UN Solutions for Optimizing Transfer Pricing Compliance

Amid increasingly complex global business processes influenced by international supply chains and technological developments, compliance with transfer pricing regulations is key for developing countries to prevent potential revenue leakage.

Therefore, in July 2024, the United Nations (UN) released the Transfer Pricing Compliance Assurance Toolkit, which is specifically designed End-to-End to increase voluntary compliance through a self-assessment system. 

Thus, it is expected to significantly reduce the tax administration's direct involvement in monitoring while preventing the often costly transfer pricing audit process.

Read: Enhancing Effective Transfer Pricing Audits, UN Releases the Toolkit

In addition, this Toolkit can also serve as a reference for tax authorities in preventing revenue loss due to erroneous transfer pricing policies, reducing costly and time-consuming transfer pricing disputes, and supporting a conducive investment climate, by maximizing the efficiency and effectiveness of limited resources.

The end-to-end transfer pricing compliance assurance process recommended by the UN includes the following steps:

• Identification of potential cases, which are then filtered down to a short list;
• Individual risk assessment of taxpayers to determine audit priority level;
• Transfer pricing audit process for high-risk taxpayers.

Meanwhile, there are two ideas discussed in this Toolkit, namely the transfer pricing risk assessment roadmap and the transfer pricing audit roadmap. 

Transfer Pricing Risk Assessment Road Map 

In conducting a risk assessment, tax authorities will generally develop an effective transfer pricing compliance program through the development of a strategic plan for risk assessment and data analysis. This step includes determining criteria, compiling an initial list of taxpayers, and conducting individual analyses of taxpayers.

• Risk Assessment Approach

UN explained that in planning the risk assessment, each tax authority can use two approaches, namely centralized and decentralized approaches. 

In the centralized approach, the risk assessment is conducted centrally by a risk assessment team involving input from the compliance function, or locally by the tax inspectors themselves. 

Meanwhile, in the decentralized approach, the risk assessment is conducted by the transfer pricing audit team. This approach can facilitate interaction with taxpayers and allow for broader coverage for jurisdictions with large populations. 

In addition, there are several other approaches that can be used, such as global vs industry-specific risk assessment, taxpayer classification, and transactional vs jurisdictional vs risk-based approaches.

In the risk assessment process, the assessment team can utilize information from various sources, including tax reports, transfer pricing documentation (such as country-by-country reports, master files, and local files), advance pricing agreements, as well as additional information like financial statements, questionnaires, and public sources such as internet searches and commercial databases.

• Data and Information Analysis

All information is used for cross-verification for more accurate risk identification. Once the information is collected, the assessment team conducts quantitative analysis to prioritise cases that are considered high risk. 

The quantitative analysis includes calculating the taxpayer's financial ratios which are then compared with other taxpayers in the same industry or with the results of the group as a whole, the results of affiliates in other jurisdictions, or the taxpayer's results in the previous period. 

If the financial ratios are different from the industry standard, the taxpayer will be assessed as having a high risk.

In addition to examining the taxpayer's risk level, the tax authority may also evaluate the costs that may be incurred and the tax benefits received if an audit is conducted. If the tax benefits that may be received by the tax office are considered minimal, the tax authority will concentrate its resources on cases that have greater tax benefits.

Besides quantitative analysis, it is equally important to conduct functional analysis in the transfer pricing risk assessment process. Functional analysis determines the functions, assets and risks of each party and is the core part of transfer pricing analysis. 

The two initial steps of functional analysis are: (1) analyze the functional profile of the taxpayers involved in the transaction by considering the actual transaction conditions; and (2) evaluate whether the methodology and application of transfer pricing in the taxpayers are in line with their functional profile. 

After going through the quantitative and functional analysis process, the tax authority can classify the risks using the "traffic light approach", where each risk is represented by red (high risk, tax audit should be conducted), yellow (medium risk, supervision and communication with taxpayers should be conducted), and green (low risk, no tax audit is required).

Road Map for Transfer Pricing Audit

Transfer pricing audit aims to assess tax compliance by thoroughly considering the actual facts and conditions of the taxpayer's case. The process of transfer pricing audit is divided into the initial stage, implementation stage, audit closure, and follow-up stage.

• Initial and Implementation Stage

In the initial stage, the first step that can be taken by the tax authority is to form a transfer pricing audit team, review the previous period's audit work, and establish the team, audit plan, and implementation schedule.

The implementation stage includes steps such as information gathering, analysis of economic characteristics, review of intercompany agreements, site/facility visits, interviews with key managers/staff, determination of functional profiles, evaluation of transfer pricing methodologies, and presentation and resolution of issues.

• Audit Closure and Follow-up Phase

Following the audit process, the audit team should prepare a final report that includes an executive summary, a summary of the audit operations performed, factual and functional analysis, a summary of the transfer pricing methodology, the tax authority's assessment of the transactions in question, a summary of the proposed transfer pricing adjustments, and conclusions and recommendations.

This report not only serves as an evaluation of the previous audit but can also be a consideration for taxpayers who wish to apply for an Advance Pricing Agreement (APA)/Mutual Agreement Procedure (MAP). Based on the audit report, the tax authority can also update the taxpayer's risk profile. Thus, the effectiveness of taxpayer risk assessment in the future will be improved.