Negotiation with the local tax authority representatives on transfer pricing issues is a critical element of the audit process in many jurisdictions. Successful negotiation requires, at least, the following:
• A capable, confident negotiating team;
• Full and up-to-date information on the issues under discussion; • An understanding of local statutes, case law and practice;
• A well-laid-out strategy concerning the issues at hand, identifying what positions could be compromised and others on which the company would not budge; • Experience of the general attitude of the local tax authority towards the type of
issues under consideration; and
• A clear view of the financial risks of reaching or not reaching agreement. The old adage “know thine enemy” is of crucial importance in pursuing a favourable outcome to a transfer pricing dispute. At all stages of the audit, the company will need to consider the nature and experience of the tax authority team. For example, is it
dealing with a local tax inspector, a revenue commissioner in transfer pricing, a trained economist or a professional revenue attorney?
The implication of not reaching an agreement is, of course, ultimately, litigation in the local jurisdiction. The company needs to consider the implications of local litigation on transfer pricing issues very carefully, as the chances of success in the courts may vary widely in different countries. Again, the extent to which transfer pricing issues, being substantially questions of fact, can be escalated in the legal system would have to be borne in mind relative to other available administrative relief measures. The burden of proof is different from jurisdiction to jurisdiction, and at various times local courts may reflect public concern that foreigners are shifting taxable income out of the country rather than the pure technical integrity of the matter. In these instances, the taxpayer may feel that it should not pursue its case through the local judicial system. The implication of a transfer pricing adjustment resulting in a liability is the payment of the tax demand. This presents a cash flow situation for the taxpayer, regardless of whether the company decides to pursue litigation or alternative dispute-resolution avenues. Furthermore, the company must consider the implications of the transfer pricing assessments and the dispute-resolution measures to be taken and how these matters should be disclosed on its publicly released financial statements. This is becoming evermore a critical matter in today’s environment, where transparency of a company’s accounting policies is required by public markets.
When negotiation or litigation has resulted in a tax adjustment, the company must consider whether an offsetting adjustment can be made in the other country involved. This may be through the mutual agreement procedures of the relevant income-tax convention or, alternatively, a special-purpose arbitration vehicle such as the European Arbitration Convention for countries that are part of the European Union (see chapter
10). Considering all the avenues that are available to a taxpayer, it is critical to
consider the appropriate timing of when to invoke one avenue versus the another (i.e. should the taxpayer pursue a mutual agreement procedure process if negotiations with the local inspectors fail, should litigation be pursued instead, or should both processes be initiated at the same time). The decision on these matters hinges on where the taxpayer believes it will be able to reach the best solution given the factors previously discussed.
705. Preparation
Negotiation, litigation and arbitration are all procedures that demand extensive preparation if the company is to protect its best interests. It should be borne in mind that individuals other than those directly involved in managing the audit process may be required to answer questions or give evidence and they must be adequately briefed to ensure that they can deal with the questions addressed to them.
The taxpayer’s audit team must research the powers of the local tax authority and plan to meet its likely requirements. For example, the local tax authority may have the power to require the provision of substantial amounts of information about the group’s transactions within a short time frame. Further, in view of protracted revenue audit or litigation proceedings, which may take place long after the transactions in question have occurred, the importance of documentation at every step (by way of work papers, notices, hearing memos, submissions and rejoinders) cannot be overemphasised.
Any information that is to be provided to the local tax authority (verbal or
documented) must be carefully reviewed by the audit team to ensure the following: • All of the information is correct;
• All of the information is consistent with the tax returns and accounts of the relevant entities and other information which may be available to the local tax authority; • The positive or negative implications of the information have been fully considered
(i.e. does it support the existing pricing structure, and the functional analysis of the relevant entities’ activities or does it identify a tax exposure?); and
• Proper consideration has been given to the possibility that the information will be made available to other tax authorities and that the local tax authority may have sought information of other authorities under the exchange of information procedure in income tax conventions.