Meaning
National tax authorities conduct a formal examination of transactions that occur between related entities within a multinational enterprise. This transfer pricing audit verifies that prices charged for intercompany sales of goods, services, or intellectual property comply with the arm’s length principle. The goal is to ensure that profits are taxed in the jurisdiction where the economic activity occurs.
Audit Process
Tax inspectors review corporate intercompany contracts and compare the transaction prices against database benchmarks of comparable independent transactions. This comparison is used to determine if the pricing lies within a reasonable market range. The process can take several years and requires extensive documentation from the taxpayer.
Adjustment Risk
Tax authorities can adjust the taxable income of the entities involved if they determine that the transactions were priced artificially to shift profits. This adjustment can result in a significant double taxation risk, where the same income is taxed in both jurisdictions. The company can also face substantial penalties and interest charges on the reassessed tax liability, which can erode profits and impact shareholder value.
This risk makes careful documentation essential for multinational groups.
Documentation Practice
Corporations prepare detailed transfer pricing reports, including master files and local files, to defend their pricing strategies before an audit occurs. This documentation must be updated annually to reflect market changes. Maintaining robust records is the primary defence against tax adjustments during an audit.
