Corporate Tax Management for Transfer Pricing Audits

Setting up and operating a transfer pricing regime is an effective way to keep transnational corporations from using non-arm's transaction arrangements to evade tax. As such, it is also a way for a country to preserve its right of taxation and protect its tax base from being eroded by tax authorities in other countries.

The tax systems of different countries are developed to varying degrees, and governments maintain different policies and postures towards transfer pricing. Some countries (the United States in particular) were early to establish a set of generally applicable procedures, and allocate resources, for carrying out transfer pricing audits. Governments in some countries, meanwhile, adopted relatively lax transfer pricing policies, to the extent that an enterprise's transaction prices had to be beyond the bounds of reason before it would face a transfer pricing audit. However, the US's aggressive stance on transfer pricing spurred those with looser transfer pricing policies (Japan and South Korea, for instance) to devote more resources to transfer pricing and draft correspondingly detailed regulations, all to keep their tax bases from being leached away to other tax jurisdictions. This has led many other countries to accelerate the pace of their legislative reforms in recent years, and to usher in new transfer pricing rules, and tax authorities around the world have gradually shifted the emphasis of their tax audit work towards transfer pricing issues.

Before the Ministry of Finance released its "Draft Transfer Pricing Audit Standards for Income Taxes Inconsistent with Arm's Length Transactions" on 8 October 2004, the focus of its tax return auditing was still mainly on withholding and the recognition of business-related expenses. A transfer pricing audit was typically only an examination of a corporate group's transactions based on limited documentation. This sort of audit stressed the outward forms of vouchers and receipts, or the existence or non-existence of contracts. Following the formulation of transfer pricing rules, however, one may anticipate that transfer pricing issues will also become a major focus of corporate tax return audits by Taiwan's taxation authorities.

According to the currently announced draft audit standards and related reports, the strategy adopted by the tax authority towards transfer pricing audits includes: requiring corporations to declare specifically all of their related-party transactions; strengthening the taxpayer's responsibility for producing evidence to support their transfer pricing policies for transactions with affiliated companies; and promoting the adoption and use of the advance pricing agreement system. On the other hand, the tax authority will have comparatively less recourse to measures like overseas investigations and international information exchanges, since not very many countries have signed taxation agreements with Taiwan thus far.

When a corporation is facing a transfer pricing audit, the biggest concern is usually over exactly what materials need to be provided and how long the audit process will take. However, unless a corporation adopts a proactive attitude and gets a firm grip on the audit process, these questions will be very hard to answer. And, in terms of attitude, if a corporation wishes to establish its mastery over the transfer pricing audit process, it must take an unshakable position, invest adequate resources by, for example, appointing a competent team to handle the audit process, and it must formulate cautious plans and related defensive strategies to accommodate audits at home and abroad. But speaking in terms of just providing information, if they want to protect their own best interests, companies should require that all documents go through an internal task force for review before they are provided to the tax authority. The objectives of this are: (1) Verify that all information is accurate; (2) Make sure all information is consistent with each unit's income tax returns and financial statements; (3) See that the positive and negative effects of the information are all meticulously considered. (For example, does the information provided back up the current transfer pricing strategy, and is it consistent with a functional analysis of the enterprise's units? Then one must consider whether the supplied information is likely to induce other tax risks.) (4) Consider carefully what other information may be obtained by the tax authorities in other countries, and the likelihood that Taiwan's tax authority might obtain such information through an international information exchange program.

On account of differing tax environments and economic circumstances, there are corresponding differences in the depth and extent of the demands countries place on companies for the production of transfer pricing documents. Multinationals invariably need to spend large sums of money to respond to tax administration demands of this sort. If an international enterprise bases its transfer pricing on administrative convenience, or lets prices be set independently in each country, and does not base it on a consistently maintained position across the group, then it is bound to face a large-scale increase in risk associated with providing inconsistent information. On the other hand, if the enterprise has its global transfer pricing strategy planned in advance, performs effective tax management of possible problems, and documents and records for the current period are prepared as needed (such as global core documentation), then one can respond more effectively to tax authority audits.

Transfer pricing audits, like other tax matters, are subject to legal and procedural changes over time. In any event, however, taxpaying organizations must all give thought to the response strategy they adopt. Will it be to bury your head in the sand and react negatively when problems occur, or will you take the initiative and prepare thoroughly for that transfer pricing audit you assume will come in the not-to-distant future.