18-Dec-2023 What are the most common transfer pricing disputes and how can we avoid them?

To put it in the words of Kofi Annan, 
"It has been said that arguing against globalization, is like arguing against the laws of gravity." 
To imagine a country with an economy that keeps its doors closed to the global markets is nearly impossible. The growing splurge of transborder transactions between nations in recent decades has increased the need to have in place more laws and regulations to govern these international transactions and one of the significant causes of concern to multilateral governments is "Tax Evasion".

Multinational Enterprises (MNE) entering into contracts with their Associated Enterprises (Related Parties to say) tend to engage in the erosion of tax bases and profit shifting from countries with high tax rates to those with lower tax rates, thus enabling tax avoidance and evasion. To mitigate this problem, every country initiated the formulation of their own Transfer Pricing Laws in the light of the Organization for Economic Co-operation and Development (OECD) Model Tax Convention guidelines. For example in India, the Income Tax Act, 1961 under the Finance Act 2001, introduced Sections 92 to 92F vide Chapter X under the title "Special Provisions relating to avoidance of tax".

Transfer Price: Meaning & Cause for Concern 

The Transfer Price refers to the price at which an enterprise transfers physical goods or intangible properties or provides services to its related parties which are forming a part of the same MNE Group. As the tax rates vary from country to country, there is an incentive for the MNE Group to set transfer prices for transactions between its group members such that the tax liability for the group as a whole can be minimized. This involves setting the transfer prices in such a way that less profits are booked in countries with higher tax rates and vice versa. This could adversely affect a country's share of due revenue and hence transfer pricing has its share of disputes. 

To alleviate the disputes, the OECD Model Tax Convention guidelines (most commonly referred to as guidelines) prescribe that the MNEs must transact between their Associated Enterprises at the ALP – Arm's Length Price i.e., the price at which two independent entities would transact as if it were two independent and unrelated business concerns, thereby arriving at a proper transfer pricing range that would be void of any tax evasion motives. 

Common Dispute Areas: Transactions Attracting Tax Authority's attention 

Corporate Restructurings: 
Business restructuring involves the activity wherein companies significantly modify their financial and operational aspects. It involves reallocation of profits, transfer of assets and business activities, termination or renegotiation of existing agreements which can lead to further debatable issues. 

Management Costs: 
To ensure the maintenance of global standards, quality, and competitive edge it is generally seen that centrally coordinated services are provided by the parent company to all the entities forming part of the same MNE Group. Payments towards such services, referred to as Management Service Fees are usually viewed more with suspicion by the tax authorities. Such payments often get disallowed because no services were received the amounts charged were not reasonable or only incidental benefits were received. 

Intangible Assets: 
Over the years, there has been a significant increase in the sharing of intangibles between associated enterprises. The revenue from such intangibles is quite easy to transfer to a tax jurisdiction with lower tax rates often referred to as Tax Havens. Such activities usually attract special scrutiny from the tax authorities. 

Double Taxation: 
The question of which country gets the authority to tax the income always remains open as they may compete to earn their share of revenue and this can always be a cause of serious dispute for the MNEs as their tax burden shoots up if they end up paying tax to both the states. 

Stumbling Blocks for MNEs in Transfer Pricing: Measures to manage 

Selection of appropriate Transfer Pricing Method: 
The OECD Transfer Pricing Guidelines recognize several methods for the determination of Arm's Length Price, inter alia, Comparable Uncontrolled Price (CUP) Method, Resale Price Method, Cost Plus Method, and Transactional Net Margin Method. Eachmethod has its limitations and advantages/disadvantages and the price can vary significantly based on the method adopted by the MNEs for benchmarking its transactions. 
As this is the fundamental aspect that usually gets challenged by the tax authorities, the MNEs must select the most appropriate method applicable to them based on the nature of the transaction, availability of data, and the level of comparability. 

Maintaining robust Transfer Pricing Documentation: 
Lacking adequate documentation to back the selection of the most appropriate method as well as justifying the non-selection of other methods is another common cause of dispute. The MNEs must maintain proper documentation i.e., a detailed Transfer Pricing Study Report consisting of a Master File, a Local File, and a Country-by-Country Report. Such documentation is essential to display good faith and transparency and to avoid penalties and adjustments from tax authorities. 

Conducting Transfer Pricing Audits: 
Transfer pricing audits initiated by the tax authorities would involve a thorough examination of the MNE's transfer pricing practices and transactions and verification as to the conformation of the Arm's Length Principle and other applicable rules. Such audits can be time-consuming, costly, and stressful as they expose the MNEs to the risk of litigation. To avoid such a scenario, 
it's better to have an in-house audit already conducted by a professional whose reports can increase the answerability of the practices followed by the MNEs. 

Other Preventive Measures:

Mutual Agreement Procedures (MAPs): 
Mutual Agreement Procedure is a means to set out in various tax treaties that allow designated government representatives of Treaty partners, referred to as "Competent Authorities" to work together and resolve international tax disputes. Through this process, the competent authorities usually negotiate an arm's length position that is acceptable to both tax authorities, which ultimately seeks to avoid double taxation for taxpayers. 

Safe Harbour (SH) Rules: 
Safe Harbour Rules are circumstances in which a certain category of taxpayers can follow a simple set of rules under which the revenue authorities automatically accept the transfer prices. An example of the Safe Harbour Rule (in the context of Indian Income Tax Law) is, 
If the international transaction pertains to advancing intra-group loans where the amount of the loan doesn't exceed 50 crores, the Transfer Price (Interest Rate) declared by the taxpayer shall be accepted by the tax authorities, if it is not less than the base rate of State Bank of India (SBI) as on 30th June of the relevant previous year plus 150 basis points. So, if the base rate of SBI is 10.10%, an Interest Rate declared by the taxpayer of 11.60% or more shall be accepted as ALP. 

Advance Pricing Agreements (APAs): 
An APA is an agreement between a taxpayer and tax authority determining the transfer pricing methodology for pricing the taxpayer's international transactions for future years. The methodology is to be applied for a certain period of time based on the fulfillment of certain terms and conditions (called critical assumptions). 
 

Summary:
It is always said that prevention is better than cure and it is inevitable that transborder transfer pricing arrangements are bound to encounter certain disputes. However, if the MNEs well deploy counterstriking measures it will save them from needless litigations. 

Thank you Readers for your Time and Attention. If you have any questions or suggestions, please don't hesitate to reach out our Author CA Chirag Goyal on chiragkumar.goyal@gmail.com and info@apmh.in. Your input is invaluable.