The Effect of Transfer Pricing on Taxes and Corporate Management

"Every manager must manage two firms: the present one and the future one." Jorge Vasconcellos e Sa

After consulting both the OECD's "Transfer Pricing Guidelines" and Section 482 of the USA's Internal Revenue Act, the Ministry of Finance finally issued "Amendment to provisions of ‘Profit-Seeking Enterprise Income Tax Audit Standards'" on 2 January 2004. The amendment gives rules on income tax audits and adjustments for transfer pricing between related parties that is inconsistent with arm's length transactions. Along with provisions inserted in "Profit-Seeking Enterprise Income Tax Audit Standards" no. 141-1, it covers rules for apportioning among affiliated companies their mutual earnings, costs, and expenses, along with profits/losses. In order to preserve the nation's right of taxation and its tax base, however, where a company appears to have evaded or reduced its tax obligation by such means, an adjustment must be made based on the arm's length transaction principle.

In addition, on 8 October 2004, the MOF issued an advance notice of its draft "Transfer Pricing Audit Standards for Profit-Seeking Enterprise Income Taxes Inconsistent with Arm's Length Transactions", which goes a step further to set explicit standards for the principles and procedures to be used in performing transfer pricing audits. The MOF also let it be known that after an advance notice period of 30 days, it would gather opinions and suggestions from the public and revise the contents of the draft "Transfer Pricing Audit Standards", with promulgation expected in December.

The new policy announces the dawn of a new era in which Taiwan's transfer pricing system will officially be in close alignment with the international system. Many unknowns remain, but one may foresee this much: Putting these transfer pricing audit standards into practice will have a profound and far-reaching impact on Taiwan's financial and economic foundation. Seeing how advanced nations have used transfer pricing regulations to keep companies from abusing transactions that are incompatible with arm's length transactions, the actual implementation of Taiwan's new transfer pricing system should be viewed not merely as following international trends, but as a pragmatic move to protect its tax base.

One major consequence of the new transfer pricing system is that it will change the tax authorities' longstanding audit approach—from one emphasizing form to one emphasizing substance. The legal liability and taxation environment companies face will also be vastly different as a result. In the past, the tax authorities' audit methods stressed the outward forms of receipts and other evidence. This will change after the new system is taken up, as the arm's length transaction principle is used to audit the actual substance of income claims. The focus of audits will not be merely on whether expenses can be recognized, but on whether they are consistent with the corporation's business patterns, and on checking that transaction conditions and reported income are compatible with arm's length principles.

For example, when R&D expenses were audited in the past, it involved examining whether the relevant documents or tasks met the requirements for investment tax credits. Rarely were companies audited to see if they could apply for investment credits. However, corporations have routinely taken advantage of their relationships with affiliated companies to lower their taxes in Taiwan, yet transmitted their research results abroad for their overseas affiliates to use free of charge. Once the new transfer pricing system is operational, the tax authorities can apply rules in "Transfer Pricing Audit Standards" and require companies to send back to Taiwan the proceeds the corporation earned from R&D output sent abroad, and if they are unable at that time to recognize such income, they will be subject to the relevant penalties under the law for underreporting income.

In addition to the above, the new transfer pricing regime also strengthens corporations' obligation to produce supplemental evidence. When Taiwan's companies engaged in tax planning in the past, they were not accustomed to keeping contracts or legal documents for use later as required evidence. This too will change along with implementation of the new system. In practice, the tax collection authorities are unlikely to begin an investigation until two or three years after the end of the accounting year. By that time, there may have been changes in a company's people and business environment. To avoid future difficulties responding to an audit by the tax authorities, companies need to develop and preserve documentation to support all important decisions and transactions, and have it ready if/when needed for a transfer pricing audit.

The ideal approach is to prepare, on time and according to regulations, transfer pricing documentation recording the corporation's circumstances and its handling of tax matters in each given year. This way, it can avoid the problems that might emerge later when the corporation is required to submit related documentary evidence. Article 21 of the draft audit standards stipulates that when a profit-seeking enterprise files an income tax return, it must follow a prescribed format to disclose information on related-party transactions and controlled transactions. Article 22 then spells out the documents that need to be prepared respecting controlled transactions. Among these, only the transfer pricing report (in Section 1, paragraph 4) will come into use when filing 2005 income tax returns. The other provisions apply beginning from 2004. In other words, when corporations file income tax returns for this year (2004), they will need to reveal the circumstances surrounding their transactions with related parties, and whether or not the results reported for those transactions are consistent with the results of arm's length transactions. Corporations should pay particularly close attention to this rule in order to avoid being in violation.

On a more positive note, the new transfer pricing system can also be a source of inspiration. Corporations have a chance to start out with a strategic perspective embracing all of their business operations and transactions. Then, they can undertake flexible and rational planning for the corporate family based on each member's particular organizational structure, acquisition method and investment pattern, as well as on disparities between tax preferences in different countries. The result can be a win-win situation combining good corporate results and a minimal tax burden.