What are the usual trigger points for tax authorities to start auditing/investigating/challenging businesses on their TP?

FULL QUESTION

What are the usual trigger points for tax authorities to start auditing/investigating/challenging businesses on their TP? Do tax authorities often go on a fishing expedition targeting large MNEs, trying to nitpick their TP practices or are there usually some ‘blunders’ that trigger tax authorities to dig deeper.

FULL WRITTEN ANSWER

Tax authorities initiate audits or investigations into transfer pricing (TP) practices based on various triggers and indicators rather than engaging in arbitrary “fishing expeditions.” Their goal is to ensure compliance with local and international tax laws, aiming to prevent tax base erosion and profit shifting. Common triggers for TP audits or investigations include:

• Inconsistencies in Transfer Pricing Documentation: Tax authorities expect detailed, accurate, and comprehensive TP documentation that aligns with the arm’s length principle and local regulations. Inconsistencies, lack of documentation, or failure to meet documentation requirements can trigger an audit.
• Significant Intercompany Transactions: Large or complex intercompany transactions, especially those involving intangibles, financial transactions, or services, are scrutinized closely. Tax authorities may look for transactions that do not reflect market conditions or that appear to shift profits to low-tax jurisdictions.
• Disparities in Financial Performance: Entities within a multinational enterprise (MNE) showing continuous losses, especially in high-tax jurisdictions, while associated enterprises in low-tax jurisdictions report high profits, may attract attention. Such disparities could suggest that transfer pricing arrangements do not reflect the economic reality of where value is created.
• Outcomes of Country-by-Country Reporting: Under the OECD’s Base Erosion and Profit Shifting (BEPS) initiatives, MNEs are required to file country-by-country reports that provide a breakdown of their income, taxes, and economic activity by jurisdiction. Tax authorities use these reports to identify risks of profit shifting and to prioritize audits.
• Transactions with Tax Havens: Transactions involving jurisdictions with low or no tax rates, especially those lacking economic substance, are closely monitored. Tax authorities may investigate to ensure that these transactions are based on the arm’s length principle.
• Changes in TP Policies or Business Restructurings: Significant changes in an MNE’s TP policies or business restructurings that impact the allocation of profits among jurisdictions can trigger a review to ensure that the changes are justified and align with the arm’s length principle.
• Requests for Advanced Pricing Agreements (APAs) or Mutual Agreement Procedures (MAPs): While APAs and MAPs are tools for preventing disputes, the information disclosed during the application process can reveal areas of potential concern and trigger further scrutiny.
• Industry-Specific Factors: Tax authorities may target industries with high-value intangible assets, complex supply chains, or those known for aggressive tax planning strategies for more frequent or detailed audits.
• Public Information and Whistleblower Tips: Publicly available information, such as media reports on aggressive tax planning, or tips from whistleblowers, can also lead tax authorities to initiate investigations.

Tax authorities target areas where there is a higher risk of non-compliance or potential for significant tax base erosion. While large MNEs may seem to be under increased scrutiny due to their size and the complexity of their operations, the focus is typically on specific risk indicators rather than arbitrary examinations. Ensuring compliance with TP documentation requirements, adopting transparent and consistent TP policies, and proactively engaging with tax authorities can help mitigate the risk of adverse audit outcomes.