffering a transfer pricing adjustment in 2001, double taxation was the result in 47% of cases, an increase from 42% in 1999.

The only means to resolve double taxation from a transfer pricing adjustment is to invoke the mutual agreement process through a country's competent authority. Historically, this has been a slow process, often taking several years. The increase in proposed transfer pricing adjustments will generate a concomitant rise in double tax cases.

As the number of double taxation cases grows, the backlog of such cases pending with competent authorities also grows, making the process even slower. Even though the competent authority process is the only way to resolve double tax issues, there is no guarantee that such issues will be resolved. The competent authority process prevents double taxation in approximately 90% of cases, but 10% still result in double taxation. To avoid this, MNEs must take a proactive role in the process and justify both sides of the transaction. Moreover, they must make certain that the competent authority from each country fully understands the MNE's position from both sides of the intercompany transaction.

As seen in Exhibit 5, MNEs seek competent authority relief for double taxation approximately 30% of time. This translates into double taxation 70% of the time. Across the survey, MNEs that did not seek competent authority relief to eliminate double taxation indicated that the process was "too expensive" or "took too long." Others said that competent authorities might use secret comparables or a favored methodology with an adverse impact on the MNE.

Another avenue to resolve transfer pricing adjustments and potential double taxation is the advance pricing agreement (APA) process. The APA process is a dispute resolution tool increasingly used by MNEs. In 2001, 15% of MNEs reported using the APA process, up from 12% in 1999. Various countries' APA processes are not regarded by MNEs as user friendly despite efforts by revenue authorities to make them so. In addition, some tax authorities lack the resources to offer a credible APA program. Others do not differentiate between an APA, which is an alternative dispute resolution process, and a transfer pricing audit.

Despite these difficulties, the APA process remains a viable venue for resolving transfer pricing disputes (18 countries have an APA-type process). MNEs use the APA process when the MNE has-

• a poor or adversarial relationship with the audit team,
• the same audit issues extending into future years, and
• complex or unique transfer pricing issues, such as post-merger integration or supply chain rationalization.

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