Knocking on multinational enterprise’s door

In an era marked by increasing globalisation, multinational enterprises (MNEs) are playing a pivotal role in shaping cross-border economic activity.

However, their complex structures and aggressive tax planning initiatives have also drawn heightened scrutiny from tax authorities across the world.

The knock by tax authorities often leads to complex investigations, disputes, adjustments, penalties, or reputational damage.

This article dissects the anatomy of a tax audit on an MNE group, exploring what triggers such an audit, what unfolds behind the scenes, and how MNEs can proactively manage the process to ensure compliance and mitigate risk.

What triggers the knock?

Transfer pricing audits do not emerge from thin air. They are triggered by specific red flags and signals that suggest potential non-compliance or risk to the tax base such as failure to file transfer pricing documentation; unusual intercompany transactions; restructuring business operations or business model; reporting persistent losses despite the group’s global profitability; significant transactions with associated enterprises located in tax havens; and inconsistencies between financial statements and tax returns.

These triggers are not merely speculative. They are part of a strategic approach to identify potential Base Erosion and Profit Shifting (BEPS) practices.

Increasingly, tax authorities are leveraging international data-sharing arrangements such as Country-by-Country Reporting to identify high-risk taxpayers; and databases such as TP Catalyst’s Orbis or Royalty Range to benchmark taxpayer margins against industry norms.

Inside the audit

Transfer pricing remains a common area of focus in MNE audits. Common transfer pricing issues include the following:

Management and support services: Whether services were actually rendered (benefit test); duplicative or shareholder services; and mark-ups applied on costs.

Intercompany financing: Scrutinised for thin capitalisation breaches; arm’s length interest rates; and credit risk or debt capacity analysis. MNEs must prove that intercompany loans would have been acceptable to a third party under similar terms.

Intellectual property transfers: Tax authorities assess who performs and controls value-driving activities or Dempe analysis (Development, Enhancement, Maintenance, Protection, and Exploitation); valuation methodologies; intellectual property (IP) migration schemes and substance in low-tax jurisdictions.

Royalty and license fees: Key concerns include excessive royalty rates; payment to IP owners with no Dempe functions; and no economic value from the brand or IP in the local context.

Tangible goods and commodities: Scrutiny involves use of inappropriate comparables; fluctuating gross margins; under- or over-invoicing of tangible goods; and misapplication of the transfer pricing methods.

Cost contribution arrangements (CCAs): Assess whether CCAs reflect real shared benefits; alignment of contributions with expected benefits; and existence of formal agreements.

Business restructuring: Auditors investigate shifts of functions or risks without compensation; contract manufacturing transitions; and loss of domestic profit-making ability. Compensation may be required where restructuring results in a loss of income potential or assets.

Best practices for MNEs

Given the increasing likelihood of transfer pricing audits, MNEs must adopt best practices that embed tax compliance into their business culture and systems.

MNEs can minimise audit risks by maintaining robust transfer pricing documentation; ensuring that profits are allocated where value is created; benchmarking periodically i.e. updating comparables and financial analyses every few years or when material changes occur; implementing intercompany agreements; maintaining appropriate records to substantiate intercompany charges; and evaluating transfer pricing policies annually.

Conclusion

Transfer pricing compliance is not just about documentation. It is about aligning substance with form, ensuring transparency, and demonstrating that profits are earned where value is created. By adopting robust policies and engaging proactively with tax authorities, MNEs can avoid surprises when the knock comes and possibly keep the door closed to unnecessary disputes.

In the post-BEPS era, the knock on the door is no longer a matter of if but when. The time to prepare is before the knock. Remember if you don’t tell your story, the auditor will write one for you.

*Vilipo Muchina Munthali is managing consultant at Swift Resources, an international tax and transfer pricing consulting firm that specialises in developing, implementing and defending transfer pricing policies for both local groups and multinational enterprises.

Feedback: vilipo@swiftmalawi.com

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