Transfer Pricing: Dispute resolutions key challenge

Transfer pricing (TP) is the most important international tax issue that multinational enterprises (MNEs) face today.

The key findings of a recent survey - 2005-06 Global Transfer Pricing Survey - by Ernst & Young covering 348 parent companies and 128 subsidiary companies in 22 countries, include:

• 39% of the respondents list TP as the most important item on the agenda of their corporate tax directors;
• Almost 70% of the respondents believe that TP documentation is more important today than two years ago;
• An increased level of TP audit activity by tax authorities, with 65% of the parent companies and 59% of subsidiaries having experienced examinations of their transfer prices since 2001. More than 33% of known outcomes involved adjustments;
• 34% of the MNEs have elevated responsibilities for TP policies to the CFO level.

Transfer pricing involves the price at which transactions between units of multinational entities take place including the inter-company transfer of goods, property, services, loans and leases. The dramatic increase in international trade and investments in the past years has had important implications for TP.

Much of the attention has focused on adapting substantive tax principles to the new economic circumstances. Equally important, however, are the procedural aspects of TP. As the frequency of international transactions increases, so does the potential number of TP disputes involving several countries.

Tax executives worldwide are under pressure to resolve complex TP matters brought on by globalisation. These developments are certain to continue in the future, and thus it is timely to undertake a review of the process for resolving TP disputes.

For MNEs an added issue is that double taxation may occur if two or more tax administrations take different positions in assessing such arm's length conditions regarding transactions with related parties. Double taxation is undesirable and should be eliminated whenever possible because it constitutes a potential barrier to the development of international trade and investment flows.

TP audit practices vary widely among countries. Differences in procedures may be prompted by such factors as the tax administration's system and structure, the country's geographic size, the level of international trade, as well as the nature of the country's documentation, penalty, and litigation practices.

For both the tax administration and the taxpayer, TP cases can present special challenges. Such cases are fact-intensive and may involve difficult evaluations of comparability, markets, and financial and other industry information. Consequently, a number of tax administrations have specialists conducting TP audits.

Mechanisms for TP examination and dispute resolution would typically cover the administrative process of selecting taxpayers for audit, examination process adopted by the tax administration and procedures for dispute resolution and controversy management in case of disagreement between taxpayer and tax administration.

The risk of taxpayers being selected for a TP audit appears to be high in most countries as the tax authorities routinely include TP review as part of their taxpayer examination process. Most countries such as Australia, Canada, U.K., and US have also developed focused approach for subjecting taxpayers to detailed TP scrutiny. For e.g. taxpayers with significant intra-group services transactions and intangible property transactions are at greater risk. Tax authorities also focus their attention on taxpayers undergoing business model restructuring and transactions of taxpayers that do not produce commercially realistic results.

In the US, the tax administration has for many years used a so-called large case examination programme "� the Coordinated Examination Program (CEP). The programme's objectives are stated to be performing timely, effectively planned and managed tax examinations that will produce quality results notwithstanding obstacles created by size, complexity, diversification, or geographical dispersion of operations.

The US tax administration also has a specific examination programme relating to international issues and activities "� International Enforcement Program (IEP). The IEP's purpose is to focus the attention of the tax administration on what are often the largest potential issues in the CEP, including TP issues. The IEP transfer pricing examination guidelines provide guidance to international examiners about the conduct of TP examinations. These guidelines are also instructive for taxpayers and taxpayer advisers regarding what can be expected in these examinations.

To focus on issues in specific industries, tax administration in certain countries have organised special administrative arrangements for certain industry groupings. In the US, the administration has for several years coordinated examination activities in specific industries. The programme's purpose is to ensure uniform and consistent treatment of issues on a national basis, and to provide better identification and development of issues.

Issues in India:

In light of the approach adopted in a number of countries, it may be useful for the Indian tax administration to review whether the present approach of selecting taxpayers for TP audits based on fairly low monetary threshold of Rs 5 crore is efficient from an administrative practice as well as from a taxpayer perspective. In addition to re-considering the threshold, a case can also be made for developing a more focused approach for identifying taxpayers and a coordinated and consistent approach for addressing common issues.

Under the present administrative practice in India, even though a separate procedure exists for TP audit, tax authorities look at TP results for each tax year in isolation. Keeping in mind the fact that in a number of situations whether TP practice adopted by a MNE satisfies the arm's length standard or not would depend upon results over a period of time (and not necessarily a single tax year), there is a need to re-consider the TP audit process. For e.g. in case a taxpayer relies on business strategy for defending initial year losses, from an arm's length perspective success or otherwise of the strategy can be assessed only by reviewing the results over a period of time. To facilitate such situations, administrative practices of a number of countries permit the tax administration to conduct a TP examination by reviewing results for more than one tax year.

Dispute Resolution Process:

The existing dispute resolution procedures developed in the mutual agreement procedure (MAP) process incorporated in bilateral tax treaties have in general worked effectively among developed countries, but are increasingly being put under strain.

The volume of cases and the complexity of the cases with which the MAP has to deal have increased sharply. Although most TP conflicts can be resolved by mutual agreement and corresponding adjustment procedures, taxpayers have expressed serious concerns about how such procedures have been implemented.

A common taxpayer concern is that because TP issues are so complex, there may not be sufficient safeguards in the procedures against double taxation. Another common concern of taxpayers is fear that individual cases may not be settled based on their individual, respective merits, but rather by referring to a balance of the results in several cases that are "on the table" at the same time (or over time).

In some situations, there may also be a fear that the country from which a corresponding adjustment is requested will retaliate or enact offsetting adjustments.

The reluctance of taxpayers to rely on MAP as a mechanism for dispute resolution could either result in unresolved double taxation or less satisfactory unilateral solutions.

The Organisation for Economic Cooperation and Development (OECD) has launched an initiative for improving the effectiveness of MAP as a dispute resolution mechanism, and is also considering introduction of supplementary dispute resolution (SDR) techniques for resolving international tax and TP disputes.

Some of the SDR techniques under discussion include the possibility of obtaining an "advisory opinion" from an independent expert, formation of a joint working group for studying the issue in further detail, arbitration etc. The aim of the project is to ensure a fully effective MAP process that has the confidence of taxpayers and that therefore covers all aspects of the MAP from initial access to implementation of a mutual agreement.

It would be useful for the Indian tax administration to participate in the OECD dialogue on improving the process for resolving international tax disputes. In addition, Indian tax administration could also consider introduction of Advance Pricing Agreements (APAs). The concept of APA is to provide a means by which taxpayers and tax administrations can voluntarily and mutually agree on TP issues in advance.

The APA mechanism is beneficial to both taxpayers and tax administrations because complex factual issues can be resolved forestalling the process of a comprehensive tax examination.

As the incidence and magnitude of TP examinations, penalty regimes, and issues proliferate, several elements raise the stakes for MNEs when they select the most appropriate path for resolving TP disputes.

In the face of these developments, a critical international tax concern for MNEs is how to satisfy the multiplicity of requirements imposed by the countries in which they conduct business. The nightmare to be avoided is repeated intensive fact-and-circumstance examinations of TP policies, risks, and functions conducted in different countries with no means of facilitating acceptance of the findings of one tax authority by other authorities.

Both business and governments involved have an important stake in improved dispute resolution techniques. From a business perspective, the possibility of unresolved disputes can distort patterns of trade and investment and lead to increased administrative and compliance costs. Similarly, governments lose when unresolved tax disputes inhibit effective tax administration.

(Courtesy: Ernst & Young)