Master Thesis
University of Groningen
Transfer Pricing and Tax Control Framework
A tax practitioners’ view
Name: Mike van Marwijk Student number: S3030407
Institution: University of Groningen Specialization: MSc Accountancy
Student mail: m.van.marwijk@student.rug.nl First reviewer: Prof. Dr. I.J.J. Burgers
Second reviewer: Dr. S. Girdhar Date: June 16th, 2017
Number of words: 13.125
Internship EY, Arnhem
Abstract
National and international developments in the tax dimension have increased the focus on Tax Control Frameworks and transfer pricing. Transfer prices can be set to decrease the overall companies’ tax burden. In response, organizations have taken initiatives to increase transparency to inhibit aggressive use of transfer pricing. Therefore, transfer pricing is a high risk from multiple perspectives. In this paper, the content of the tax control framework relating to transfer pricing is examined from three perspectives, namely the tax authorities, tax function within a company and external auditors. The aim is to provide guidance on which transfer pricing information should be part of the tax control
framework. Each perspective has its own interest related to Tax Control Frameworks and transfer pricing. The results show that transfer pricing is an essential part of the Tax Control Framework. Each perspective uses the TCF with a different focus which is also reflected in the content.
1 Introduction 1
2 Theoretical framework 4
2.1 Theories 4
2.1.1 Stakeholder Theory 4
2.1.2 Legitimacy Theory 5
2.2 Transfer pricing risk 6
2.2.1 Multiple transfer pricing issues 6
2.2.2 Arm’s length principle 6
2.3 Comparability & functional analysis & transfer pricing methods 7
2.3.1 Comparability analysis 7
2.3.2 Functional analysis 7
2.3.3 Transfer pricing methods 7
2.4 OECD documentation requirements 8
2.4.1 Master file 8
2.4.2 Local file 9
2.4.3 Country-by-Country Reporting 9
2.4.4 Recommendations of the European Union 10
2.5 Tax audit, Audit Layer Model & Audit of Tax 10
2.5.1 Tax audit 10
2.5.2 Audit layer model & audit of tax 10
2.5.3 Steps to test the at arm’s length principle 11
2.6 Content tax control framework regarding transfer pricing 12
2.6.1 General features TCF 12
2.6.2 Specific features regarding transfer pricing 12
3 Methodology 14 3.1 Scope 14 3.2 Research Question 14 3.3 Research Design 14 3.4 Data gathering 15 4 Results interviews 16
4.1 Perspective: tax function within the company 16
4.1.1 Transfer pricing documentation (tax function within the company) 16 4.1.2 Building blocks TCF (tax function within the company) 17
4.2 Perspective: tax authorities 18
4.2.1 Transfer pricing documentation (tax authorities) 18
4.2.2 Building blocks TCF (tax authorities) 19
4.3 Perspective: external auditor 20
4.3.1 Transfer pricing documentation (external auditor) 20
4.3.2 Building blocks TCF (external auditor) 21
4.4 Other results 22
11.2 Appendix B: Transfer pricing methods 29
11.3 Appendix C: OECD transfer pricing recommendations 30
11.4 Appendix D: European Union transfer pricing documentation 36
11.5 Appendix E: Interview guide 37
12 References 39
1 | P a g e
1
Introduction
Worldwide, tax authorities are challenged with growing international operations by organizations, profit shifting to so-called tax havens and constrained with limited capacity (Veldhuizen, 2015; OECD, 2015a). Therefore, it has become essential for tax authorities to allocate their resources in a targeted and effective manner. Since 2004 the Organization for Economic Cooperation and
Development (OECD) called for an enhanced relationship between tax authorities, tax administrations and intermediaries1. Several countries followed the advice of the OECD2. The Netherlands introduced horizontal monitoring (HM) in 2005. Initiatives such as HM changed the way of working into co-operative compliance, a co-operating way of working between the taxpayer and the tax authority (OECD, 2013). The underlying idea of HM is to identify the low-risk taxpayers, described as those who are willing and able to be compliant with tax law and regulations (Veldhuizen, 2015). In a covenant, the taxpayer and the Netherlands Tax and Customs Administration (NTCA) agree to co-operate based on trust and transparency. Mutual trust is essential since there is an information asymmetry between the two parties. The taxpayer is expected to be transparent about their internal control framework (ICF) and relevant tax issues, while the NTCA is open about their implementation of supervision (NTCA, 2010). A presumption for establishing a relationship based on trust and transparency, is that companies are ‘in control of taxes’. The OECD (2013, p. 59) defines the scope of ‘in control of taxes’ as:” The need to be in control of tax consequences of all processes and
transactions within the enterprise and not only the tax processes.” Hence, companies must disclose tax risks and the underlying ICF providing assurance. In particular the elements of ICF relating to tax processes, the Tax Control Framework (TCF). The TCF should enable companies to detect, document and report all relevant tax risks timely to the tax authority (OECD, 2016). A TCF is required within the risk-based approach in HM and is part of the internal control system. As to Bakker and
Kloosterhof (2010):” A TCF should result in an effective, efficient and transparent tax function. In this tax function, risks that are not the counterpart of an opportunity are avoided to an efficient extent. All opportunities are made transparent as to risk and reward (taking into account the strategy of the organization) so that a reasoned decision can be made on which opportunities to pursue (and risk to take on) and which opportunities not to pursue. In a TCF for each process in an organization, the roles and responsibilities as to the tax aspects are set and procedures and tools are made available. The allocation of roles and responsibilities should be made in such a way that all opportunities and risks are spotted. Subsequently, in a TCF all of the above is properly documented and reported” (p. 24). Within co-operative compliance the TCF is essential (Bronzeskwa & Van der Enden, 2014; Van der Laan, 2009; Bakker & Kloosterhof, 2010). Bronzeskwa & Van der Enden (2014, p. 6) stated:” A TCF is at the center of a proper tax function. It is the engine that enables MNEs to file timely and correct tax returns, in whatever form, and to meet their tax compliance obligations. A TCF is also at the heart of the co-operative compliance relationship with tax administrations, as it enables a company to demonstrate that it controls and validates relevant tax outputs”.
The growing role of multinational enterprises (MNEs) in world trade presents complex taxation issues to control for businesses as well as for tax authorities. For tax authorities, these issues arise from determining which profit should be considered within a jurisdiction. Transfer pricing (TP) have been advocated over the years to be a relevant tax issue for tax authorities and businesses. TP is defined by the OECD (2010, p. 21) as:” The prices at which an enterprise transfers physical goods and intangible
1 In 2013, the OECD changed the enhanced relationship into a co-operative compliance relationship, because co-operative compliance describes, according to the OECD, the concept the most accurately (OECD, 2013).
2 | P a g e
property or provide services to associated enterprises.” TP contributes to base erosion and profit shifting (BEPS), because TP determines the income and expenses of associated enterprises in different tax jurisdictions. A tax-motivated definition of TP is giving by Hasset and Newmark (2008, p.208):” The practice of multinational corporations of arranging intrafirm sales such that most of the profit is made in a low-tax country.” Literature on TP has studied the relation between tax rates and TP. The results of the studies suggest that companies do consider tax consequences when setting TP (Harris and Sansing, 1998; Sansing, 1999; Smith, 2002; Bartelsman and Beetsma, 2003; Clausing, 2003; Klassen et al., 2017). Companies, like Starbucks and Apple use TP to shift their profit to lower tax jurisdictions (Reuters, 2012; Reuters, 2016). Surveys on TP (EY, 2013; Alvarez & Marsal, 2012) indicate the importance of TP. The Global TP Survey by EY (2013) indicate that companies have difficulty to manage TP. 66% of parent company respondents acknowledged the high priority of risk management on TP. Furthermore, tax authorities are more willing to challenge transactions, which have led to adjustments and penalties.
The issue of tax-motivated income shifting within MNEs has attracted increasing global attention in recent years. Tax-motivated income shifting within MNEs is currently the subject of extensive discussion among organizations3. Hanlon & Heitzman (2010), in there review of tax research, take a broad view of activities corporations can use to reduce tax payments (e.g. TP). Despite the legality of some aggressive tax activities one can question if these companies are acting in the spirit of the law. The morale question of aggressive tax planning activities was expressed by Margaret Hodge (2012), a member of the UK House of Commons:“ We are not accusing you of being illegal, we are accusing you of being immoral”. This behaviour of companies has triggered a situation in which the society is more interested in the fair contribution of companies. By shifting away corporate income from the countries where the income is generated, companies are not paying its “fair share” to ensure the financing of public goods. These practices are costly to the society (Weisbach, 2002; Freedman, 2003; Landolf, 2006; Williams, 2007; Friese et al., 2008; Slemrod, 2004). ”Multinationals that do not contribute their fair share eat away at the fundamental confidence society has in its institutions” (Happé, 2015, p. 64).
The OECD, to a great extent, influences TP (i.e. tax-motivated income shifting). In 1979, the OECD published TP Guidelines4. The guidelines by the OECD are intended to help tax authorities and MNEs to set TP in accordance with the arm’s length principle. The arm’s length principle is codified in article 9 of the OECD Model Tax Convention. PWC (2014) defines the arm’s length principle as:” Compensation for any intercompany transaction conform to the level that would have applied had the transaction taken place between unrelated parties, all other factors remaining the same” (p. 18). Intercompany transactions should be set conform the arm’s length principle to avoid double taxation and protect the tax base in each jurisdiction (OECD, 2010; Keuschnigg & Devereux, 2009). Tax authorities as well as businesses are struggling with obtaining information to apply an arm’s length price. Applying the arm’s length principle requires taxpayers and tax authorities to evaluate
uncontrolled transactions and business activities of independent enterprises. This process demands a considerable amount of data (OECD, 2010). Chapter 5 of the OECD Transfer Pricing Guidelines provides guidance about the TP information5. Furthermore, the OECD/G20 released in 2015 the final “Action Plan on Base Erosion and Profit Shifting” (Hereafter: BEPS 2015). BEPS 2015 addresses the
3 Organizations like Oxfam, EU, OECD, Tax Justice Network, are interested in developing a ‘fair tax’ world
4 In 1995 & 2010 the OECD released a revised version of the ‘TP Guidelines for Multinational Enterprises and Tax Administrations’
5 The OECD Guidelines (2010) recognize that the information relevant to an individual TP audit depends on the facts and circumstances of the case. The OECD also recognize the certain features common to any TP enquiry
3 | P a g e
opportunities for MNEs to minimize their tax burden and recommend tax authorities to embrace co-operative compliance concept. The idea is that transparency will lower aggressive tax avoidance strategies through the provision of timely information to tax authorities. Action 13 (TP Documentation and Country-by-Country reporting) of BEPS 2015 specifically focusses on TP documentation. The main objective is to provide tax administrations with information to early recognize aggressive tax planning and to deter companies to enter a tax scheme.
Tax authorities are encouraged to consider the MNEs commercial judgment about the application of the arm’s length principle (EY, 2013; OECD, 2010). The MNEs should produce its records to enable the tax authorities to assess intercompany transactions. The TCF plays an essential role within this process. The significance of the TCF can be explained by its ability to provide reasonable assurance that the information and tax returns submitted by a taxpayer are accurate and complete (OECD, 2016). However, there are no specific requirements regarding the content of the TCF6. As explained by the
NTCA (2010):” The actual design of the organization’s tax control is dependent on its size, complexity and the choices it has made for example, on the basis of the selected risk profile or budget). TCFs are customized and specific to each organization”. As TP is considered to be a key tax issue for tax authorities and businesses and compliance strategies are moving to co-operative
compliance, TP should be considered in the TCF. To give guidance on the content of the TCF relating to TP, this study examines the following research question:
This study distinguishes three tax practitioners who are stakeholders of the TCF and have an interest in TP. The first perspective is the tax function within a company. Due to the focus of the tax authorities towards TP (EY, 2013), differences in interpretation of transfer pricing standards and the increased documentation requirements (OECD, 2015b), TP is considered to be a high risk for companies. A TCF helps companies to control TP risks. Second perspective is the tax authority. Aggressive tax planning (e.g. TP) has led to revenue losses for countries. Tax authorities need to assure that an arm’s length price is applied for intercompany transactions. Therefore, transparency is necessary. Within co-operative compliance, the TCF plays an essential role to create transparency and trust between companies and tax authorities. Third perspective is the external auditor. At consolidated level, the differences in tax rates and/or a different income tax treatment of transactions or entities within jurisdiction, will have an impact on the net tax expense. Therefore the risk of a material misstatement relating to the tax effect on intercompany transactions exists. The TCF should enable auditors to rely on the provided documentation by companies.
This thesis will give guidance for TP information as part of the TCF based on information needs from three perspectives. Tax authorities, as well as corporations and external auditors are considering TP as a high risk (EY, 2013; Alvarez & Marsal, 2012). The combination of TP as a high risk and the risk management approach applied by tax authorities makes it interesting to investigate which information relating to TP should be part of the TCF. The study contributes to the literature by investigating the content of the TCF relating to TP. Research (Bakker & Kloosterhof, 2010;
Bronzewska & Van der Enden, 2014; OECD, 2016) have examined the general features of the TCF. Further, the OECD (Action 13, 2015) are recommending specific TP documentation. Past research did not pay attention to the content of the TCF relating to TP.
6 The OECD (2016) published a report that should help businesses to design and operate their TCFs. The OECD identified six principles or essential building blocks for a TCF (discussed in paragraph 2.6)
4 | P a g e
This thesis contributes also to the profession because it gives multiple tax practitioners recommendations about which TP information should be part of the TCF to assess the TP risk. Therefore, this study can contribute to a further co-operation between firms, tax authorities and external auditors.
2
Theoretical framework
The chapter begins to describe two theories which help to understand the context of this study. The remainder of the chapter describes the TP risk and applied guidelines to control the TP risk. The end of this chapter gives a literature overview concerning the content of the TCF relating to TP.
2.1
Theories
2.1.1 Stakeholder Theory
The publication of Freeman’s book, Strategic Management: A Stakeholder Approach, in 1984, have started an emphasis on the stakeholder concept (Donaldson & Preston, 1995). The stakeholder theory acknowledge that an organization establishes relationships with a variety of stakeholders in the society which could affect how an organization conducts its activities. From a stakeholder perspective, an organization should endeavor to meet goals of a wide range of stakeholders rather than only those of the shareholders. Foley (2005, p. 138) defines stakeholders as:” Entities and/or issues, which a business identifies from the universe of all who are interested in and/or affected by the activities of existence of that business, and are capable of causing the enterprise to fail, or could unacceptable levels of damage, if their needs are not met”. Stakeholders can be divided in primary stakeholders and secondary stakeholders. Primary stakeholders are for example shareholders and financial institutions, employees, suppliers, customers and the government. They engage in direct economic transactions with the firm. These stakeholders can directly affect firms’ performance and can be affected by the firms’ actions. Secondary stakeholders are for example community, media, academics, environmental pressure groups and fair-trade bodies. They can influence the firms action and performance, but do not engage in direct economic transactions with the firm (Garvare and Johansson, 2010; Wu and Wokutch, 2015).
Stakeholder theory often relates to the term accountability. Mulgan (1997) describes accountability as a relationship between two parties in which one party has the responsibility to another to perform certain duties. Under the shareholder view, the organization merely needs to discharge accountability to its shareholders. However, within a stakeholder view, an organization should also be accountable to other stakeholders as well.
The principal concepts of stakeholder theory are that the organization is part of the broader social system in which it operates. Christensen and Murphy (2004, p. 37) state:“ Paying taxes is perhaps the most fundamental way in which private and corporate citizens engage with broader society.” Activities by firms to reduce the tax burden will be interpreted by the society as irresponsible (Christensen and Murphy, 2004; Erle, 2008; Schön, 2008). Nonetheless, if transparent behavior is seen as honest and desirable by stakeholders, transparent behavior may provide esteem and satisfaction to the firms’ stakeholders (Harrison and Wicks, 2013). As one of the primary stakeholders, due to its tax claim on firm profits, the tax authority will specifically be interested in companies paying their ‘fair’ tax share (Desai, et al., 2007). By engaging in a relationship with companies based on trust and co-operation, tax authorities and companies can improve their relationship. By providing tax authorities with relevant information, the tax authorities are able to discharge organizations from their
accountability. It can be expected that disclosure could reduce information asymmetry between organizations and its stakeholders, and consequently improve the relationships between them. A good
5 | P a g e
relationship between a company and various stakeholders may be beneficial (Deegan and Samkin, 2009; Gray et al., 1996).
2.1.2 Legitimacy Theory
A second theory concerned with the relationship between the organization and the society, is the legitimacy theory. It argues that organizations could seek to guarantee that their operations are within the bounds and norms of the communities so as to be perceived as legitimate by various stakeholder groups in society (Deegan and Samkin, 2009; Guthrie et al., 2006). Legitimacy is defined by Suchman (1995) as:“ The generalized perception or assumption that the actions of an entity are desirable, proper, or appropriate within some socially constructed system of norms, values, beliefs, and definitions” (p. 574).
Legitimacy theory suggests that there is a social contract between the organization and the society in which it operates with respect to the state of organization legitimacy (Brown & Deegan, 1998; Deegan, 2006). The concept of the social contract implies that the organization should conduct its operations within the expectations and norms of the society, rather than only the expectation and norms of investors. Legitimacy is not fixed, but it is subject to change in terms of time and place due to changing community attitudes (Deegan, 2006). So, organizations are required to adapt their
activities to the changing requirements of legitimacy for survival. There seems to be a gap between the perception of society regarding how an organization should act and the action that the organization takes – the so-called legitimacy gap. Lindblom (1994) proposed a number of strategies that an organization can adapt. One of these strategies is that organizations can seek to change the perception of the relevant publics by an actual change in its activities. They must signal their legitimacy to various stakeholder groups in society, which is consistent with the signaling theory7. They also need to take all measures necessary to ensure that their activities are perceived to be commensurate with the societal expectations of various stakeholder groups.
The legitimacy theory is useful to understand the recent development of more tax transparency between MNEs and tax authorities. As stated by the legitimacy theory, the firm should comply with the social expectations, norms and rules while they conduct their operations. It is clear from
recommendations of the OECD (2015a; 2015b), publications by non-governmental organizations (NGOs) (Oxfam, 2016a; Oxfam, 2016b; Tax Justice Network, 2012) and the tax literature (Christensen and Murphy, 2004; Zemzem & Ftouhi, 2013; Weisbach, 2002; Hanlon & Slemrod, 2009), mentioning that corporate actions to reduce their tax burden by BEPS is a significant public concern and that it is often seen inconsistent with the general societal expectations. The payment of corporate taxes does have community and societal implications because corporate taxes play an important role in funding the provision of public goods. This has led to increased social pressure.
From the perspective of legitimacy theory, organizations should report information that is expected by society since the compliance of societal expectations could be positive for the organization. In regard to taxes, evidence by Lanis and Richardson (2012) suggest a positive and statistically significant association between corporate tax aggressiveness and CSR disclosure, which is consistent with the legitimacy theory.
The tax authorities protect and monitor the social contract (Dyck & Zingales, 2004). The legitimacy theory indicates that when there is a legitimacy gap, corporations need to signal their legitimacy to their stakeholders. By establishing a relationship based on trust and co-operation with the tax authorities, corporations can signal their legitimacy to their various stakeholders (e.g. tax
7 The signaling theory considers how information asymmetry problems with the society can be addressed. It is mainly focused on intentionally communicating positive information to outsiders to reduce information asymmetry in exchange for positive attributes (Connelly et al., 2011)
6 | P a g e
authorities and society). By increasing the information flow about tax risk between firms and the tax authority, corporations increase their legitimacy. This way of thinking is in line with the new way of working in co-operative compliance. The flow of TP information can be used to signal that the corporations have identified their tax risks and that these risks will be managed properly.
2.2
Transfer pricing risk
2.2.1 Multiple transfer pricing issues
Tax-motivated TP arise when transfers of goods as of dealings are between units located in different jurisdictions – one in high-tax jurisdiction and the other in a low-tax jurisdiction. Intercompany transactions take place through, amongst others, sales of tangible or transfers of intangible properties (e.g. trademarks), the provision of services (e.g. accounting or legal services), intercompany financing (e.g. long-term loans) and rental and leasing arrangements. Tax planning with intangibles has become a popular topic in international taxation. Companies can allocate valuable intangibles to group
companies resident in low-tax countries and use these intangibles to lower their tax burden (Darby and Lernaster, 2007; Fuest et al., 2013; Kang & Ngo, 2012; Verlinden & Smits, 2009). Evers & Spengel (2015) recognize three intellectual property tax planning opportunities. First, the disposal of
intangibles from the parent company to an operating subsidiary in which the parent company gets the sale price. Second, the composition of licensing arrangements between related entities in which a license or royalty fee is paid in exchange to have the right to produce and to use intellectual property by another group entity. Third, R&D contracts with related entities where the parent company receives the contract R&D fee.
2.2.2 Arm’s length principle
When trades are made between independent companies, natural market forces guide the pricing behaviour of products and services. When a company has a financial interest in another and the two are trading goods or services, this natural market force disappear. In this case, the income of the related companies may lack economic reality. In this situation a key question appears: what price represents a ‘fair’ TP? These prices can be derived from external benchmarks (e.g. online databases) or internal pricing rules. Internal pricing rules can consider multiple calculation methods (see paragraph 2.3). Ultimately, the TP should represent a price that is approximate conform the price which have applied had the transaction taken place between independent parties. Burgers and Van der Meer-Kooistra (2015) describe the aim of the arm’s length principle as:” To reconcile the legitimate rights of states to tax the profits of a taxpayers based upon income and expenses, that can reasonably be considered to arise with their territory, with the need to avoid double taxation and thus create a level playing field between companies that operate locally and internally operating companies, and thus to contribute to the expansion of world trade on a multilateral, non-discriminatory basis and to achieve higher sustainable economic growth” (p. 340-1). The determination of arm’s length
compensation is difficult. The OECD Transfer Pricing Guidelines (2010) corroborate the difficulty to gather sufficient information to verify an arm’s length price, but state that it is the best theory available to reproduce an external price. The OECD Transfer Pricing Guidelines give guidance for applying the arm’s length principle and will be discussed in paragraph 2.3 and 2.4.
7 | P a g e
2.3
Comparability & functional analysis & transfer pricing methods
2.3.1 Comparability analysis
A comparison of conditions (e.g. price or margin) in a controlled transaction with the conditions in transactions between independent enterprises is often a manner to apply to the arm’s length principle. Burgers and Van der Meer-Kooistra (2015) define a comparability analysis as:” A comparison of a controlled transaction/internal dealing with an uncontrolled transaction or transactions” (p. 344). The authors define controlled transactions as:” Transactions between two enterprises that are associated enterprises with respect to each other”, and internal dealings as:” Transactions between a head office and a permanent establishment or between two permanent establishments” (2015, p. 344). The economically relevant characteristics of the situations compared must be sufficiently comparable. The OECD Transfer Pricing Guidelines (2010) explains comparable as:” None of the differences (if any) between the situations being compared could materially affect the condition begin examined in the methodology (e.g. price or margin), or that reasonably accurate adjustments can be made to eliminate the effect of any such differences” (p. 63). The OECD gives a best practice for performing the comparability analysis, which is a nine-step process (see Appendix A). The OECD Transfer Pricing Guidelines (2010) acknowledge five factors that should be considered when determining the comparability:
1) The characteristics of the property or services transferred; 2) The functions performed by the parties;
3) The contractual terms;
4) The economic circumstances of the parties; 5) The business strategies pursued by the parties.
2.3.2 Functional analysis
Functional analysis is essential for ensuring that a valid comparison with third parties is made. It is a system to organize facts about a business regarding its functions, risks and intangibles with the
purpose to identify how these are allocated between the companies in the transaction. Functions reflect the activities which the involved entities in a transaction normally perform (PWC, 2014). Burgers and Van der Meer-Kooistra (2015) defined a functional analysis as:” An analysis of the functions
performed (taking into account assets used and risks assumed) in controlled transactions of associated companies or in internal dealings between a permanent establishment and its head office or between two permanent establishments of the same company” (p. 344). In transactions between two
independent enterprises, compensation usually reflect the function that each enterprise performs. Thereby, considering the assets used and risk assumed. Therefore, in determining whether controlled and uncontrolled transactions or entities are comparable, a functional analysis is necessary. When performing a functional analysis, the economically significant activities and responsibilities
undertaken, assets used and risk assumed by the parties in the transactions need to be identified and compared.
2.3.3 Transfer pricing methods
To calculate TP the OECD Transfer Pricing Guidelines (2010) distinguishes traditional transaction methods (comparable uncontrolled price method, the resale price method, and the cost-plus method) and transactional profit methods (transactional net margin method and the transactional profit split method). The methods are explained in more detail in Appendix B. The selection of the TP method aims at finding the most appropriate method for a particular case. The appropriateness is determined
8 | P a g e
by the functional analysis, the availability of reliable information to apply a method, and the degree of comparability between controlled and uncontrolled transactions (PWC, 2014; OECD, 2010). The OECD Guidelines recognize that the selection of one TP method is not straightforward, and the selection of more than one method can result in better-estimated arm’s length prices.
2.4
OECD documentation requirements
The OECD Transfer Pricing Guidelines (2010) give also guidance in respect to documentation to test if controlled transactions are in line with the arm’s length principle8. Under BEPS Action 13 the
OECD recommend for enlargement of the TP documentation. The TP documentation requirements will enhance transparency. Further, it provides relevant governments with needed information (e.g. company’s global allocation of the income, economic activity and taxes paid among countries). The OECD (2015, Action 13) distinguishes three reasons for governments to create TP documentation:” 1) To ensure that taxpayers give appropriate consideration to TP requirements in establishing
prices and other conditions for transactions between associated enterprises and in reporting the income derived from such transactions in their tax returns;
2) To provide tax administrations with the information necessary to conduct an informed TP risk assessment; and
3) To provide tax administrations with useful information to employ in conducting an
appropriately thorough audit of the TP practices of entities subject to tax in their jurisdiction, although it may be necessary to supplement the documentation with additional information as the audit progresses” (p. 12).
The OECD recognizes that the information relevant to TP audits depends on the facts and circumstances. Therefore, it is not possible to define the precise extent and nature of the TP
documentation required for tax authorities and for the taxpayer. However, certain features are common to any TP audit. The OECD recommends three documents: (1) a master file; (2) a local file; and (3) a country-by-country report (CbCR). The three documents will require taxpayers to communicate consistent TP positions and enable tax authorities to assess TP risks. The documentation also informs tax authorities about where audit resources can most effectively be deployed and in the event of an audit also support the audit procedures. Under BEPS 2015 Action 13 (chapter V) information to be included in the files is set out.
2.4.1 Master file
The master file should provide a high-level overview of the group. Information included are the organization structure, the nature of its global business operations, its overall TP policies and its global allocation of income and economic activity. The information should enable tax authorities to evaluate if significant TP risks are present. The master file provides a blueprint of the MNE group. The information can be grouped into five categories,
I. Organizational structure which illustrate the MNEs legal and ownership structure and geographical locations of associated entities;
II. A general description of the MNs business which include the drivers of business profit, description of the value chain, list of service arrangements between members of the MNE group and a brief functional analysis per entity;
8 OECD TP Guidelines (2010) underscore that the described TP information should not be viewed as a minimum requirement or as an exhaustive list that tax authorities may be entitled to request.
9 | P a g e
III. Information related to MNEs intangibles which considers a general description the overall strategy for the development, ownership and exploitation of intangibles, and a list of intangibles that are important for TP purposes and which entities legally own them; IV. Intercompany financial activities which include a general description of how the group is
financed, an identification of entities with a central financing function and a description of the MNEs TP policies related to intercompany financing.
V. The MNEs financial and tax positions which include a list and description of the MNE group’s existing unilateral advance pricing agreements (APAs) and other tax rulings relating to the allocation of income among countries.
Appendix C provide a more detailed overview of the required information for the master file, local file and CbCR.
2.4.2 Local file
The local file provides more detailed information relating to material cross-border intercompany transactions. The objective of the local file is to ensure that the MNE has complied with the arm’s length principle. The recommendation for the local file consists of three main topics:
I. Management structure and strategy of the local entity;
II. Specific information for each material category of controlled transactions which include, amongst other, a description of material controlled transactions, detailed comparability and functional analysis and the selection and application of the most appropriate TP method. III. Financial information, which include financial accounts of the local entities and information
about how and which financial data is used for applying the TP method.
2.4.3 Country-by-Country Reporting
CbCR has been recommended by the OECD as a possible reform to prevent aggressive tax planning. Aggressive tax planning has led to revenue losses for high-tax countries (Cockfield & MacArthur, 2015). The current OECD proposal, will require MNEs to disperse information to tax authorities on a confidential basis. BEPS Action 13 (OECD, 2015b) emphasize that the tax authorities are responsible to take steps to safeguard that there is no public disclosure of confidential information. Information will only be exchanged between governments (G20, OECD-countries and all other countries that have implemented the BEPS package). The purpose of the CbCR is to provide data for high-level TP risk assessment by tax authorities. The goal is that more transparency will inhibit aggressive tax-avoidance strategies. The provision of superior and timely information to tax authorities should enable them to determine which MNEs should be audited. The following figures need to be disclosed, on a country-by-country basis:
• Revenues earned by unrelated and related parties; • Profit (loss) before income tax;
• Income tax paid; • Income tax accrued; • Stated Capital;
• Accumulated earnings; • Number of employees;
• Tangible assets other than cash and cash equivalents.
Critics of CbCR argue that more reporting requirements for MNEs could result in harmful policy outcomes. They refer to the compliance costs of the increased documentation requirements (Cockfield & MacArthur, 2015).
10 | P a g e
2.4.4 Recommendations of the European Union
On June 27th 2006, the EU Member States adopted the Code of Conduct on Transfer Pricing
Documentation (EU TPD). The EU TPD is a form of soft law and is not binding on the Member States (Vernia, 2017). The EU TPD aims to standardize the documentation that multinationals must provide to tax authorities on cross-border intercompany transactions. The EU TPD also aims to improve assessment by both MNEs and tax authorities. MNEs can better identify transactions that may require more detailed explanation and documentation. Tax authorities use the TP documentation to allocate their resources in an effective manner.
The EU TPD consists of two main elements, a master file and country-specific documentation. Together, the documentation would constitute the documentation file for EU Member States. The documentation should provide tax authorities with greater transparency on the TP system of MNEs. Appendix D provides an overview of the documents that should be included in the master file and in the country-specific documentation. The TP documentation requirements are comparable with the recommendations of the OECD (Appendix C).
2.5
Tax audit, Audit Layer Model & Audit of Tax
2.5.1 Tax audit
Companies as well as tax authorities consider TP as a material tax issue which will be communicated upfront in HM (preventive measure). Furthermore, tax authorities need to assure that TP is in line with the arm’s length principle by conducting tax audits (repressive measures). A tax audit can be defined as:” An audit whereby an auditor checks or assesses the object of the audit for which another party is responsible on the basis of criteria and about which the tax auditor forms an opinion which provides the intended user with a certain degree of assurance” (Engelmoer, 2015, p. 425). Tax auditors need to obtain reasonable assurance that tax returns are free from any material misstatement. To assess the acceptability of tax returns, the tax auditors also validate the premise that organizations are in control of all tax processes and transparent by performing audits (NTCA, 2013). By analysing and assessing the accounting organization and the implemented internal controls, the tax auditor is able to assess the risks that need to be covered with audit procedures. An adequate TCF will give insights to tax
authorities to determine the extent of a tax audit and the completeness and accuracy of the TP documentation.
2.5.2 Audit layer model & audit of tax
For tax auditors to obtain sufficient audit evidence regarding the effectiveness of a TCF and acceptability of the tax return, the work carried out by other parties also provide evidence (NTCA, 2013). This principle is based on the ‘audit layer model’. Figure 1 (NTCA, 2010, p, 10) display the Audit Layer Model within HM. The model implies that the tax auditor tries to use information gathered by others as much as possible. The model is based on the idea that every corporation needs reliable information to run their business and therefore have implemented control measures
(Veldhuizen, 2015). The audits conducted by the internal audit departments and/or external specialists (external auditor) are also of importance; their work also contributes to the quality of the information on which the tax returns ultimately will be based (NTCA, 2010).
As part of the annual external audit, the external auditor gathers information related to the internal control system of a company. In the audit of tax the external auditor also performs specific audit procedures related to the fiscal positions recorded in the annual accounts. The work of the
11 | P a g e
external auditor contributes to the quality of the information on which the tax returns ultimately will be based.
2.5.3 Steps to test the at arm’s length principle
A tax audit is likely the most important source of information on global trading (Douvier, 2005). To test the at arm’s length nature of intercompany transactions four steps can be distinguished (Wesdorp, 2015). The first step is to identify the intercompany transactions that can have a tax impact above the audit threshold or transactions that are outside the normal course of business. The auditor needs obtain understanding of the legal structure and all related parties. The auditor also obtains an understanding of the controls that are in place to identify, account for, disclose and authorize related party
relationships and transactions. The intercompany transactions will be classified and the auditor assesses which transactions may have a risk of material misstatement. Second, per selected intercompany transaction the auditor obtains relevant information such as:
• The intercompany arrangements including all conditions; • Substantiation of TP methods applied;
• Documents underlying the comparability analysis; • The models for valuation of intangibles for TP purposes; • Applicable ruling;
Third step is assessing whether the documentation and TP applied meet the income tax law requirements in this respect. The tax auditor assesses whether the TP applied is within the at arm’s length range. Fourth, based on the assessment the auditor determines if there are additional TP risks and estimates the amount of potential outflow of sources. When the TP risks are high, a TP expert will be involved.
12 | P a g e
2.6
Content tax control framework regarding transfer pricing
In chapter 2.4 the recommendations regarding TP documentation are described. The following part emphasizes key elements, which should be part of the TCF to control TP risks. In this respect, one should realize that there is no “one size fits all” TCF.
2.6.1 General features TCF
The TCF encompasses all relevant taxes and tax risks within the organization in order to file an acceptable tax returns (NTCA, 2013). Despite the limited guidance by the OECD and NTCA for designing a TCF, the COSO framework is referred to as a starting point to develop a TCF (Jacobs et al., 2015; Colon and Swagerman, 2015; Hoyng and Van der Reijden, 2009; Van der Enden and De Groot, 2015). Despite the fact that each TCF needs to be custom built, there are a number of generic elements (building blocks) that apply to each TCF. The OECD (2016) recognize six features regarding the requirements of the TCF:
1) A documented tax strategy;
2) The TCF should cover the full range of activities performed by the organization, because all transactions have possible tax consequences. This is consistent with Poolen (2009), who noticed that the TCF should have a companywide view;
3) Roles and responsibilities regarding the design and implementation of the TCF should be recognized and properly resourced;
4) The transactions should be compared with the documented governance code. A system of procedures and reporting should the undertaken transaction are in accordance with good governance;
5) The TCF should be subject to regular monitoring, testing and maintenance; and 6) The TCF should be able to provide assurance to internal and external stakeholder. Literature also discussed some elements of a TCF. Durlinger and Prinsen (2014) argued that risk assessment is essential in a well-functioning TCF. The authors argued that without an adequate risk assessment the TCF is not effective. Researchers (Durlinger & Prinsen, 2014; Van der Enden & De Groot, 2015; Bronzewska and Van der Enden, 2014; Bakker & Kloosterhof, 2010) expressed the importance of monitoring. Taxes are subject to a changing environment and without monitoring it is possible that TCF loses its effectiveness over time. Bronzewska & Van der Enden (2014) and Bakker & Kloosterhof (2010) have given some concrete elements for the content of the TCF. The authors agreed that tax strategy; corporate governance; identify tax risk within processes; and monitoring are key features of the TCF. Bronzewska & Van der Enden (2014) state that the TCF should provide internal and external stakeholders insights that the firm is in control of taxes. Bakker and Kloosterhof (2010) further mention the importance of tax accounting and reporting and the essential role of the automation of processes to facilitate the tax processes in an organization.
2.6.2 Specific features regarding transfer pricing
The information gathered by companies to support the arm’s length principle of the intercompany transactions and evidence for tax authorities should be part of the TCF (Burgers & Van der Meer-Kooistra, 2015). The literature discussed some elements of a TCF relating to TP. Plesner Rossing and Pearson (2014) argue that an internal control system is a prerequisite for the ability of MNEs to manage TP tax risks. They discuss the need for an accounting information system, which is able to reconstruct data, information and knowledge related to historical TP practices, therefore, signifying the importance of IT. The authors also mention the importance of the organizing the responsibilities
13 | P a g e
regarding TP task. Furthermore, they expressed the high demand for employees to execute TP related tasks (employee skills).
Oosterhoff (2006) identify four elements in order to deal with the TP risk for companies. Firstly, a TP policy. This should entail a clear definition of the TP policy of the organization. Secondly
transaction mapping/identification, which involves identifying the cross-border transactions that take place within the organization. Thirdly, TP risk identification, which involves identifying the nature of the TP risk. Fourth, TP risk management processes, a foundation which involves establishing the processes for managing the TP risk.
Oosterhoff and Donga (2001) argue that the implementation and monitoring of APAs should be part of the internal control framework. The OECD (1999, p. 20) defined APA as:” Arrangement that determines, in advance of controlled transactions, an appropriate set of criteria (e.g. method,
comparables, and appropriate adjustments thereto, critical assumptions as to future events) for the determination of the TP for those transactions over a fixed period of time”. If the company not or incorrectly implements tax advice or a ruling with tax authorities, this could lead to an adverse tax impact due to non-applicability of the APA. It could also result in penalties and may have a negative impact on the relationship with the tax authorities (Oosterhoff and Donga, 2001). A ruling or tax advice only has value to the extent it is correctly implemented and monitored to comply with all requirements. Plesner Rossing & Pearson (2014) acknowledge the complex process of implementing APAs and the potential involvement of multiple tax authorities.
Transfer Pricing Associates (2016) acknowledge the need for companies to develop control frameworks, especially relating to TP. The design of the TCF should be aligned with the business model (main value drivers within the industry). TP associates (2016) identify nine key elements, which should be part of the TCF relating to TP.
1. Documentation: include defining transfer methods used for price setting and quality control (e.g. updating documentation, systems used to store documents) relating to the documentation. 2. Risk management: include a country risk matrix and BEPS readiness check.
3. Consultancy.
4. Audit support: include communication with tax authorities and other stakeholders. 5. Systems for data sourcing, data processing, quality control and final delivery.
6. Legal agreements: include sourcing of information, documentation of information and assessing validity of agreements.
7. Sign-off: consisting of tax/ TP policy papers, audit, risk management projects and legal agreements.
8. Global benchmark platform: includes maintenance of internal databases, update of existing benchmarks, identification of other benchmarking data sources and defining use of external databases.
9. Capacity planning.
Furthermore, clear roles and responsibilities can help companies to be in control of TP risks. TP Associates (2016) recommend a RACI matrix9 as a tool to organize the roles and responsibilities.
9 The RACI Matrix distinguish four roles: R (Responsible): Person who owns the ‘problem’;
A (Accountable): Persons who have the authority to approve on work before it is effective; C (Consulted): Person has expertise or capabilities necessary to complete the project; I (Informed): person who needs to be notified of results.
14 | P a g e
3
Methodology
3.1
Scope
The country chosen in order to study the central question is the Netherlands. The Netherlands has implemented a co-operative compliance strategy in 2005, in which a TCF is essential. The Dutch tax authority wants to co-operate with very large businesses (VLB) as well as with medium sized enterprises (SME). This study is focused on the VLB segment taking into account the significance of the TCF in this segment (Van der Hel & Pheijffer, 2012; NTCA, 2013). Although this thesis is limited to the Netherlands, the OECD statements about TP are relevant because their initatives are considered as guidelies and could result in adjustments in policies in the local political environment (Colon and Swagerman, 2015).
3.2
Research Question
This study investigates the following research question:
Three perspectives are adopted to give deeper understanding of the content of the TCF relating to TP10. In order to answer the research question the following sub questions are composed:
1.) Which information should be part of the TCF relating to transfer pricing from the perspective of the tax function within the company?
2.) Which information should be part of the TCF relating to transfer pricing from the perspective of the tax authority?
3.) Which information should be part of the TCF relating to transfer pricing from the perspective of the external auditor?
3.3
Research Design
The research design depends on the questions to answer, the data to collect and context in which the data is collected (Vennix, 2011). According to Ragin (1994) a research design is a action plan to collect and analyse evidence in order to answer the central question of the study. In order to answer the central question: ‘Which information relating to TP should be part of the TCF, a tax practitioners’ perspective?’, a qualitative research is performed. Qualitative research is more focused on the meaning than on numbers (Smith, 2015). Quantitative research offers the opportunity to generate specific statements with regard to a little variables whereas qualitative research provides the opportunity to seek between themes with more variables (Swanborn, 2013). Different research strategies are distinguished within the qualitative research. In this research a pilot study is adopted as a research strategy. A pilot study is defined by Everit (2006, p. 163) as:” Investigation designed to test the feasibility of methods and procedures for later use on a large scale or to search for possible effects and associations that may be worth following up in a subsequent larger study”. Pilot studies can provide valuable insights for organizations (Van Teijlingen & Hundley, 2001). There are multiple reasons to conduct a pilot study. Two important reasons are: (1) to assess the feasibility of a (full scale) study; (2) collecting preliminary data (Van Teijlingen & Hundley, 2001). This pilot study consider what
15 | P a g e
information should be part of the TCF relating to TP from the perspective of three tax practitioners. As stated by policymakers (OECD, 2013; NTCA; 2013) the content of the TCF is dependent on the organizations, but further research is needed to develop a well-functioning TCF. A pilot study can inform the reader about the present knowledge gaps and unresolved puzzles. It should be recognized pilot studies may also have a number of limitations. One important limitation include the possibility of making inaccurate predictions or assumptions on the basis of pilot data.
3.4
Data gathering
Data to answer the research question is collected by literature review and empirical research. The literature search - chapter two - was conducted in an attempt to answer the research question. To answer the subquestions interviews are conducted with tax practitioners from each perspective, which act as the primary data source of this study. Separate interview protocols were used per perspective. The interviews are considered as an in-depth one-on-one, semi-structured interview. Interviews provides the opportunity to get an in-depth understanding and the social interaction present at an interview could motivate the respondents to provide more comprehensive answers with regard to their perception, which are often neglected by quantitative forms of data gathering. Furthermore, a semi-structured interview allows bringing up more ideas and themes, moreover responses are richer and more flexible (Smith, 2015; Blijenberg, 2015).
Gathering proces
The datacollection conducted by interviews consists of various steps. The first step was to prepare the questionaire based on the literature review. The questionlist can be found in Appendix E. The list includes several topics with open questions. Whether certain questions on a particular topic were actually asked depended on the answer of the interviewees. The second step was to choose the interviewees. Based on consultation with the main supervisor and external supervisor and assessing matters like working experience, function and their specialization, the interviewees were chosen. Table 1 presents the function, perspective, dates and duration of each interviewee. Three of the four
interviewees have work experience in another perspective, therefore, these interviewees can contribute to more than one perspective. Based on the preference of the interviewee, the questionaire was sent in advance. Every participant is informed beforehand regarding confidentiality and anonymity. The interviews were recorded and manually typed into a transcript. Permission regarding tape recording the interview is asked to the interviewee beforehand.11 Recording the interviews results in more comprehensive transcripts and better interaction with the interviewee as less attention could be paid to making notes during the interview. All interviews are conducted in Dutch language. By conducting the interviews in Dutch, a potential language barrier is taken away which will enable the interviewees to tell what they want without translating. Moreover, the essence of the interview could be loosed due to interpretation and perceptions. The transcripts are written in Dutch. The transcripts however are translated when they are cited in the results, which could cause a loss of information due to a loss of essence. Lastly, conclusions are drawn by means of analyzing the transcripts multiple times.
16 | P a g e
4
Results interviews
This chapter elaborates the findings based on the analyses of the conducted interviews. The content of the TCF relating to TP is described, starting with the business perspective, followed by the tax
authorities and external auditors. The results are divided into TP documentation and building blocks of the TCF. Furthermore, additional findings will also be highlighted providing input for further research.
4.1
Perspective: tax function within the company
4.1.1 Transfer pricing documentation (tax function within the company)
The TCF is considered as an important document to control all tax related processes. It serves as an important document to file an acceptable tax return and is important for participating in HM. Company X considers TP as a relevant risk. The pressure to establish sound TP documentation creates additional risks. These risk can be controlled as part of the TCF. TP is a hot topic on the agenda of the Tax Manager which is expressed in the quote below:
[“… Each intercompany transaction which we do with related entities, is attached with certain risks. My experience is that each intercompany transaction can result in a debate with the involved countries (tax authorities).” – Tax Manager]
The TP documentation is indirectly part of the TCF via a link to a separate TP file. Regarding the TP documentation, the OECD Transfer Pricing Guidelines are followed. A master file and local file are developed12 in co-operation with tax advisors.
Master file
The master file does explain how Company X has formalize their TP. The following key information is part of the master file:
• Organizational structure; • TP policy;
• Business model & TP model;
• Profit margins for local entities determined by a benchmark study.
TP policy
The TP policy described how the transfer prices have been established. A TP policy cannot be
established, set in stone and then ignored. To have value, the policy must be responsive to the dynamic business environment and must be reviewed on an ongoing basis. Company X emphasize the
importance of a coherent and defensible TP policy.
Business model & TP model
The Tax Manager emphasize the crucial role of the business model relating to TP. To control the TP risk the company should ensure that the business model and TP model are aligned. The business model used by Company X to operate their business is the basis for their TP model. Nowadays, it is more important to identify which activities in the business generate value and how profits get
allocated. The OECD is addressing demands from governments to be able to see the entire value chain of a business without being limited to the part that is residing in their country.
[“… For me it is very important that the business model is part of the TP documentation and describes where the value is created” – Tax Manager]
17 | P a g e
Local file
The local file is set up for countries where Company X has many activities. The following key information is part of the local file:
• Description of the important local entities; • Description controlled transactions; • TP method;
• Cost price;
• Profit margin (reward for local entity).
4.1.2 Building blocks TCF (tax function within the company)
The COSO cube has served as a basis for developing the TCF. Therefore, control environment, risk assessment, control activities, information & communication, and monitoring activities are essential. Important building blocks relating to TP are:
• TP strategy;
• Corporate governance (is the TP-policy consistent with the procedures?); • Tax department structure;
• Processes; • Risk assessment; • Monitoring & testing;
• Accounting information system.
Processes
The processes relating to all taxes are described, which could have implications for TP. However, the processes specifically related to TP have not been described (nor asked by the tax authorities). The TCF described the reward-system for related entities and the TP system. Further information is documented in separate files. However, some TP related processes should be part of the TCF, as the following quotes makes clear:
[“… We (Company X) calculate our transfer prices based on budgeted figures. During the year we determine the actual costs which could lead to adjustments” - Tax Manager]
[“… I do not describe this process, but I think it will be an improvement to the current TCF. Now when I think about it, it is a little bit strange that I did not describe this” - Tax Manager]
The Tax Manager recognize the importance to describe the processes related to TP, like the year-end check in which the budgeted costs are compared to the actual costs which could lead to adjustments.
Risk assessment & Monitoring:
The Tax Manager assesses and monitors the TP risks. Specifically, relating to the recent developments by the OECD and EU to increase the TP documentation requirements. Furthermore, in conversations with the tax authorities relevant TP issues will be discussed (e.g. if the value creation is consistent with the business model).
Accounting information system
The Tax Manager agreed on the value of a well-functioning accounting information system:
[“… We are in the happy circumstances that we have implemented SAP worldwide. Our entities also have SAP. So I can easily get the transfer pricing information out of the information system.” – Tax manager]
18 | P a g e
4.2
Perspective: tax authorities
Tax audit and TCF
Tax authorities aim to allocate their resources in the most effective manner. TCFs enable tax authorities to identify the low-risk taxpayers. The risk assessment by tax authorities is based on the rest risk (non-compliance risk), as is expressed as one of the interviewees states:
[“… I am not only interested in the inherent risk, but especially interested in my rest risk. So, if an organization can explain how the inherent risk are controlled and in my opinion they did a good job, a high-risk profile company can become a low-risk company for me. – Accountant VLB Segment]
The TCF assists tax authorities to assess the TP risk and helps to determine where a tax audit should be performed. From the perspective of the tax authority, according to the Accountant VLB Segment, TP risk is heavily determined by the TP strategy of the company. The TCF should be aligned with the TP strategy. For example, if companies followed an aggressive TP strategy, the TCF should be aligned with the TP strategy by more control procedures. As illustrated by the employee of the tax authority:
[“…from the aspect of tax assurance, and also considering the TCF, I adopt another strategy or questions when companies are less aggressive with transfer pricing. At aggressive companies, I am more interested in risk management and how they control the transfer pricing risks.”- …]
4.2.1 Transfer pricing documentation (tax authorities)
The OECD Transfer Pricing Guidelines (2010) and BEPS 2015 (Action 13) give a good oversight of the needed information by tax auditors as emphasized by all interviewees. Further, as within HM the willingness and ability to be transparent is essential. This transparent behaviour is also reflected in the way the transfer pricing information is exchanged between MNEs and tax authorities. As explained by the Tax Manager:
[“… If the Dutch tax authority feels the need to ask for more information, they will just ask for the information. We (Company X) will then provide the information.“ – Tax Manager]
The interviewees did not recognize the need for additional information which should be reported to the Dutch tax authority, but essential transfer pricing documentation for tax authorities are:
• Business model; • Value chain analysis;
• Documentation supporting an arm’s length price.
Business model & Value chain analysis
Tax authorities are interested in documentation which describe where the value is generated as also argued by the Tax Manager as:
[“… The tax authority does take note of the business model. I have spoken with the tax authority about the alignment between the value creation and business model.” – Tax Manager]
The value creation should be aligned with the business model, which could result in discussions between tax authorities and, for example, tax managers.
19 | P a g e
Documentation supporting an arm’s length price
TP documentation should enable tax authorities to assess how the transfer prices are established. Documentation which should be used when considering the arm’s length principle is per intercompany transaction the used transfer pricing method and a study/report which determine the price range for the transfer pricing. According to the Tax Partner, a tax audit is performed to review the documentation related to TP. He recognize that companies are struggling to produce ‘appropriate’ TP documentation.
4.2.2 Building blocks TCF (tax authorities)
The process to control transfer pricing risk as well as TP documentation is one focus area within HM. The focus is not only on the current TP documentation, but also on the implemented internal controls to ensure that TP documentation is of good quality in the future. The COSO elements are regarded as important to control the TP risk.
[“… For me it is not about the current situation, it is about a continuous process to be in control. All elements of COSO Internal Control or Enterprise Risk Management are crucial, also in the context of transfer pricing.” – Accountant VLB Segment]
The following features are relevant to control the transfer pricing risk: • Transfer pricing strategy;
• Transfer pricing documentation; • Business processes;
• Risk management; • Monitoring & testing.
Transfer Pricing Strategy
The TP risk is amongst other dependent on the TP strategy, as mentioned earlier.
Transfer pricing documentation
Transfer pricing documentation is crucial to control the TP risk. However, the process of generating the TP documentation should be embedded in a continuous process within the organization. As is reflected in the quote below:
[“… In practice, the discussion is primarily focused on TP-documentation. From my perspective, I am more interested in the organization aspect, because if I understand the underlying organization aspects to generate TP-documentation, I have not only insight in the current documentation, but also a feeling about the documentation in the next period.” – Accountant VLB Segment]
Risk management
Risk assessment is about the control procedures implemented to assess and mitigate the identified TP risk.
Monitoring & Testing
The monitoring cycle is essential in the contemporary tax environment. Monitoring is amongst other meant to confirm that everything which has been described on paper, also is implemented. The
essential function of monitoring is that the company is in a continues learning process and oversees the changing environment.
20 | P a g e
4.3
Perspective: external auditor
4.3.1 Transfer pricing documentation (external auditor)
Substantive procedures
The external auditor test if the intercompany transactions comply with the arm’s length principle. The testing will primarily be done by substantive procedures. Intercompany transactions above threshold and outside the normal course of business will be tested. These transactions could have a material effect on the tax expenses.
[“… We barely rely on the internal controls related to corporate income tax (TP). The most important judgmental issues will be tested substantive. However, for the identification of uncertain tax position, we use the TCF. Specifically, how does this company manage the tax risk?” – Tax Director]
[“…Everything considered to be subjective will be assessed. So, TP will be substantive. But if there are errors, we will use the TCF to identify the reason for the error. Why is this error not detected by the internal control department?” – Tax Director]
The external auditor will especially focused on large deviations in tax rates between two jurisdictions. The substantive procedures will be focused on assessing the obtained information. In order to generate these documentations a well-functioned TCF need to be in place. During an audit of tax for TP
purposes, a TP specialist will be part of the audit team.
Supporting documentation
To perform substantive test the quality of the documentation is essential. The chance on a material misstatement will decline when the TP documentation is good. The needed documentation for substantive testing as part of the TCF will consists of:
• All intercompany transactions;
• Documentation to assists the arm’s length price (comparability analysis); • TP method;
• Price range report; • Applicable rulings;
• Announced of pending TP audits.
All intercompany transaction and supporting documentation
The intercompany transactions between a high-tax jurisdiction and a low-tax jurisdiction are primarily focused on. Questions to be answered are: which intercompany transactions have supporting
documentation? And, how are these transactions documented? Furthermore, transactions with associated entities outside Europe fall within the scope. The external auditor needs all the intercompany transactions and all documentation supporting the TP calculation.
[“…What should be a standard part of the TCF is per intercompany transaction a
substantiation of the used TP method. Or a study/report which determine the TP range”. – Tax Director]
Advance pricing rulings
APAs do mitigate the TP risk for both the company and external auditor, because there is a pre-arranged price range. The external auditor assesses if the APA is implemented correctly and if any
