UN Guidelines for Transfer Pricing Risk Assessment in Developing Countries

The United Nations (UN) recently released a toolkit titled "End-to-End Transfer Pricing Compliance Assurance," specifically designed to support developing countries in ensuring compliance with transfer pricing (TP) regulations.

This toolkit focuses on two main pillars: a TP risk assessment roadmap and a TP audit roadmap. However, this article will focus more specifically on the TP risk assessment roadmap for countries or jurisdictions, as outlined by the UN.

Details on the second pillar, the TP audit roadmap based on this toolkit, can be found in a separate article, as part of the series on the "End-to-End Transfer Pricing Compliance Assurance" Toolkit.

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

Transfer Pricing Risk Assessment Approach

The transfer pricing (TP) risk assessment is a vital tool for tax authorities in setting audit priorities. This ensures that handling is carried out appropriately, especially for related party transactions that may involve tax risks.

Each country or jurisdiction has its own approach to assessing transfer pricing risks, which the UN acknowledges in its documents. However, the UN considers it necessary to have a comprehensive guide that can serve as a reference for all countries.

Accordingly, the UN toolkit outlines three key steps for conducting a risk assessment. First, defining a strategic plan for risk assessment. Second, consolidating assessment criteria and creating an initial list of taxpayers to be evaluated. Third, performing the risk assessment.

Read: UN Solutions for Optimizing Transfer Pricing Compliance

Defining the Risk Assessment Strategic Plan

The definition of a strategic plan in TP risk assessment is not singular; it depends on various influencing aspects. For instance, the assessment can be based on whether it is centralized or decentralized. It can also be based on industry type, transaction type, tax rates of counterpart jurisdictions, or the revenue or transaction value of the taxpayer.

Each approach used in the strategic plan has its strengths and weaknesses. For example, a centralized approach is suitable for countries with relatively compact territories and limited resources. Conversely, a decentralized approach is more suitable in certain situations, where interaction with taxpayers can enhance understanding of their business activities.

When a country has a prominent, strategically important industry, an industry-based risk assessment might be a viable choice. Available audit resources can be allocated to assess industries frequently involved in profit-shifting practices.

For TP risk assessment to be effective, it requires a solid understanding of the taxpayer’s business activities and industry conditions, based on relevant information, to make a more accurate risk assessment, including:

• Tax Return (SPT)
• Transfer Pricing Documentation (TP Doc)
• Previous years’ tax audit files
• Financial information exchange with other jurisdictions
• Questionnaires for specific taxpayers
• Customs data, related to tangible goods transactions with foreign parties
• Intellectual property rights agencies, related to intangible asset information
• Additional information from public sources (internet, news, commercial databases, or taxpayer websites)

To facilitate the risk identification process and gain a comprehensive view of taxpayers, tax authorities can combine various data sources.

The UN also emphasizes that the evaluation of taxpayer documentation should focus not only on compliance with requirements but also on the accuracy in depicting the related party transactions conducted.

Read: Single or Multiple Year Dilemma as Transfer Pricing Comparable Data

Conducting a TP Risk Assessment

In conducting a TP (transfer pricing) risk assessment, tax authorities should follow several phases, including the preliminary stage, the execution phase, and the outcome phase.

Preliminary Stage

The preliminary stage focuses on gathering documents and information to gain an initial understanding of the taxpayer's background and the business sector in which they operate.

This stage includes, first, data collection and review to understand the taxpayer's industry. This helps identify key value or profit drivers, detect extraordinary events that may impact economic conditions, and understand the level of competition within the industry.

Second, further review of the taxpayer's background and operational activities to obtain a holistic overview of the taxpayer.

Third, a financial ratio analysis that begins with the calculation of financial ratios, based on the taxpayer's financial information over several years, and then compared to the performance of the industry in which the taxpayer operates. 

The financial indicators used in this analysis vary depending on the nature of the taxpayer's business, such as profit margin, effective tax rate, profit per unit of economic activity, reliance on related party transactions, pre- and post-tax return on equity, and so on. 

The results of financial ratio calculations may provide an early indication of potential TP risks. However, these indicators need to be compared with similar companies in the same industry, the business group as a whole, related parties in other jurisdictions, and the taxpayer's performance in recent years, to determine the level of risk.

Fourth, develop a preliminary hypothesis to identify potential risks. The aim is to focus tax administration resources on taxpayers that show indications of risk.

Read: Understanding Three New Transfer Pricing Methods in Government Regulation Number 55 of 2022

Here are some transfer pricing risk flags that can be further evaluated in the initial hypothesis development stage. 

1.    Business Group Track Record 

A limited track record or report of a business group within a jurisdiction may indicate potential risk. For example, an agent or commissioner company that only reports commission income without specifying sales figures as its calculation basis makes it difficult for tax authorities to assess the company’s track record and actual risk.

2.    Profit and Activity Discrepancies

Risks can also be observed when a group entity reports significant profit with limited activity or vice versa. This may indicate profit shifting from a jurisdiction where substantial economic activity occurs.

3.    Low-Tax Profit Shifting

Indications of profit shifting can also be seen from group entities with significant profits in a jurisdiction with a low effective tax rate, but paying low taxes. 

4.    Risk of Intangible Assets

The transfer of intangible assets between related parties may also pose TP risks. In particular, if the intangible assets transferred are unique, making it difficult to value accurately and difficult to find reliable comparables.

5.    Business Restructuring

Business restructuring can raise two main issues: the classification or characterization of newly formed entities, and the TP analysis of profits for entities with principal or entrepreneurial functions and routine functions post-restructuring. This risk depends on the jurisdiction where the restructuring occurs.

6. Specific Payment Types

Payments like interest, insurance premiums, and royalties may pose higher TP risks, especially if directed to parties in low-tax jurisdictions or those that apply safe harbors. This includes risks of reduced profit or the creation of loss-making domestic entities as a means of global profit shifting.

7. Excessive Debt

Excessive debt can indicate TP risk, particularly when combined with poor tax compliance and weak documentation.

After conducting the preliminary quantitative analysis, tax authorities need to determine their position through a cost-benefit analysis. This aims to evaluate the taxpayer's potential risk relative to the available resources and the time required.

In this context, the Country-by-Country Report (CbCR) plays an essential role by providing an initial understanding of the activities of group members in the country or jurisdiction where the tax authority is based.

Read: OECD Updates CbC Report Guidance on BEPS Action 13

Execution Phase 

At this stage, tax authorities can narrow down the list of taxpayers, resulting in a more accurate list of potential taxpayers by applying a series of more detailed and qualitative analyses. 

The analyses focus on three transaction scenarios. Firstly, recurring related party transactions. Second, related party transactions that occur once but are significant or complex, such as business restructuring and asset transfer transactions. Third, related party transactions that occur within a business group, with an ineffective tax control framework. 

In this stage, two steps can be taken, namely reviewing the functional analysis conducted by the taxpayer and evaluating the suitability of the TP methodology applied by the taxpayer to the affiliated transaction analysis method used, including the price level indicators and comparables selected. 

If these two steps are still inconclusive in determining the list of potential taxpayers, the tax authority can send an ad hoc questionnaire to ask taxpayers for further information. 

Outcome Phase 

At this stage, the tax authority focuses on quantifying the risk of TP by considering the estimated additional tax revenue and potential recurring systematic risks that may arise. Accordingly, it should prioritize only cases with a high-risk classification (red lights).

Furthermore, the results of the assessment should be documented in accordance with UN TP Manual Section 13.2.8, including the legal filing requirements, the period analyzed, as well as the indicator table. The assessment should include a brief description of the transactions analyzed and the information reviewed. 

In addition, it is important to include a measurement of the risks associated with the transaction. For example, based on an estimate of the possible tax contingency combined with an estimate of the likelihood of the risk occurring. 

Finally, the tax authority should provide recommendations, along with the rationale behind them, as the final outcome of the risk assessment process.