Arming your transfer pricing arsenal: essential evidence for tax-proof documentation
Nouran Ibrahim and Haidy Elaasser of Saleh, Barsoum & Abdel Aziz – Grant Thornton Egypt explain what supporting evidence should be kept in readiness for potential queries raised by the Egyptian Tax Authority at times of audit
Following the work of the OECD/G20 Inclusive Framework on BEPS on Actions 8–10, the Egyptian transfer pricing environment has witnessed an increase in audits and a requirement for higher transparency and compiling higher-quality transfer pricing documentation by taxpayers.
Transfer pricing documentation is considered a taxpayer’s first line of defence. However, at times of an audit, tax authorities require more supporting documentation, thus raising the need to maintain evidence and background information to support the analyses within documentation.
In normal circumstances during an audit, tax authorities request supporting documents referenced in transfer pricing documentation, such as financial statements and intercompany agreements. However, enquiries are increasingly being made for more granular evidence, which can be bundled into two broad categories:
Evidence to support the correct application of a taxpayer’s transfer pricing policy; and
Evidence to support the commercial rationale behind transfer pricing policy deviations.
Evidence to support the correct application of transfer pricing policy
The following are examples from the authors’ experiences during transfer pricing audits, demonstrating two of the most common areas where further evidence is usually required.
Evidence to support the application of internal CUPs
Taxpayers often adopt third-party selling price as a transfer pricing policy to be tested via the comparable uncontrolled price (CUP) method without considering how CUP data would be used to test the outcomes of intercompany transactions at year end. During the year, taxpayers need to consider that upon audit, they will likely be asked to provide robust evidence to demonstrate the comparability of the transactions, and per-unit data on the intercompany transaction side and the uncontrolled transaction side.
Taxpayers need to be mindful of quantifiable adjustments to achieve an ‘apples-to-apples’ comparison and think about data sources and presentation in advance. If granular analysis is not included within transfer pricing documentation, it will likely need to be made available upon audit, when there may not be enough time to develop analyses from different sources.
The source data for cost bases used for central service charges
Taxpayers often enter transactions involving inbound central services. These charges are often composed of a cost base in addition to a mark-up. Transfer pricing documentation sometimes focuses on defending the mark-up without giving proper attention to the cost base. Tax administrations are just as concerned with the build-up of the cost base as they are about the mark-up.
Accordingly, taxpayers need to continuously identify and gather relevant source data from their counterparts during the year to allow smoother demonstration of evidence in documentation or upon audit. This would include cost allocation records and the methodologies and mechanisms related to how the costs have been allocated across the legal entities, how shareholder costs and duplicative costs have been treated, possibly financial statements of counterparts, intercompany billing records, and details around the allocation keys used for any indirect charges. This may include enquiries for time records, IT systems data, usage metrics, and HR records.
Another important aspect is the benefit test, which is an integral component documenting central services. It includes details about the benefits that the service recipient receives in exchange for the service payment. The tax administration often asks for further evidence supporting benefits received. This may include examples with reference to specific projects undertaken under the service transaction, demonstrating the importance of the service to the service recipient, and providing reassurance that these services are not duplicated. This is often implemented by a point-by-point audit of the intercompany agreement by the tax administration.
By thoroughly reviewing these sources of data and benefit details, taxpayers can establish sound evidence for defending cost bases related to central service charges, ensuring compliance with the arm's-length principle.
Evidence to support the commercial rationale behind transfer pricing policy deviations
In times of uncertainty, there are often policy deviations. The following examples demonstrate the most common areas where further evidence is required to support policy deviations.
Evidence to support extraordinary costs or revenues
In certain instances, taxpayers can incur extraordinary costs or revenues that are exceptional to their normal business operations. To support such items during a transfer pricing audit, taxpayers are expected to accurately quantify any extraordinary items and provide robust evidence to demonstrate the legitimacy and appropriateness of the treatment of such costs or revenues.
From the authors’ experience, tax authorities expect to see evidence to support the nature of such extraordinary costs or revenues, which could include financial models and budgets/projections, and how these differ from the taxpayer’s actual results/financial statements; internal communication records explaining the nature of these items and their link to commercial/industrial reality; and financial auditor’s opinions.
By gathering and documenting comprehensive evidence, taxpayers can strengthen their position during a transfer pricing audit.
Evidence to support operating versus non-operating costs
Tax authorities focus heavily on ensuring that taxpayers provide evidence to support their operating versus non-operating costs at times of an audit. Differentiating between operating and non-operating costs is crucial for accurately determining the arm’s-length pricing of transactions, and testing a taxpayer’s operating results in relation to the transactions under audit. Operating costs are those directly tied to the day-to-day operations of a business, while non-operating costs are typically not directly related to core business activities.
To support the distinction between these types of costs, taxpayers are expected to provide relevant evidence pertaining to their cost classification policies, accounting policies, evidence of business purpose, and whether the costs are tied to business activities that generate revenue or have another purpose, such as one-time projects or investments.
Some line items are not clearly identifiable between operating and non-operating, such as foreign exchange gains or losses, and their categorisation needs to be defended on a case-by-case basis. Gathering timely evidence in this regard is extremely important.
It is important to note that the tax administration relies heavily on how financial auditors have categorised line items in the financial statements (i.e., before or after the operating profit line) . This has carries significant weight in an audit by the Egyptian transfer pricing unit. As such, taxpayers should exert effort in explaining to their financial auditors the nature of each line item, whether costs or revenues, to accurately present them in financial statements in a way that provides a clear distinction between operating and non-operating items.,
Close monitoring of different types of provisions and write-offs
Monitoring various types of provisions is essential for ensuring compliance with tax regulations and the arm's-length principle.
Certain provisions, such as tax provisions or legal provisions, are usually considered non-operating. However, assessments related to bad debt are less straightforward. Evidence regarding the commercial nature of these amounts and their purpose is the driver of whether they are to be included within a profitability calculation for transfer pricing purposes.
Takeaways for taxpayers
Taxpayers are advised to continuously work on identifying events throughout the year that are affecting pricing policies, and collect comparable data, market information, and internal documents that support commercially rational decision making in response to such events. This provides evidence and assurance to tax authorities that policy deviations are not indicative of profit shifting and provides for much smoother transfer pricing audits.
Taxpayers should also keep in mind that the tax administration relies heavily on how financial auditors have categorised line items in the financial statements, which has significant weight in an audit by the Egyptian transfer pricing unit.