Trends in Transfer Pricing Audits
By Valdis Leikus
Article first published in Tax Talk
In November 2023, the Organisation for Economic Co-operation and Development (OECD) released Revenue Statistics in Africa 2023[1]. The report underscores the financing challenges facing African countries as a result of the COVID-19 pandemic, which have resulted in widespread increases in borrowing and debt service costs. Interestingly, the report indicates that tax-to-GDP ratios remained below pre-pandemic levels in 17 of the 33 African countries covered in 2021, widening the gap between tax-to-GDP ratios in Africa and other regions. This indicates that revenue authorities will continue focusing on collection of tax revenues through tax audits. Transfer pricing is no exception in this regard. Even though there is no official publicly released data, most multinational enterprises and tax advisors would agree that transfer pricing audits are on the rise and are becoming more frequent. This article summarises five key trends observed over the last several years from the author’s experience and from discussions with various stakeholders.
Trend No. 1: intra-group service transactions are still high on the radar of tax authorities
Historically, intra-group service transactions have always been a ‘low hanging fruit’ for tax authorities, i.e., these transactions were frequently challenged, especially from the perspective of a company receiving these charges and claiming deductibility of costs for income tax purposes. Tax authorities continue to challenge intra-group service transactions, especially those involved in providing centralised support such as management support services, technical support or shared support services. The good news is that more and more African tax authorities acknowledge that the receipt of management support within the multinational group has a commercial rationale (historically, tax authorities used to argue that charging for intra-group services is just a mechanism to erode the local company’s tax base). Even though it becomes less common to deny deductibility of the full cost of intra-group services recognised by the service recipient, tax authorities still challenge taxpayers on these transactions, especially if the charge for these transactions makes up a significant cost to the taxpayer. Typical reasons for making an assessment may include the following:
- The service recipient company cannot prove that services were actually rendered;
- The service recipient company cannot prove that it has requested these services and that they are not duplicative of the functions performed by locally employed personnel;
- The service recipient company cannot prove that services cannot be purchased locally;
- Allocation keys used to determine charges for various support activities are not aligned with the consumption of services by service recipients;
- Certain activities would not benefit the local company, therefore, these costs are either reclassified as shareholder costs or as incidental benefits; and
- Charges are based on budgeted financial information and there is no consideration of actual costs.
In light of the above, it is imperative that taxpayers develop a robust transfer pricing model for charging intra-group services and collect supporting information contemporaneously.
Trend No. 2: focus on more complex/unique intercompany transactions
An emerging trend in recent transfer pricing audits is the focus on more complex and unique intercompany transactions, especially if they are material to the local company’s tax base. For example, transactions involving intellectual property (franchise concept or use of internally developed technology platforms) are scrutinised more often, transfers of assets and rights are reviewed from a transfer pricing perspective and transactions based on cost contribution arrangements are being challenged. Through various initiatives, such as Tax Inspectors Without Borders, tax authorities are getting more upskilled in tackling these complex transactions.
In light of the above, taxpayers must ensure that any complex or unique transactions have robust transfer pricing analysis and supporting documentation in place.
Trend No. 3: challenging a point in an arm’s length range derived from a benchmarking study
In order to meet transfer pricing requirements, taxpayers often require performing or updating benchmarking studies, which assist in testing the price or profitability of their intercompany transactions. Tax authorities always challenged benchmarking studies performed by taxpayers. The approach taken by tax authorities was usually to perform their own benchmarking study and adjust the taxpayer’s profit markup or margin accordingly. However, more recently, some tax authorities have been focusing on benchmarking studies that have been performed and have looked to reject certain comparables to cause the range to change. They then target the median of the range and make an adjustment to that point.
For taxpayers, this means that they need to ensure greater levels of scrutiny on searches performed. In particular, it must be ensured that accepted comparables are reliable and that they can be defended. Also, it is important to carefully consider where the taxpayer is within the range. In most cases, any point within the interquartile range should be fine. However, if the taxpayer’s result deviates significantly from the median of the range, additional considerations should be given to justify the point in the range.
Trend No. 4: the rise in exchange of information
When performing transfer pricing audits, tax authorities are more frequently requesting for information from other tax authorities. These requests are made to confirm the information provided by the taxpayer or where the taxpayer refuses to provide information or cannot provide it due to confidentiality purposes. The exchange of information might take place even in the absence of bilateral tax information of exchange agreements between the governments (tax administrations) of two jurisdictions, which enables them to exchange tax information upon request.
For multinational companies operating in various African jurisdictions, this means that they need to ensure the consistency of information submitted to tax authorities in relation to their intercompany transactions and applicable transfer pricing policies.
Trend No. 5: transactions with perceived low-tax jurisdictions are likely to be scrutinised from a substance perspective
Intercompany transactions with perceived low-tax jurisdiction such as Mauritius, United Arab Emirates, Switzerland, Singapore, Hong Kong and similar jurisdictions still attract the attention of tax authorities. However, tax authorities no longer focus on the pricing of intercompany transactions only. They investigate whether companies in these low-tax jurisdictions are fully staffed and assume/manage risks related to intercompany transactions. If tax authorities determine that there is not enough substance in these jurisdictions, they look to make an adjustment to transfer prices agreed between the taxpayer and its related party .
In light of the above, it is imperative that taxpayers are comfortable to defend transactions entered into with their related parties in these jurisdictions. If the perceived low-tax jurisdictions lack substance, taxpayers should consider reviewing and adjusting transfer pricing models to align them with local and international transfer pricing legislation and regulations.
As can be seen from these trends, transfer pricing audits will continue to be on the rise and will become more rigorous. As information requested by tax authorities during transfer pricing audits gets longer, taxpayers could be more proactive and put safeguards in place to be audit ready. For example:
- Review of transfer pricing models—taxpayers should constantly review and scrutinise their own intercompany transactions to ensure that they can withstand the scrutiny from tax authorities. It must be noted that Africa has its own operational challenges, therefore, global transfer pricing policies might have to be adapted to this region.
- Build a defence file—in order not to scramble with information that must be provided to tax authorities during the transfer pricing audit, taxpayers should start developing the defence files contemporaneously, which would include supporting information that is likely to be requested by tax authorities.
- Prepare the local company personnel—during transfer pricing audits, tax authorities often undertake interviews with local personnel to better understand the company’s activities as well as how intercompany transactions relate to the company’s business activities. If the company’s personnel is not prepared, tax authorities may take certain responses out of context and make assessments on intercompany transactions without reviewing documentary evidence.
[1] OECD/AUC/ATAF (2023), Revenue Statistics in Africa 2023, OECD Publishing, Paris, https://doi.org/10.1787/15bc5bc6-en-fr.
About the author
Valdis Leikus, executive director at Graphene Economics, started his professional career in his home country, Lithuania, where he joined EY’s tax team in 2008. He has more than a decade of transfer pricing experience and has a Master’s Degree in Financial Markets (Economics) and a Bachelor’s Degree (with distinction) in Economics (Accounting). Valdis is a member of the South African Institute of Tax Practitioners (SAIT) as well as the Institute of Business Advisors Southern Africa (IBASA).
