Transfer pricing audits – the surprise multinationals want to avoid, says Michael Hewson
Graphene Economics founder says transfer pricing audits arrive years down the line, creating surprise risk exposure.
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Transfer pricing is a tax matter – not directly part of a company’s internal audit function and sometimes not considered in detail as part of the external audit reporting function. But Graphene Economics founder and director Michael Hewson believes that multinational enterprises (MNEs) need to ensure their audit committees, tax teams and CFOs are all aware of and involved in managing the risks that transfer pricing audits can pose – sometimes several years down the line.
“Transfer pricing relates to the setting of the price for goods and services that are sold between controlled (or related) legal entities within an enterprise,” explains Michael. “Transfer ricing principles govern how all cross-border related party transactions are accounted for, and how profit is distributed, depending on the contributions made by each entity. As revenue authorities, particularly in Africa, look to maximise collections, corporate tax and specifically transfer pricing aare increasingly coming under the spotlight. We’re seeing an increasing number of transfer pricing audits, and these generally happen a few years down the line, when exposure may have mounted.”
Michael says that transfer pricing audits may result in a tax amount payable, plus interest and penalties. “And what many people don’t realise is that transfer pricing affects many aspects of a multinational business, from operations to finance, the brand and reputation and the stakeholders,” he says.
“Whereas transfer pricing used to be the domain of MNE tax teams, we’re seeing more and more that CFOs are involved. It makes sense, given that CFOs are very involved in setting operations up from a cross-border perspective. But when there is a transfer pricing exposure or audit, the amounts are often very large, and that also gets raised to the attention of the CFO to manage that risk with other stakeholders, such as external auditors or very often with the board of directors as well. We’ve recently even seen transfer pricing being specifically identified in financial reporting for some MNEs because they’ve realised the risk is so large.”
Michael believes that there are a few things driving the increased focus on transfer pricing from revenue authorities (and therefore by CFOs and internal finance and tax teams). One is the increasing capacity of tax authorities in specialist areas like transfer pricing, coupled with the increase in levels of transparency of MNEs’ business. Another is simply the fact that transfer pricing issues tend to go back many years and the amounts are very large.
Four strategies for managing transfer pricing risk
“Managing transfer pricing risk is not simply about compliance,” says Michael. “The first important step for MNEs to avoid transfer pricing audit shocks is to prioritise transfer pricing. Prioritising it means allocating sufficient budget and resources and supporting the tax team, and the CFO being available and aware. It also means that other key executives are brought in where necessary because they understand specific risks within the business.”
The second strategy is to operationalise. Transfer pricing involves price setting and Michael says this needs to be embedded into an MNE’s operations, down to the level of unit pricing, determining pricing for goods and services, or the set-up of operations. “It also sometimes involves the setting of targets for sales targets or pricing targets for profitability. All of these aspects have transfer pricing bearing and implication. There are also legal considerations. For example, legal agreements, and who takes the risk of certain transactions. Or another example: with goods that may have been in transit to another country and that were destroyed in the recent unrest, who should assume those risks?”
It’s important for MNEs to think about transfer pricing in relation to real-world issues, Michael stresses. Covid-19 has accelerated remote working and digitisation, and that affects value creation in different countries, which has transfer pricing and tax implications. “I think it's a critical aspect for CFOs to address – to ensure there are no unwarranted tax exposures that arise because you’ve said to people they can live in one country and report into another.”
Another aspect of operationalising it is monitoring. “As with internal audit and any risk function, it’s important to monitor to be able to manage,” Michael says. “MNEs need to monitor the transactions and contributions of all their parties and entities. Then there's less likelihood to make a significant adjustment or large correction payment at the end of the year, which may be called into question.”
Michael says MNEs should leverage the capabilities of their internal audit teams in implementing financial controls and transfer pricing monitoring, including documenting evidence that may be required by revenue authorities. “For example, if you say services are being performed in one country, are you keeping documentary evidence that can demonstrate that the services were actually performed?”
The next strategy is to communicate. “Certainly, communication is critical internally within an organisation to ensure the proper prioritisation of transfer pricing and understanding of the relevant principles. Some of our clients have a training structure in place to give training to various teams, from procurement to marketing, finance or legal. But communication is also critical beyond internal structures, for example with external auditors and the board of directors. We’re seeing more CFOs proactively presenting how they’re structuring cross-border transactions and managing their transfer pricing so there are no surprises at year-end.”
He suggests that in certain industries and instances, MNEs might want to also consider communication with external stakeholders. “We’re seeing more large MNEs publishing tax and economic contribution reports, where they proactively communicate what they’re doing, where they’re making money, what contributions they're making to local communities, etc., to manage the perception of their brand.”
The final strategy is to be able to defend transfer pricing. Michael says, “Companies need to be able to defend their transfer pricing from various perspectives. There’s a lot more transparency through things like country-by-country reporting and through additional disclosures required in many countries.
Increasing exchange of information by revenue authorities and digitalization means that MNEs can be queried on a lot of different fronts. So, CFOs need to be comfortable that they will be able to satisfy those queries – to defend and substantiate their pricing. They need to have evidence of the contributions made by the different parties, as well as the extent of the value of those contributions.
“From a CFO’s point of view, it's also really important to show to the board of directors that all of these things are under control and have been managed,” says Michael. “MNEs need to understand that transfer pricing compliance is only one area – actively managing the transfer pricing across the business is critical to its long-term sustainability.”