Tax policy under the microscope as authorities increase enforcement efforts

Even with an improving global economy, governments facing daunting deficits remain focused on raising revenues through taxation, with transfer pricing being a key instrument. As a result, the world’s leading companies expect to devote far more resources to transfer pricing compliance: 31% report an increase in internal head count. Sixty-two percent note an increase in the use of external consultants and 23% report an increase in the use of software or similar tools. This is according to the Ernst & Young Global Transfer Pricing Survey,a survey of 877 multinationals from 25 countries, released today.

Heavier regulatory hand

Since the 2007 Ernst & Young Global Transfer Pricing Survey, revenue authorities in several jurisdictions have significantly increased their staffing in this area, adopted more centralized approaches to managing inquiries and established a more strategic, risk-based approach to prioritizing transfer pricing reviews. In the US, for example, the Internal Revenue Service added 1,200 employees in 2009 to deal with international issues, with another 800 expected to be added by the end of 2010. In the UK, Revenue and Customs issued guidance in late 2010 on more extensive use of penalties in transfer pricing cases. In China, the State Administration of Taxation has adopted a targeted approach, designating 30% of Chinese taxpayers as key audit targets based on selected criteria.

John Hobster, Ernst & Young’s Transfer Pricing Global Accounts Leader, says: “It’s clear that the regulatory environment has got much tougher, and companies will need to adjust accordingly. They will need to devote resources to understand, catalogue, and document thoroughly their transfer pricing policies in an ever increasing number of countries.”

Tougher enforcement

Thirty-two percent of tax directors identify transfer pricing as the most important tax challenge their organization faces, and three-quarters of tax directors believe that transfer pricing will be “absolutely critical” or “very important” to their organization over the next two years. This feeling was strongest in Europe, followed closely by the US and Asia. There were also differences by sector, with pharmaceutical and biotech companies far more concerned about transfer pricing than telecoms or financial services companies.

“Tax authorities typically target industries with high-value, portable intellectual property, and those that generate high margins,” Thomas Borstell, Global Director of Ernst & Young’s Transfer Pricing group says: “This might explain why pharmaceuticals top the ranking. Multi-nationals need to self assess their transfer pricing profile and manage the risk of aggressive audits and potential double taxation.”

Audit experience

Two-thirds of the respondents in the 2010 survey say they have undergone a transfer pricing audit, compared with 52% in the 2007 survey. Further, one in five audit adjustments triggered a material penalty, compared with one in 25 in 2005.

Hobster says: “We are seeing increased audit activity and evidence of increased penalties, with a particularly marked increase in audits in emerging markets such as China and India.”

The survey reveals that authorities are placing greater emphasis on inter-company financing transactions and service transactions, along with an ongoing interest in transactions relating to intellectual property. Reviews of inter-company financing transactions increased dramatically to 42% in 2010 from 7% in 2007, and respondents indicating that service transactions had undergone review increased to 66% in 2010 from 55% in 2007.

Attacked from all sides?

Hobster concludes that multi-nationals must take a more proactive approach to transfer pricing as the risk of challenge by the authorities continues to increase.