Transfer pricing audit: a genie in a lamp can’t save you!

In the “Aladdin’s Lamp” tale, there is an iconic blue genie who appears and grants three wishes whenever the magical lamp is rubbed. But, if there’s one wish that even this “genie” cannot grant, it’s that your business will never be audited by the taxman! However, don’t panic. A “tax audit” is a check used by tax authorities - and it doesn’t necessarily mean that your company is avoiding tax, or is non-compliant in taxation matters.

One type of such a tax audit is a transfer pricing (TP) audit, which is a review with a specific focus on TP matters so as to ascertain compliance with the applicable TP regulations.

Its objective is both to: (i) increase future compliance (which indirectly contributes to future tax revenue and protection of the tax base) and (ii) increase current tax revenues (where cases are successfully audited).

The general approach of tax authorities around the world, including the Tanzania Revenue Authority (TRA), is a “fine-tooth comb” one, so as to understand related party transactions (also technically known as “controlled transactions”) of multinational enterprises (MNEs).

In doing this, they routinely question the finer elements of where and how profits are made among entities within a MNE Group.

The TRA’s TP audits (predominantly done by the International Tax Unit (ITU) of the Large Taxpayers’ Department) can be standalone audits or part of a general tax audit.

The ITU will normally use a risk differentiation framework model to identify and select specific cases of higher-risk taxpayers for TP audits. The selection may also be routine every few years based on criteria such as industry or sector groupings, locations etc..

Factors that can “flag” higher risk transactions and trigger TP audits include compliance level of TP obligations, significant and recurring losses, transactions with entities in tax havens or lower tax jurisdictions, payments for services and royalty, business restructuring, and centralised sourcing.

These flags should not be treated as if mis-pricing has occurred, but they do help identify transactions with a higher than normal likelihood of such mis-pricing.

Whether you’re facing your first audit or have been audited previously, the old adage “prior preparation is key” also applies to TP audits since they require significantly more investment in time and resources.

Getting your house in order and ensuring an early preparation will help you alleviate the stress level and reduce exposure risks. Now, let’s rub the lamp for our three wishes which will act as the main pointers on how to adequately prepare for your first or next TP audit - namely (i) adequate self assessment; (ii) alignment with actual conduct, and: (iii) sufficient documentary evidence.

As an initial step, a self-assessment can help you keep a pulse on your TP health and identify any exposure (if any) well ahead of any inquiry from the taxman and so help you better manage the audit process.

Proactive implementation of a process to establish, monitor, and review your transfer prices, taking into account the size and complexity of your controlled transactions and the level of risk involved, can ensure a much stronger defence position - notwithstanding that TP is not an exact science!

Secondly, you need to go an extra mile beyond TP documentation compliance and demonstrate alignment with conduct. To put it in the words of the tax auditor: “Show, don’t tell”!

In other words, the mere existence of a TP documentation is not enough to discharge the burden of proof that rests on the taxpayer, as a TP audit will go beyond a mere documentation review and extend to scrutiny of whether the taxpayers in a controlled transaction have conducted the transaction in a manner which is in accordance with the terms set out in the TP documentation. Where inconsistencies arise, this will possibly result in TP adjustments and potential penalties. Therefore, it is essential that on an ongoing basis taxpayers ensure that the actual conduct is aligned with both the contractual arrangements and what has been documented.

Lastly, it is important to keep sufficient documentary evidence (for example, invoices, correspondence with service providers, deliverables of services rendered) so as to have an effective TP defence file. TP audits can be conducted several years after transactions have occurred, and in many instances this creates a challenge where a taxpayer has underestimated the amount of information or documents required and so is unable to defend their TP position when thoroughly scrutinised.

As we are witnessing tax authorities around the world become much more protective of their tax revenues, MNEs from the smallest to the largest, need to pay more attention to ensure that their controlled transactions are compliant with TP regulations, robust enough to stand up to increased scrutiny from tax authorities, and are designed to mitigate the unintended TP exposures.

Now that we’ve established that tax and audit can never be taken out of the business equation, I’d like to pose a question… “If the taxman comes knocking at your door today, will you be ready?”

Agnes Koni is a Senior Associate specialising in Transfer Pricing at PwC Tanzania