For tax professionals who missed the Barnum & Bailey show over the holidays, I bring good news: there is still ample time to catch the annual financial statement Audit Circus, which features equally grotesque and unfathomable exhibitions, and which will visit countless offices around the world in the coming weeks.
For good reason, financial statement audits are heavily regulated and formalized processes, with set procedures for determining and quantifying financial statement and tax risk. However, this isn't always a great fit for highly specialized and subjective areas like transfer pricing, which often requires an obnoxious combination of theoretical judgement calls and exasperating devil's advocacy.
Today we explore one of the most common pitfalls of auditing transfer pricing: the curious case of the missing transaction.
Auditing Transfer Pricing
While transfer pricing (mostly) eliminates in consolidated financial statements, it does have an impact at the jurisdictional/local statutory level via its effect the allocation of income between jurisdictions. If the transactions identified exceed audit materiality threshold, the accounting firm's TP team, the accounting firm TP team is parachuted in to evaluate the appropriateness of the policies for the transactions identified. If the taxpayer's methodology is deemed unsatisfactory, additional work is done to determine whether adjustments or reserves are necessary.
The Plot Twist: Unpriced Intercompany Transactions
Tax authorities expect related-party relationships to comply with the arm’s length principle, meaning they should be priced as if the parties were independent. In cases of tangible products or value-added services, these relationships are sometimes obvious and easily identified by the business and auditors alike. Yet some intercompany relationships that would have had a price tag attached if engaged with a third party may be overlooked without a well-trained eye to spot and price them.
Common Scenarios Where Pricing Is Overlooked
- Intangible licensing or support: Brand management, know-how, or other or IP-related activities may be essential to the recipient affiliate's business but are often difficult to describe and quantify
- Centralized Services: Headquarters functions like HR, IT, and finance often benefit multiple entities but remain uncharged for lack of awareness or cash management considerations
- Strategic Management: Executive oversight and decision-making at headquarters frequently go uncompensated, especially after acquisitions or restructurings.
By distorting profit allocation between affiliates, unpriced transactions increase the likelihood of tax adjustments and accompanying penalties.
Pitfalls in TP Audits
Audit teams fail to pick up on unpriced intercompany transactions for a variety of reasons. Some common ones:
- The "same-as-last year" trap: SALY is the enemy of all audit procedures, not just TP
- Relying on "what's there" - workpapers, Forms 5471s, etc. - rather than "what should be there." The latter requires a holistic understanding and in-depth assessment of the taxpayer's business model and value chain - not just their existing TP policies
- A focus on margins/markups rather than on economic realities and substance: TP audits can miss the forest for the trees by, for instance, accepting an inappropriate cost-plus policy and instead harping on the difference between a 5% and 7% markup
- Insufficient scoping and budgeting for transfer pricing review: TP experts are often brought in late in the game, and with implicit or explicit pressure to keep things within the original budget and on track for sign-off
- Failure to match policy and actuals: an intercompany agreement or policy document describing a transaction doesn't necessarily mean it shows up in the local financials
- Lack of TP risk awareness: the misconception that intercompany eliminations blunt or remove the risk of TP-related tax risk is pervasive. Similarly, any identified exposure is often disregarded if tax exposure in one jurisdiction would be offset by a corresponding tax benefit of a similar magnitude in the counterparty jurisdiction. While this stance may be justified, it requires careful analysis of the availability of double tax treaty relief, as well as confirmation that the taxpayer would in fact pursue such relief under the lengthy and costly competent authority process.
How do Eide Bailly and our clients avoid these pitfalls? For a start, we default to including in transfer pricing in the audit program for all multinational taxpayers, regardless of whatever think we know about their TP materiality. Second, we maintain a model of cross-functional collaboration, including regular coordination between audit and tax teams, local statutory audit counterparts, and relevant taxpayer contacts. Finally, we communicate the messages in this article to internal and external stakeholders, so that we all know what proper review entails and why each component is necessary.
Unlike Barnum & Bailey, the Audit Circus is better enjoyed without surprises.
Make a habit of sustained success.
