The Impact of Transfer Pricing on Corporate Disclosures

Aiming to plug tax collection leaks, impose reasonable tax burdens and bring Taiwan in line with the international trend, toward the end of 2004 the Ministry of Finance issued and put into effect "Income Tax Audit Standards for Transfer Pricing Inconsistent with Arm’s Length Transactions".

Following the implementation of the transfer pricing audit standards, not only will the taxation authorities be able to investigate back five years to see if corporate income taxes were consistent with “arm’s length” transactions; henceforth the burden of proof will have shifted from the National Tax Administration to corporations. Corporations will have to furnish evidence on their own behalf to prove their transactions are consistent with arm’s length ones, furnishing the relevant documents. As a result of this, thousands of entities - affiliated companies, parts of corporate groups, foreign businesses in Taiwan, and factories set up in Mainland China - face heavy tax risk on their “related party transactions”. And for public companies, because of their larger scale of operations and the ease of obtaining their regularly issued financial statements, the disclosures in public company financial statements prescribed by the transfer pricing audit standards will have a major impact.

As provided in “Guidelines Governing the Preparation of Financial Reports by Securities Issuers”, when a public company prepares its financial statements, in addition to following financial accounting standards, it must disclose in the notes to those statements its related party transaction circumstances, including the names of related parties, transactions having a significant effect on financial conditions, information on investments in other companies requiring disclosure, etc. In addition, to understand the influence of Mainland China investments on the financial statement, it is also necessary to make a special disclosure of the company’s mode(s) of investment in Mainland China, its gains/losses on those investments, and so forth.

In the past, Taiwan’s laws prohibited direct trade with the mainland, so the “Taiwan receives the orders, Mainland China ships the goods” model was developed. The prevailing triangular trade pattern left profits in third countries. Later, although direct trade was opened up, Taiwan’s businesses were accustomed to going through third countries to manipulate their taxed gains/losses. To this was added the trend towards a global division of labor in industry, with Taiwan-based companies clamoring to invest in Mainland China, so in current financial statements one often sees balance sheet pre-tax net profit coming mostly from equity investments, large sums in related-party transactions, and other methods, with long-term expenditures falling short of funds. You also have companies that were set up years ago for tax considerations, but with mainland operations booming, they accumulated huge surpluses offshore. To gain control over those funds while avoiding taxes on surpluses remitted from overseas, they use borrowings from those surpluses, which are given to their Taiwan parent companies for long-term use. For these types of related-party transactions, the demands on public companies for thorough disclosures in their financial statements, plus the recent tendency towards greater strictness in the competent securities authorities’ oversight attitude, mean that non-arm’s length transactions described in the transfer pricing audit standards will find nowhere to hide in financial statements.

Before the transfer pricing audit standards were established, the National Tax Administration mostly used a selective rejection approach to deal with the Mainland China expenses and salaries of Taiwan nationals sent to the mainland by multinationals and companies with Mainland China investments. Although this later evolved to include interest on excessively old accounts receivable and advances, and selective rejection of claimed R&D expenses and investment credits for R&D whose research results were not yet used in Taiwan, there was still no way to effectively get at the crux of the problem. Audit effectiveness was low and positive results were hard to come by.

Following the establishment of the transfer pricing audit standards, in the case of public companies with their larger scale of operations and easily obtained financial statements, the National Tax Administration may carry out non-arms length audit adjustments of the transactions mentioned in the preceding paragraph and disclosed in statements. It may also demand the calculation of reasonable transaction prices and collection of reasonable compensation for transactions that have not appeared in the financial statements, namely those substantive transactions with affiliates that Taiwanese companies have seldom recognized before: income for “management services”, “transfer of R&D results”, “business referrals” and other functions.

Companies now face possible transfer pricing audits by the National Tax Administration, for which they will bear the burden of proof, and a great many documents must be provided as evidence. Besides needing to prepare a corporate overview and organizational structure, summary information on controlled transactions, etc., transfer pricing reports must also be provided where transactions reach a certain monetary value. Then there is all the communication and correspondence over the course of a Tax Administration audit, additional documentary evidence and so on. Inevitably, this will consume a great deal of manpower. Also, once a Tax Administration audit imposes a supplemental tax payment due to non-arm’s length prices, it can use that as the basis for pursuing its audit back five years to see if there were “non-arm’s length” transactions in those years as well, further increasing the firm’s tax risk.

In the past, public companies all made preliminary estimates of income tax and deferred income tax liability on current year investment income from overseas equity investments. However, when an adjustment is made under the transfer pricing audit standards’ “non-arm’s length” criteria, companies will not only see a large outflow of cash to pay back taxes; they will also find themselves in a double taxation predicament, there being no way for their overseas invested companies to make a corresponding adjustment. If a corporation has not established a pricing strategy or planned out sensibly how to divide functions and risk bearing between the parent company and its subsidiaries in different locations, tax arrears “landmines” will make future financial statements vastly more unpredictable. For those with severe transfer pricing problems, these uncertainties may cause independent accountants to issue a qualified audit opinion, or to be unable to issue an opinion.

With the establishment and implementation of transfer pricing audit standards, companies must first use their 2004 data to perform simulations and provide explanations as soon as possible in order to make a thorough assessment of their past transfer pricing risks. Beyond this, in order to increase their sustainable competitive strength, companies should take advantage of this opportunity - starting out from the enterprise’s overall business operation and transaction strategy - to adjust unnecessary transactions with invested companies and affiliates, reexamine how they arrange their transaction procedures, and establish legal and sensible transaction prices for their business functions and the risks they give rise to.