TAX FORUM
TRANSFER PRICING COMPLIANCE
Mitigating tax and compliance issues – and reducing risk exposure
Globalisation has significantly changed the landscape of commercial transactions with a substantial portion of activities occurring between associated or related parties. These transactions can take place within a single jurisdiction, internationally or across multiple jurisdictions, attracting scrutiny from local offices of the Inland Revenue Department (IRD).
Each office aims to ensure it receives a fair share of the profits and taxes from such transactions.
CONCEPT OF TRANSFER PRICING Deloitte Sri Lanka and Maldives Head of Tax and Legal Charmaine Tillekeratne says that regulatory oversight is implemented to ensure that the pricing of goods, services or intellectual property transferred between associated parties accurately reflects the actual economic activity undertaken by each party in their respective jurisdictions.
She adds: “Essentially, transfer pricing (TP) is a principle that mandates transactions between related entities be conducted as if they were between unrelated parties. This approach ensures fairness and helps prevent potential tax evasion or profit shifting strategies.”
YEAR END TP ADJUSTMENTS Transactions between affiliated enterprises must adhere to the arm’s length principle. However, achieving the desired arm’s length results by the end of a financial year can be challenging, Tillekeratne notes.
TP policies play a crucial role in this process – typically, they are established on an ex-ante basis using projections such as sales and expenses. She explains that the arm’s length nature of these transactions should be tested annually in most tax jurisdictions by applying the annuity principle.
Since projections often deviate from reality due to inefficiencies, increased costs or lower sales prices, a transfer pricing adjustment is necessary to align actual operating results with the arm’s length principle.
Tillekeratne explains that “true-up and true-down adjustments are essential tools in financial planning and forecasting, ensuring that a company’s financial statements accurately reflect its performance compared to its budget or estimates.”
True-up adjustments are made to increase income when actual results fall short of budgeted or estimated figures, while true-down adjustments reduce income when actual results exceed budgeted or estimated numbers.
TP adjustments are not independently controlled transactions; rather, they’re part of a controlled transaction, a group of controlled transactions or payments between associated enterprises, she elaborates.
TIMING OF YEAR END TP Taxpayers can proactively make year end transfer pricing adjustments during their TP analysis, ideally before the fiscal year ends.
Adjustments made before closing the books can be reflected in accounting records, ensuring accurate pricing from both commercial and accounting perspectives. However, adjustments made subsequent to the finalisation of financial statements for the year can be adjusted either before or after filing a tax return.
YEAR END TP CHALLENGES Tillekeratne asserts that the primary challenge with year end TP downward adjustments lies in their deductibility. Generally, making TP downward adjustments before closing the books is the preferred method to comply with the arm’s length principle.
“These adjustments are not separate transactions but integral to the primary transaction. Therefore, TP downward adjustments made before the books are closed are typically allowed as deductible expenses,” she says.
However, some countries do not recognise TP downward adjustments made by the taxpayer in a tax return as it should reflect actual transactions. This could lead to double taxation as relief may not be available in another jurisdiction.
Various tax authorities including those in Poland, Singapore and Canada have issued guidelines regarding TP downward adjustments. Citing an example, Tillekeratne notes that the Inland Revenue Authority of Singapore (IRAS) has specified conditions for adjustments to be considered deductible.
These include the company having TP analyses and contemporaneous documentation in place to establish arm’s length prices, and the year end adjustment must be made symmetrically in the accounts of the affected related parties to avoid double taxation or double non-taxation.
Additionally, the adjustment must be made before filing the income tax return for the relevant financial year. There may also be other tax implications related to these adjustments, particularly concerning remittance tax, VAT and reporting requirements, she remarks.
IRD POSITION ON YEAR END TP Tillekeratne points out that Sri Lanka’s TP regulations do not provide specific guidance on handling year end transfer pricing adjustments.
In response to item No. 28 of the OECD country profile, which inquires whether the jurisdiction allows or requires taxpayers to make year end adjustments, Sri Lanka’s answer is ‘no.’
Tillekeratne asserts that the IRD seems to be adopting this stance to year end TP downward adjustments made before closing the books of accounts. She feels that this approach is considered regressive and presents practical challenges for multinational corporations operating in Sri Lanka, which in turn undermines the ease of doing business in the country.
Additionally, she asserts that “the IRD appears to believe that TP downward adjustments are not eligible for deduction for several reasons: they’re not explicitly permitted, they were not incurred by the taxpayer during the year and they were not incurred in the process of generating income.”
Given these considerations she says Deloitte encourages the IRD to provide guidance on year end adjustments made before closing the accounts, as these represent genuine and legitimate expenses incurred during the production of income.
RECOMMENDED APPROACH Deloitte’s Head of Tax and Legal says it is advisable for multinational corporations to regularly assess their TP results, ideally on a monthly or quarterly basis, as opposed to waiting until the end of the fiscal year.
This proactive approach, Tillekeratne believes, allows for timely pricing adjustments, influencing profitability within the fiscal year.
She also recommends that multinationals should consider developing a comprehensive TP policy, which details the types of transactions with related parties, their respective prices and profit margins, supported by appropriate comparables for future reference.
Tillekeratne concludes: “While this process requires significant time and resources – particularly for organisations with complex intercompany transactions – it helps mitigate tax and TP compliance issues, and reduces risk exposure.”
