Penalties in transfer pricing controversy: always show your working

This article considers how prudent multinational enterprises can reduce the likelihood of a penalty being levied by a tax administration should their underlying transfer pricing applied ultimately be shown to be incorrect. This is not a straightforward matter due to the very nature of transfer pricing and the nature of tax penalty regimes around the globe. To understand how to reduce the incidence of transfer pricing penalties, it is worthwhile to first consider why tax penalty regimes exist.

It is fairly well accepted that penalties do not (or should not, at any rate) exist to raise money – that purpose is a function of the underlying tax regime. Penalties exist to encourage compliance with tax rules. Where the rules are not followed, a penalty may apply.

In general, penalties are fixed (e.g., a particular amount for a particular failure) or linked to the underlying tax amount under-declared at the proper time. It is common for the latter type of penalty, even where applicable, to be reduced based on various factors linked to the nature and severity of the offence (severity is not always inextricably a reflection of the size of the error) and the underlying behaviour of the taxpayer concerned. The latter is counted both at the time of the original failure (e.g., when a tax return is made) and during the subsequent tax administration audit that results in the error becoming apparent.

Hence we begin to see how appropriate behaviour in setting transfer pricing, and again in any interaction with a tax administration to check the transfer pricing, can (or would normally) reduce the likelihood of a penalty and the amount of any such penalty if the transfer pricing is found to be incorrect. Proper due diligence in setting transfer prices in the first instance will, of course, reduce the likelihood of any adjustment.

Some penalty regimes attempt to impose a penalty if certain administrative tasks are not completed, irrespective of whether tax is underpaid (e.g., a penalty could be levied if documentation was incomplete, even if the transfer pricing is correct). It is obviously vital to get the administration (e.g., documentation) right for this type of regime.

The main focus needs to be on getting the transfer pricing right and being able to show the steps taken during that exercise. Where a taxpayer can show that the work done was prudent and undertaken with the proper amount of due diligence, their actions would normally be taken into account in mitigating any penalty, even if the transfer pricing applied is subsequently shown to be less appropriate than the revised approach.

This aspect of a penalty regime is a necessary one if, as is ideal, a tax administration is to recognise the subjective nature of transfer pricing itself, unlike many other areas of tax. In other words, an error that arose even after proper due diligence, if a penalty is to be applied, can potentially attract a lesser penalty than a same-sized revision that arose with improper levels of due diligence applied by the taxpayer concerned. Penalty regimes that accommodate this range of behaviour are often seen as inherently fairer than more arbitrary regimes.

Also consider the overlapping processes in play before the existence of any revision becomes apparent and final. The taxpayer at the proper time makes a tax return convinced that the transfer pricing is correct. A tax administration audit of that return may ultimately result in an agreement that the transfer pricing is not an appropriate approach or a court-imposed judgment saying the same. This adjustment may then go to a mutual agreement procedure, which may result in an adjustment lower than the first. (It is generally accepted that any penalty due needs to be based on this latter amount.)

Therefore, any error only crystallises after multiple processes but often a considerable time after the underlying transaction being checked. It is in the nature of transfer pricing that a taxpayer, having performed appropriate due diligence, can believe the transfer pricing to be correct, but a tax administration can take a different view that the taxpayer or a court subsequently agrees with. But after that event, a mutual agreement procedure can produce a different answer; one that may, in itself, be subject to court proceedings.

All these complexities mean that the best approaches to reducing the incidence of a transfer pricing penalty are not only to apply best efforts to get transfer pricing right at the proper time (e.g., when a tax return is due) but to ensure that these best efforts are properly recorded and can be subsequently shown to have been carried out at the proper time. Overlaying this will be interacting appropriately with the tax administration during any subsequent check or audit. Penalty regimes will seem fairer where these three broad behaviours are recognised.

To sum up, there have been many instances where even after a transfer pricing error becomes final, no penalty is due. Thankfully, many penalty regimes are applied on this basis.

In transfer pricing controversy, penalties come into play at a rather late stage, but in most part they depend on the taxpayer’s documentation report, which was often prepared several years earlier. Due diligence is best done at the time of the transaction concerned when the facts are fresh; next best, but the absolute minimum necessary for many tax administrations, is when a tax declaration must be made (e.g., a tax return submitted). Proving what the facts were at the time is best done at the time – not years later in a tax audit.

Accuracy and completeness are the relevant watchwords. A surprise during an audit would be an unwelcome and unfortunate development: a fact subsequently coming to light that should have been known at the time is likely to be a clear step towards a penalty if a tax adjustment becomes due.

Any technical analysis of whether the documentation report satisfies all the requirements of penalty protection can be a complicated exercise to perform under the local law. For example, the US transfer pricing penalty regulations specifically require the taxpayer to “engage in a reasonably thorough search for the data” and, after that search, to “consider which method would provide the most reliable measure of an arm’s length result” (see Treasury Regulation Section 1.6662-6(d)(2)(ii)(A)). Technically speaking, a taxpayer’s documentation would best anticipate and address the data and methods the tax authority ended up selecting in the audit many years later.

Some tax administrations have well-established views on how transfer pricing would normally be established under various fact patterns. A taxpayer may well choose to go down these previously trodden paths but equally may believe, based on its facts, that a different approach is valid.

A risk-based approach that tailors the amount of work to the underlying risk of an adjustment is prudent. For transactions where there is a clear choice of the tested party and there is a good history of tax authorities relying on a particular method (for example, an inbound distributor being tested using the transactional net margin method (TNMM) or the comparable profits method (CPM), a documented search for comparable companies carrying out comparable transactions may well be sufficient. However, other cases will require more effort.

Here are some examples of cases that would require more upfront preparation to facilitate penalty protection down the road.

The rules and guidance for the selection of the appropriate tested party for the application of the TNMM or CPM does not include clear-cut criteria. In cases where that decision can go either way and the consequences are substantial, taxpayers may want to include more substantiation of their selection in their transfer pricing documentation to mitigate further challenges regarding the completeness of documentation and penalty protection. Doing so would also help with the audit defence process.

A classic example would be the transactions between a manufacturer with know-how but with no legally protected (IP) and a value-added distributor with significant customer relationships. The selection of the tested party in such a case would rely on detailed facts and circumstances, and subjective judgements. A simple explanation may not suffice for ensuring penalty protection.

A special case of the tested party selection would be one in which the selection of the tested party depends on identifying the entrepreneur in a transaction. Prior to the introduction of the control of risk paradigm by the OECD, the contractual arrangements were the primary driver in identifying the entrepreneur. Under the control of risk paradigm, however, a more detailed analysis of how critical risks are managed within the controlled group became more prominent, requiring a more in-depth analysis of the division of labour among executives.

In many cases, taxpayers would have readily available data for applying an alternative transfer pricing method, but, due to reliability or comparability concerns, they do not select that method for analysis. A classic example would be a manufacturer selling to related distributors in some jurisdictions and to unrelated distributors in others.

The transactional cost-plus method could be applied in this instance using the gross margin data on sales to unrelated distributors but would require numerous comparability adjustments for the geographic market, volume, functional, and risk differences for a reliable application. Often, documentation reports list these concerns to dismiss the cost-plus method and move on to an application of the TNMM or CPM. In many audits, tax authorities enquire about this type of data and may pursue a transactional cost-plus approach to support their proposed adjustment.

Over the past decade, taxpayers began to provide more information to the tax authorities regarding their global value chain through the introduction of the master file concept and country-by-country reporting. This allows the tax authorities to evaluate the transfer pricing methods applied for specific transactions within the context of the global value chain.

In particular, they may evaluate profitability differences across jurisdictions as a reasonableness test (often referred to as a ‘smell test’). This, of course, is not a formal transfer pricing method, but a risk assessment tool for the tax authorities. If they see that the taxable income reported in their jurisdiction is relatively low, they will feel compelled to enquire into the application of other methods to see if a different transfer pricing result can be obtained. In this regard, taxpayers must make sure that their method selection is consistent with a global value chain analysis and that their documentation files contain sufficient facts and details for support.

These may constitute ‘life events’ for taxpayers and are more likely to be identified as part of data-driven risk assessment processes and therefore scrutinised by tax authorities. There are more areas prone to controversy for IP transfers and restructurings, including use of the market royalty rates versus the income method, identification of the income attributable to the intangibles subject to the transfer, and the before-and-after profitability of the transferees.

In general, tax authorities enquire if an IP transfer can be more expansive than the sale or licensing of a specific asset, while the taxpayers try to focus it more narrowly on the transaction. This creates a tension in the approach to documentation and, ultimately, penalty protection. There are at least two broad schools of thought on this matter:

• In their desire for a narrow focus to the transactions, some taxpayers do not want to give any credence to alternative approaches or methods. As such, the documentation report summarily dismisses alternative methods and approaches, and presenting a singular view. However, if the audit concludes with an adjustment using an alternative method, there would be a bigger concern about the completeness of the documentation and hence protection from penalties.

• The other approach is to present the results as a congruence of all the applicable methods and approaches. If a taxpayer takes this approach, there would be little doubt about the completeness of the documentation report and a better chance of obtaining penalty protection. As an example, a taxpayer that is primarily relying on the comparable uncontrolled price method for an IP licensing transaction may also include a discussion of alternative methods such as residual profit split or TNMM and show that their applications also lead to similar results. In general, the thought is that doing so would effectively be doing the work of the tax authorities and would lead them to pick a method that can be most easily modified to provide a significantly different answer. This concern may be re-evaluated with the perspective that most of the major tax authorities now have decades of experience auditing IP transactions, and these alternative methods are known to them. Exclusion of these methods would not necessarily stop them from applying them.

Carrying out the right actions to reduce the chances of a transfer pricing adjustment is necessary, but so is recording those actions. ‘Doing’ – and documenting the doing – can only help to reduce the chances of a penalty. Be like Caesar’s wife: beyond reproach. But, also, be seen to be beyond reproach.

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