The section on safe harbours in Chapter IV of the OECD Transfer Pricing Guidelines discusses some potential disadvantages of safe harbour rules, such as the reporting of taxable income that is not in accordance with the arm’s length principle, increased risk of double taxation or double non-taxation when adopted unilaterally, potential for creating inappro-priate tax planning opportunities, and equity and uniformity issues due to the creation of two sets of rules for transfer pricing. In conclusion, where safe harbours can be negotiated on a bilateral or multilateral basis, they may provide significant relief from compliance burdens and administra-tive complexity without creating problems of double taxation or double non-taxation. This also can be achieved through unilateral safe harbour rules which both align with the arm’s length principle and fall within the scope of double tax treaties (e.g. allowing the other State to understand the technical details behind the safe harbours in order to grant total or partial relief in case it is necessary and feasible). The guidance also states that tax administrations should carefully weigh the benefits of, and concerns regarding, safe harbours, making use of such provisions where they deem it appropriate.⁹⁹

This Chapter and the two that follow it discuss aspects of the enforce-ment of transfer pricing rules by the tax administration. This Chapter (13) principally discusses the transfer pricing risk assessment usually performed by the tax administration at the beginning of an audit. Chapter 14 discusses aspects of the transfer pricing audit itself. Chapter 15 discusses the resolution of transfer pricing disputes.

An effective enforcement process seeks to achieve two impor-tant outcomes:
►    To enhance and incentivize future compliance (which indirectly contributes to future tax revenue and protection of the tax base); and
►    To increase current tax revenues through appropriate adjust-ments to the income reported by taxpayers when such adjust-ments are called for.
These objectives will be achieved only if the audit and dispute resolution process is managed successfully.

Transfer pricing audits are generally time and resource intensive. The hard work involved in a transfer pricing audit may result in the collection of significant tax revenue that can benefit a developing country. However, such results do not come quickly and easily.

The success of an audit often depends on the preparation and plan-ning that take place in the first stages of the audit, especially in the risk assessment phase. Tax administrations do not have the resources to audit every cross-border transaction or every taxpayer. Accurate risk assessment enables informed case selection, which in turn helps the tax administration avoid wasting its enforcement resources. It is therefore important to dedicate adequate time and resources to risk assessment.

13.1.5    Risk assessment should be the first step of an audit and should continue through the various stages of the audit. Risk assessment involves an ongoing cost/benefit analysis, which helps to ensure the most efficient and effective use of tax administration time and resources and ensure that taxpayers are not unnecessarily inconvenienced when their compliance with the transfer pricing rules is evident. Risk assessment must be built into the auditing process and incorporated into an audit programme.

Notwithstanding that safe harbours may present certain disad-vantages, it is worth mentioning that in the context of small taxpayers or less complex transactions, these might be outweighed by the benefits of such provisions. Provided that the safe harbour is elective, taxpayers may consider that a moderate level of double taxation, if any arises due to the safe harbour, is acceptable given the increased certainty and simplicity. It can be argued that when electing for the safe harbours, taxpayers are capable of making the decision as to whether the possible double taxation is acceptable or not.

The OECD has published a handbook on transfer pricing risk assessment.¹²⁶ This provides guidance on how the information contained in the taxpayer’s transfer pricing documentation can be effectively utilized to assess transfer pricing risks. This chapter does not seek to replicate all of the information in the OECD risk assessment handbook and tax administrations are therefore strongly encouraged to download the OECD handbook and to use it in developing their own risk assessment programmes.

Effective risk identification and assessment are important steps toward ensuring that the most appropriate cases are selected for audit. Given the resource constraints of tax administrations it is important for any tax administration that high risk transfer pricing cases do not “slip through the tax net”. However, even the most robust risk identification and assessment tools and processes may not always guarantee success in audit. The reason for this is that the level of detail contained in information available to the tax administration at the risk assessment stage may not always be sufficient to draw reliable conclusions regarding the arm’s length nature of profits/prices. A determination of whether the prices utilized by the taxpayer are in fact arm’s length will depend on a functional analysis (based on the functions performed, assets used or contributed and risks assumed by each party), the transfer pricing methods applied, and so forth. The risk assessment does not involve a full functional analysis. It is instead intended to identify whether such a full analysis is warranted given the constraints on tax administration resources.

There are several ways in which a tax administration may conduct its risk identification and assessment, and the approach taken is largely dependent upon the type of information and data that is available and accessible. For exam-ple, exchange control authorities in some countries may work hand-in-hand with the tax administration enabling sharing of information between them; on the other hand, there may countries where such interaction may be prohibited. Some countries have strong filing and documentation requirements designed to ensure that relevant and appropriate information is submitted. The new global documentation standard described in Chapter 12 will provide most tax admin-istrations with information that is useful in assessing transfer pricing risk.

It is important to draw a distinction here between the information related to filing a tax return and that contained in transfer pricing documen-tation. This may vary from country to country but in essence is as follows:
►    Filing information typically relates to questions on a tax return. This may entail a tick-the-box (i.e. yes or no) or a “fill in the box” response (e.g. inserting a quantum or value);
►    Documentation, in the context of transfer pricing, will generally include more substantial information such as answers to ques-tions about the company’s transfer pricing policy, identification of transactions with associated enterprises, legal contracts, valu-ations, identification of transfer pricing methods used, financial information, etc. For relevant taxpayers, transfer pricing docu-mentation should now also include access to the CbC report reflecting income, taxes paid, and certain measures of economic activity on a country-by-country basis.

The OECD BEPS Action 13¹²⁷ provides detailed guidance on how the information provided under the documentation standard, and especially in the CbC report, can be used by tax administrations in conducting risk assessments.

When designing safe harbours, it is important to consider whether to allow for flexibility to “opt-in” or “opt-out” of the measure. An “opt-in” safe harbour is one where the taxpayer can choose to apply the safe harbour in order to benefit from it. In this scenario, a taxpayer that chooses not to opt-in must apply the ordinary transfer pricing rules and any associ-ated documentation requirements. An “opt-out” safe-harbour requires the taxpayer to apply the method specified to the relevant transactions unless it actively chooses not to. If a taxpayer opts out, it must apply the transfer pricing rules and any associated documentation requirements, meaning that it bears the burden of proof that its controlled transactions were conducted in line with the arm’s length principle. An “opt-out” regime may thus be a more straightforward option as it has the potential to reduce administra-tive costs. There is no intrinsic difference in the option taken but it would be necessary to take into account any differences in the burden of proof implied by the choice made.

A risk identification and assessment process, followed by engage-ment with the taxpayer, can be a worthwhile approach for tax administra-tions to adopt. This allows for better understanding of the risks identified and gives taxpayers the opportunity to explain the commercial context of the transactions/risks identified. Such an approach is designed to ensure that the risks have been profiled in the most robust manner before resources are committed to carrying out an in-depth audit.

Overview
Intragroup transactions, e.g. payments for goods, services and intangibles, provision of financial assistance, etc. give rise to transfer pricing risk. Such transactions or categories of transactions are often readily identi-fiable on the income statement and/or tax return or from required transfer pricing documentation.

It may be useful to try to place the transfer pricing risks into catego-ries to give added value and context to the risk identification and assessment process. Such categorization can assist risk profilers/assessors to evaluate the aggressiveness of taxpayer positions and the complexity of the risk, the possible amount of tax at stake, and the probability of generating significant tax revenue through audit. Such classification can help determine whether a case is worth pursuing and whether the requisite resources and expertise are available.

Some of the types of transfer pricing risk that may be considered in a risk assessment include:
►    Category 1: Profit shifting through new transactions or structures;
►    Category 2: Profit shifting through restructuring of business operations;
►    Category 3: Other types of intentional profit shifting such as through incorrect functional classification, the use of incorrect methods, allocation keys etc.;
►    Category 4: Issues involving “thick” or “thin” capitalization; and
►    Category 5: Unintentional profit shifting.

The examples of risk categorization provided in the previous para-graph can assist the risk profiler/assessor in the evaluation of each of the following factors:
►    The likelihood of detection by revenue authorities;
►    The possible value or amount of the profit shifting (and therefore the potential value of the risk); and
►    The amount of time and resources required to audit the risk (including the level of expertise required when drawing upon those resources).

In general, safe harbour rules tend to provide an option that exempts taxpayers from complying with general transfer pricing rules in relation to certain transactions. In this regard, if the transactions stay within the safe harbour limits, there may be no need to apply transfer pricing methods and/or maintain contemporaneous documentation mandated in the transfer pricing legislation.

Category 1:    Profit Shifting Through New Transactions or Structures
This category includes new transactions and business structures implemented by MNEs with the intention of minimizing taxes by shifting profits. It is assumed that the potential tax reductions for groups implement-ing these types of transactions or structures may be significant and the tax risk is therefore assumed to be high.

Under the recommended transfer pricing documentation standard, important changes in corporate structure must now be disclosed (see Chapter 12). A tax administration’s awareness of possible tax planning schemes and structures and its own analysis of potential loopholes in the tax system may help identify useful lines of audit inquiry.

Category 2:  Profit Shifting Through Restructuring of Business Operations
This category is different from Category 1 as a tax minimizing/profit shifting structure is implemented at a certain point in time, resulting in a change to an existing structure or business model. Accordingly, this is referred to as a “restructuring”. The risks associated with a restructuring are different for the various jurisdictions affected. The country where the MNE is head-quartered (and possibly where the intangibles were originally developed and/ or owned) would face different risks from those faced by a country where the MNE has a subsidiary undertaking manufacturing, distribution or marketing.

In this situation, the jurisdiction where the MNE is headquartered would face issues, such as the valuation of externalized intangibles, deemed disposals of assets for capital gains tax purposes etc. In addition, the head-quarter jurisdiction may have to deal with the classification and benchmark-ing of profits for the “principal/entrepreneurial” entity remaining or created due to the restructuring.

On the other hand, the subsidiary jurisdiction(s) in Category 2 would mainly be concerned about risk stripping and loss of profits. The primary concern in this regard is that an entity has been stripped of its risks and respon-sibilities on paper (i.e. contractually), but it continues in practice to carry out the same functions or assume the same risks. The entity is effectively being paid less for doing the same things it was doing prior to the restructuring.

The OECD has proposed an elective simplified approach in the form of a fixed margin (5% mark-up on costs) for low value-adding services (LVAS).¹⁰⁰ The OECD defines LVAS as services of a supportive nature, not forming part of the core business of the enterprise, and that do not use unique and valuable intangibles or assume significant risks.

Category 3:    Other Types of Intentional Profit Shifting
MNEs may intentionally shift profits through the misclassification of entities, the application of incorrect pricing policies or unsuitable alloca-tion keys. For example, an entity may, during a period of economic upturn, be classified as a limited risk distributor and be rewarded with a fixed (but rela-tively low) profit margin, when it is in reality fulfilling the role of a fully-fledged marketer/distributor and should be sharing in the economic profits earned by the MNE as a whole. In another case, an MNE could be inappropriately allo-cating service charges as opposed to valuing the actual services performed, thereby extracting profits through excessive service charges.

It may be a challenge for a revenue authority to detect the types of intentional profit shifting activity by an MNE dealt with in Category 3. It may for instance require an evaluation of profit margins over an extended period against market/industry trends, an in-depth functional analysis of the enti-ties that are party to the transactions and a detailed understanding of the pricing policies. The CbC report and other TP documentation may be useful in supporting this type of analysis.

Category 4:    Financial Transactions and Other Issues Involving Thin or Thick Capitalization
This category of risk includes both intentional and unintentional profit shifting by MNEs using intercompany debt and capital to shift income into lower tax jurisdictions. In many countries, thin capitalization is regu-lated through limitations on allowable levels of debt to equity. Where this is the case, the likelihood for risk profilers/assessors of spotting such abuse is high, as these calculations can be easily performed or even automated to flag thinly capitalized entities. Where countries do not have prescribed limits, param-eters or thresholds can be set for risk assessment purposes. Risks related to over-capitalization (‘thick capitalization”) may be harder to identify and chal-lenge, as “bright line” tests related to excessive capital most often do not exist. It should also be noted that the treatment of thin capitalization here is at a general level and does not purport to address non arm’s length interest deductions more generally. See also the guidance on financial transactions in Part B, at 9.5.

Local laws and regulations will influence the level and amount of resources required to audit these cases. Values can range from very low to very high, but their quantification should be relatively simple (in cases where safe harbours or risk assessment thresholds exist). This should be an area of focus for developing countries with simple thin capitalization rules as it could be considered what is often termed “low hanging fruit”—meaning that audit action in such a case may be quickly and easily rewarded by identifying amounts of tax that should be paid.¹²⁸

Category 5:    Unintentional Profit Shifting
This category results from cases where mispricing by taxpay-ers occurs but was unintended. A revenue authority may disagree with the pricing policies applied, whether it be the functional classification, methods applied or other factors.

In addition, the PCT Transfer Pricing Toolkit (see 2.5.3.2) includes a comparative analysis of the country practices on safe harbours applicable to LVAS (i.e. containing information on (i) definition of LVAS; (ii) excluded transactions; and (iii) margin or mark-up for the safe harbour).

Where this occurs, it is possible that the values could be material. The level and quantum of resources required to audit the case would depend on the nature and extent of the perceived transgression by the taxpayer.

Possible “Flags” Suggesting Further Investigation
The following table summarizes some of the types of transfer pric-ing risk that can be identified in a transfer pricing risk assessment. These factors may suggest the need for additional audit investigation.

Table 13.T.1
Transfer Pricing Risks in Inbound vs Outbound Transactions
 

Overview
There are various approaches that one could take in order to iden-tify companies/groups with transfer pricing risks. These include:
►    The transactional approach;
►    The jurisdictional approach; and
►    The risk-based approach.

Where specific transfer pricing risks are identified, the tax admin-istration can design an audit programme that will efficiently investigate whether adjustments to income are appropriate under applicable transfer pricing statutes and regulations.

Transactional Approach
In order to start building capacity and expertise through on-the-job training it may be useful to adopt a transactional approach under which simpler transactions, which may be easier to price, are audited first. Some transactions are more easily identifiable but not necessarily easily audited in all circumstances. Restrictions on access to information in a particular juris-diction may limit the kinds of transactions that may be easily audited.

Some of the most common requirements for a safe harbour regime are listed below:
►    The benefits are aimed at taxpayers engaged in certain activities;
►    The regime is limited to certain conditions or thresholds such as the absolute or relative amount of the transaction;
►    Defined margins or results are established by law or administra-tive practice; and
►    Eligibility is limited to transactions where the related party is not resident in a low-tax jurisdiction.

Alternatively, the focus could be on higher risk transactions with a higher possible revenue yield, such as business restructurings, for example. Finally, examination of a combination of more complex and simpler trans-actions can be adopted in order to ensure a more consistent flow of work and revenue.

Jurisdictional Approach
A revenue authority may adopt an approach under which trans-actions entered into with entities located in specified tax jurisdictions are prioritized for audit. A crucial element of this approach is the inclusion of both direct and indirect transactions entered into with such jurisdictions, e.g. schemes or structures ultimately benefitting or involving entities in these identified jurisdictions. This will require the transfer pricing unit to iden-tify those jurisdictions it considers to be of higher risk, within the context of domestic tax rates, trade flows, tax treaties and economic policies.

It may be that transactions involving related parties in jurisdic-tions with higher tax rates are flagged for prioritization where those jurisdic-tions are perceived to have particularly aggressive transfer pricing rules or enforcement practices. MNEs may apply transfer pricing in such a way that it favours the more aggressive jurisdiction (in order to avoid potential audits in these jurisdictions) at the cost of the jurisdiction where transfer pricing is not as aggressively pursued. In adopting this approach, care should be taken not to act contrary to international non-discrimination rules such as may be found in applicable tax treaties and/or domestic law.

Risk-based Approach
This is in essence a hybrid of the transactional and jurisdictional approaches, but could also consider factors other than the jurisdiction of the related party or parties and the type of transactions.

Other factors of interest might, for instance, include:
►    The tax compliance status of the local entity or the MNE to which the entity belongs, i.e. how compliant the company/group generally is with transfer pricing and other tax/ regulatory requirements in that country or elsewhere in the world. Where groups/entities have been successfully investigated by other rev-enue authorities this could provide an indication that the group presents a higher risk for transfer pricing purposes;
►    A group that has recently undergone a business restructuring, particularly where the local entity has been “stripped” of certain risks and/or functions as part of the restructuring; and
►    Companies with excessive and/or continued accounting or tax losses despite there being profits at the consolidated group level.

For transactions exceeding or otherwise ineligible for the safe harbour limits, taxpayers could be required to comply with all transfer pricing rules.

Tax authorities should work as far as possible with the informa-tion provided by the taxpayer. The tax return should ultimately aim to obli-gate taxpayers to include the information that would be most useful for the tax authority to utilize for effective risk assessment. Information provided as part of the taxpayer’s transfer pricing documentation will be an important source of information for a risk assessment. The use of quantitative rather than qualitative data will assist in the automation of risk assessment tools. Examples of useful information on transactions include the value of the following transactions with any cross-border related party:
►    Sales;
►    Purchases;
►    Loans, including interest received and/or accrued;
►    Royalty payments;
►    Service fees;
►    Derivatives transactions;
►    Debt factoring or securitization transactions; and
►    Share remuneration transactions.
Most of this data will be included in the transfer pricing documentation described in Chapter 12.

Publicly available data can be useful. This includes newspapers, websites, databases and publications such as “Who owns Whom” or data-bases of company financial information. Unfortunately, access to databases and publications in this area can be expensive, and developing countries may often have to be more reliant than their colleagues in developed countries on information provided by taxpayers.

Published judgments of cases heard in other countries may contain useful intelligence regarding a group’s activities, transactions and pricing policies. These could also provide useful guidance on structures/schemes implemented in certain industries. The analyses of such decisions provided by law and accountancy firms to their clients are often freely available, and can also be helpful in identifying similar issues in another jurisdiction. Access to transfer pricing information databases summarizing and often including the full judgements, such as those issued by commercial publish-ers, can also be useful, if the cost of at least one licence can be borne by the administration’s budget or through donor support. Comprehensive transfer pricing databases used in transfer pricing analyses also often have a searcha-ble database of new developments.

Particular attention should be paid to any notes to the financial statements on related party transactions and loans/financial assistance.

Customs data can, in some cases, be relevant to obtaining infor-mation on intragroup transactions. Sometimes the declared import price may be an indicator of the true transfer price. See Chapter 3 for more details on the use of customs data for transfer pricing purposes; especially section 3.6.6.

Another aspect arising from some safe harbour experiences inter-nationally is that when fixed margins are established, they could be perceived as being too high, meaning that if optional, they may be unattractive to taxpayers. Furthermore, where the fixed margin is applied the other state may not accept the results as arm’s length. In these cases, there may be a significant risk of double taxation.

As noted above, information from the taxpayer’s transfer pricing documentation can be very useful.

Certain risk factors or “flags” can point to the need for further examination. However, such factors should not be treated as decisive in determining that non-arm’s length pricing has occurred. Instead, these factors point to a higher than normal likelihood of mispricing and suggest that further review is warranted. Identified risk factors may include:
►    Consistent or continued losses;
►    Significant transactions with related parties in countries with lower effective/marginal tax rates, especially “secrecy jurisdic-tions” from which tax information is not likely to be shared;
►    Local low profit or loss-making companies having material cross-border transactions with related parties offshore, where the offshore part of the group is relatively much more profitable;
►    The existence of centralized supply chain companies in favour-able tax jurisdictions, i.e. centralized sourcing or marketing companies located in jurisdictions with low-tax or no-tax regimes and which are not located in the same country/region as the group’s main customers and/or suppliers;
►    A poor tax compliance history;
►    Lack of documentation to support transfer prices;
►    Significant inconsistencies between profits of an individual group entity and the profits of the group;
►    Any significant reduction in local entity profits after such an entity is acquired by an MNE;
►    Material commercial relationships with related parties in juris-dictions with aggressive/strict transfer pricing enforcement (see 13.2.3.5. above). This also applies in the case of material commer-cial relationships with companies located in the “home” jurisdic-tion of the MNE or the location where the holding company is
listed; or
►    Material commercial relationships with companies in jurisdic-tions that employ safe harbours or similar rules that do not always align with the arm’s length principle.

As stated, the risk identification and assessment process may vary from one tax administration to another depending on the approach taken, the resource capability, and the stage at which potential challenges are consid-ered. Some tax administrations have very sophisticated processes employing computerized systems and computational analyses, while others may adopt a more simplified process. Ultimately the risk identification and assessment process will depend on what a tax administration has at its disposal in terms of information, capability and systems or technology. It can, however, be said that the more refined and sophisticated the risk identification and assessment process, the easier it will be to ensure that high risk transactions are identi-fied and audited in a timely manner.

The basic steps of the risk assessment process can be described as follows:
►    Initial review and identification of the possible risks;
►    High-level quantification of the possible risks;
►    Gathering of other intelligence;
►    Decision as to whether to proceed;
►    More in-depth risk review including high-level review of docu-mentation and functional analysis to confirm initial findings;
►    More detailed quantification of possible risks;
►    Initial interactions with the taxpayer; and
►    Decision as to whether to proceed to audit by way of specialist reviews or committee based/panel reviews.
The OECD risk assessment handbook referred to at 13.1.6 contains detailed suggestions on how the risk assessment process may be carried out.

Some of the more common risk identification and assessment tools include calculation templates for calculating key ratios relevant to trans-fer pricing. Such tools are relatively basic, based on quantitative informa-tion readily available to non-transfer pricing tax inspectors and on transfer pricing documentation. This may include, for example, information availa-ble from the tax returns and audited financial statements to assist tax inspec-tors in identifying (or “flagging”) those cases with probable transfer pricing/ thin capitalization risks.

Since implementation of transfer pricing rules may result in adjustments that increase the amount of tax payable, a taxpayer may seek, on examination, a downward transfer pricing adjustment in taxable income, arising from unintentional over-reporting of taxable income. Guidance provided in the OECD Transfer Pricing Guidelines indicates that tax admin-istrations may or may not grant the request for downward adjustment at their own discretion.¹⁰¹ Furthermore, tax administrations may also consider such requests in the context of MAP and corresponding adjustments. This is an issue which developing countries should also consider when designing their domestic legal environment for transfer pricing.

Where specialist transfer pricing capability and resources are limited, generalist tax inspectors/auditors may be used to assist with risk identification and assessment. In such cases these basic tools ideally do not require generalist auditors to apply their discretion or have specific transfer pricing knowledge. They merely require the auditors to input certain data, run the calculations (if not automated) and report the results (where above or below certain pre-established thresholds) to the transfer pricing unit. The decision as to whether to involve the auditor going forward is then a decision that should be made on a case-by-case basis by those with special transfer pricing expertise as part of the audit process.

Basic quantitative risk assessment tools are particularly effective in the identification of thin capitalization risks as this usually involves a quan-titative test of the financial data and is in most cases, depending on the local legislation, a matter of objective fact rather than more subjective opinion. Automated risk assessment tools that can be used to run through large sets of available data can be used very effectively in this area.

It is important that the outcomes of a risk identification and assess-ment process be documented and signed off for governance and control purposes and preferably saved in a central repository, i.e. a database of cases assessed, whether or not leading to a detailed audit or to tax assessment.

13.2.8.2    The tax administration should design templates containing key information relevant to their domestic requirements. Ideally these should include:
►    Statutory filing requirements (e.g. tax number etc.);
►    The nature of the transactions and risks identified;
►    The quantification of risk, where possible;
►    The jurisdictions with which the transactions occurred;
►    The information reviewed e.g. the financial statements, tax return, etc.;
►    The outcome of the risk identification and assessment process, i.e. what was recommended and why; and
►    Specific issues and transactions identified for further audit.

The tax administration should organize an audit team and proceed with an audit where the risk assessment (discussed in Chapter 13) concludes that a full transfer pricing audit of one or more issues is appropriate. This section details the considerations to be taken into account in conducting a transfer pricing audit.

The Republic of Korea’s experience may be considered as an example in this regard. In 2010, the Republic of Korea clarified in its tax law that a downward adjustment should be applied in cases where a tax adjust-ment is made under a transfer pricing method using multiple year data. Therefore, tax officials are no longer given any discretion to make the adjust-ment only for years with a deficient profit, and to disregard years with excess profits, when they adjust the taxpayer’s profit level under a transfer pricing method using multiple year data.

Where the appropriate unit of the tax administration (see section 11.5) decides to examine transfer pricing, the examination team should ideally be comprised of:
►    A manager who typically has responsibility for more than one audit;
►    A team leader who will manage the day-to-day examination of a taxpayer;
►    A domestic examiner who is responsible for audit activities pri-marily relating to domestic issues;
►    An international examiner who is responsible for audit activi-ties primarily relating to international issues including trans-fer pricing;
►    A transfer pricing economist who provides economic analysis and support for the audit;
►    A lawyer who is available for consultation on legal aspects and may be involved in audit planning and implementation;
►    A computer audit specialist who assists with the software needed to analyze computer readable data received from the taxpayer, and in organizing the data to assist the domestic and international examiners as well as the economists in analyzing transfer pricing issues; and
►    Where possible, the team should also include an industry specialist.

The above-mentioned persons may not always be present in one examination team and may be consulted as needed. The availability of resources may depend on the stage of the audit process, the organizational structure adopted by the tax administration in question and the staffing/ capacity constraints of the tax administration; see further sections 11.5 and 11.6. One person may be able to effectively perform two or more of the above functions. The skill groups identified above illustrate the knowledge and expertise needed for a transfer pricing audit team.

The international examiner, the transfer pricing economist and the lawyer are likely to be present in most cases. The international examin-ers are indispensable in the light of the international nature of transfer pric-ing. They receive special training in international issues and, in many cases, are more senior and experienced than domestic examiners. The team leader often consults the international examiner.

A transfer pricing economist should be involved from the incep-tion of the audit. An economist is almost always involved in:
►    The functional analysis of the taxpayer’s business;
►    Assisting in the selection of comparables;
►    Assisting in the selection of the methodology to be applied;
►    Providing an analysis of whether the prices for the transactions in question meet the arm’s length standard;
►    Assisting the audit team with respect to the economic arguments when in discussion with the taxpayer; and
►    Preparing or assisting the preparation of a report addressing the conclusions of the team.

The lawyer will often be involved at an early stage in reviewing important substantive or procedural decisions. Additionally, the lawyer will be consulted concerning the procedures to be used for information gather-ing, may be involved in drafting questions posed in information requests and may also participate in interviews of company personnel. The lawyer is expected to contribute to more carefully crafted inquiries for information and to resolve administrative and substantive issues. Also, the participation of the lawyer in the audit process may expedite and make the preparation of the case for possible litigation more effective.

In South Africa, the legislative provision requiring that terms and conditions should be adjusted to those that would have existed had the parties been independent persons dealing at arm’s length, is limited to situa-tions there has been a tax benefit, and therefore does not in its terms provide for downward adjustments.

A key issue for a tax administration is to ensure transfer pricing audit approaches are uniform over the whole country. This is especially a pressing problem for a country which has a vast geographical area to cover. An illustration of an effort to solve the “uniformity” problem can be seen from the case of Japan.

When Japan enacted its transfer pricing legislation in 1986 it faced the issue of ensuring uniformity in administration of the rules. There were twelve regional taxation bureaux, while a single unit had to supervise the transfer pricing assessments done by these bureaux. From the outset, a rule was established that prior approval from the Director (International Examination) in the Large Enterprise Examination Division of the National Tax Agency had to be obtained before a transfer pricing division could issue a correction notice to adjust transfer pricing of a taxpayer. Such an approval request had to be supported by an explanation of the facts of the case and the reasons for the adjustment. Transfer pricing divisions were also encouraged to consult the Director (International Examination) during the course of the examination.

This was possible at the early stages of transfer pricing enforce-ment because the number of transfer pricing cases was small. As the number of transfer pricing cases increased, however, it became impossible for the Director (International Examination) to supervise all cases. Therefore, grad-ually, the supervisory power has been delegated to the Senior Examiner (International Taxation) at each regional taxation bureau. The Director (International Examination) now supervises only the larger transfer pric-ing audit cases. It is now possible to supervise transfer pricing audits at the level of the regional taxation bureaux as the number of tax officials who share common knowledge and expertise in transfer pricing has increased considerably.

It is necessary to decide what issues will be investigated in a trans-fer pricing examination.¹³³ This will be based on the risk assessment and involves the establishment of a transfer pricing examination plan.

A transfer pricing audit usually takes longer than an ordinary tax audit because the scope of the factual matters to be investigated is much broader. The amount of time and effort needed for transfer pricing analysis is also typically much greater. In general, the time needed would be an aver-age of one to two years.

The Mexican tax administration issued rules for the application by taxpayers of transfer pricing adjustments (i.e. upwards and downward adjustments). The rules (i) define the notion and types of “transfer pricing adjustments”; (ii) set out the timing of application; (iii) indicate the infor-mation that has to be compiled by taxpayers regarding the adjustments;
(iv) explain the effects that may arise with regards to line items related to withholding; and (v) address consequences of the adjustments on indirect taxes (VAT).

Experience has shown that examinations rarely proceed in accord-ance with the timetables set forth in the examination plan. The main reason is that progress depends on whether the information requirements set forth in the examination plan are satisfied. Unfortunately, required information is not always obtained on time. It may be necessary to check the progress of the audit periodically to reconsider the audit timetable and the extent of infor-mation needed by the audit team.

The statute of limitations period for transfer pricing cases may be the same as, or different from, that for ordinary tax cases. The United States applies the same three-year statute of limitations period to both ordinary tax disputes and transfer pricing disputes. The United Kingdom (six years), Germany (four years) and France (four years) also have the same statute of limitations period for both. On the other hand, Japan applies a statute of limitations period of six years to transfer pricing cases while the statute of limitations period on ordi-nary corporate income tax liabilities is five years. Canada’s statute of limitations period is six years for transfer pricing cases and three years for ordinary tax cases.

Another aspect of the statute of limitations period is its perma-nence i.e. whether it is fixed or whether the taxpayer can waive the benefit accorded. For example, in the United States a taxpayer can waive the benefit of the statute of limitations but in other countries, including Japan, the stat-ute of limitations period is fixed.

Once a transfer pricing audit has started, it will require consider-able investment of time and effort by the examiners. It is best to require the approval and sign-off by a senior officer or the tax administration’s commit-tee on transfer pricing audits before the examination starts. This is impor-tant from the viewpoint of effective use of the tax administration’s human and other resources.

Normally, the tax authority will have certain transfer pricing infor-mation in its possession before a transfer pricing audit starts (see 14.3.3.2). A desk audit of such information, especially financial statements, should be made to evaluate whether there are any transfer pricing issues. For instance, comput-ing the following financial ratios based on tax and financial data may be useful:
►    Gross profit to net sales;
►    Operating profit to net sales;
►    Operating expenses to net sales;
►    Gross profit to operating expenses (Berry Ratio); and
►    Operating profit to average total assets.

It is also important that provisions for downward adjustments do not create opportunities for non-taxation. For example, taxpayer A in country A makes a request to decrease the price of goods sold to related party B in country B from 100 to 80 in accordance with the arm’s length principle, thereby lowering its income by 20. The newly determined arm’s length price implies that the income of B should be increased by 20. However, if this corresponding upward adjustment is not made, the 20 of income will be taxed in neither country. This risk of double non-taxation is highest in cases where a taxpayer has initiated a request outside of a MAP or APA process, and information on the position of the related party, or parties, in the other jurisdiction(s) is missing.

Comparing the taxpayer’s financial ratios to applicable standard industry ratios is useful if standard industry ratios can be found. Substantial deviations from standard industry ratios may indicate a transfer pricing problem. The findings from the desk audit should be analyzed to determine what further action, if any, is needed.

Understanding the taxpayer’s business operations is an essential part of the transfer pricing examination. This can commence before starting a transfer pricing audit, and should include an understanding of:
►    The taxpayer’s operations;
►    The operations of the taxpayer’s affiliates (domestic and foreign);
►    The relationships between the taxpayer and its affiliates (domes-tic and foreign);
►    Key value drivers in the business;
►    The role each entity plays in carrying out the activities and per-forming the business functions of the controlled group;
►    The scope, volume and nature of controlled functions; and
►    How much control and direction the taxpayer receives from the headquarters of the group.

14.2.2.2    The following may be useful sources for gaining an understanding of the taxpayer’s business operations:
►    Transfer pricing documentation;
►    Annual reports;
►    Securities reports;
►    Publications describing the taxpayer’s operations;
►    Reports published by securities companies;
►    Internal audit and management reports;
►    Organization charts and business flow charts (accessing these may require the taxpayer’s cooperation);
►    Minutes of board meetings, committee meetings and sharehold-ers’ meetings;
►    Material contracts between the MNE’s local affiliates and other entities within the MNE;
►    Policy and procedure manuals;
►    Internal approval documents;
►    Written intercompany pricing policies;
►    Customs declaration documents;
►    Sales catalogues, brochures, and pamphlets; and
►    E-mails and other written correspondence between the taxpayer and its affiliates.

The following questions are among those which may be asked in order to understand the taxpayer’s operations:
►    If the taxpayer is engaged in the distribution of products:
       - Are affiliates manufacturing the same or similar products to those distributed by the taxpayer?
      - Is technology transferred between affiliates and the taxpayer?
      - Are trademarks and other marketing intangibles being used to market the product?
      - Which members of the MNE developed the trademarks and other marketing intangibles?
      - Which members of the MNE devise and carry out advertising activities?
      - Which members of the MNE created the sales tools?
      - Which members of the MNE created and maintained the list of customers?
►    If the taxpayer is engaged in the manufacturing of products:
      - Are affiliates distributing or selling the same or similar prod-ucts to those the taxpayer manufactures?
      - Is the taxpayer using the same or similar manufacturing intangibles to those its affiliates are using?
      - What patents and/or know-how are involved in the manufac-turing process?
      - Is there a cost contribution arrangement?
      - Did affiliates or the taxpayer buy into a cost contribution arrangement?
      - What research and development is conducted?
      - What members of the MNE direct and perform research and development?
      - How are the results of research and development dissemi-nated among members of the MNE?

As intangibles may be an important aspect of the taxpayer’s busi-ness, gaining an understanding regarding a taxpayer’s intangibles may also be useful:
►    Manufacturing and marketing intangibles;
►    Domestic and foreign patents;
►    Licenses and assignments;
►    Patent, trademark or other intellectual property litigation involv-ing the taxpayer;
►    Domestic and foreign trademark development and regis-tration; and
►    Copyright creation and registrations.

Where the taxpayer has initiated downward adjustments, and a tax administration accepts in principle that a downward adjustment should be made, the taxpayer may be required to provide evidence that the amount has been included in income by a related party in the other jurisdic-tion. Alternatively, the competent authority of the country agreeing to the downward adjustment should spontaneously exchange information about the downward adjustment with the competent authority of the other jurisdic-tion, so that the latter competent authority can consider whether additional income should be recognized in its jurisdiction.

As intangibles may be an important aspect of the taxpayer’s busi-ness, gaining an understanding regarding a taxpayer’s intangibles may also be useful:
►    Manufacturing and marketing intangibles;
►    Domestic and foreign patents;
►    Licenses and assignments;
►    Patent, trademark or other intellectual property litigation involv-ing the taxpayer;
►    Domestic and foreign trademark development and regis-tration; and
►    Copyright creation and registrations.

The following items may be helpful in understanding the taxpay-er’s industry:
►    Identifying any relevant industry association;
►    Reviewing the industry association’s publications and website;
►    Reviewing industry guidelines used by the taxpayer;
►    Consulting with various industry experts;
►    Consulting various books and articles on the industry;
►    Identifying competitors in the same industry;
►    Comparing the competitors’ activities with those of the taxpayer; and
►    Comparing the competitors’ financial data with those of the taxpayer.

The approval of a senior officer, in accordance with the organiza-tional model of the transfer pricing administration, will usually be required before embarking on a full-scale transfer pricing audit of the taxpayer when the preliminary examination is completed.

The examiners need to establish the transfer pricing audit plan, which may be divided into two parts:
►    Part one identifies the audit team, the information they expect to obtain and the timetable for the examination. This part can be disclosed to the taxpayer under investigation; and
►    Part two identifies the tax administration’s resources to be devoted to the examination, the accounts and transfer pricing issues under examination, the anticipated procedures for the examination of each issue, the personnel responsible for the various steps and the management procedures to be followed by the audit team. The information in part two is generally not disclosed to the taxpayer.

A transfer pricing audit usually brings the examiners into contact with the taxpayer by phone for scheduling an initial appointment. If such contact cannot be made the examiners will send a letter notifying that they will audit the taxpayer. This is the time when the examiners send the initial information request to the taxpayer. If contemporaneous documentation is to be submitted, the request will signal the start of the period of submission.

Many countries have introduced APA procedures in their domestic laws though these may have different legal forms. For example, in certain countries an APA may be a legally binding engagement between taxpayers and tax authorities, while in other countries it may be a more informal arrangement between the tax authorities and the taxpayer. APAs are a useful dispute avoidance mechanism and are discussed in further detail in Chapter 15., including the considerations for proper operation of APA proce-dures, and the advantages and disadvantages of APAs. Consideration of APA programmes may be needed at different stages of the design of a legal frame-work for transfer pricing.

A transfer pricing audit is usually concerned with transfer pricing aspects only. However, an ordinary corporate income tax audit may develop into or include a transfer pricing audit if necessary. The number of taxable years to be covered by an audit is generally restricted by the statute of limita-tions. For example, if the statute of limitations is six years, the taxable years to be covered may be up to six prior years.

The examiners will usually suggest a meeting with the taxpayer, to discuss the audit schedule and certain ground rules. If the taxpayer has submitted certain requested documents the examiners may also discuss the contents of such documents.

The major activity in a transfer pricing audit is the gathering of information that the tax authorities consider necessary to decide whether to accept tax returns as filed or to propose transfer pricing adjustments. The tax authorities rely primarily on the taxpayer to provide that information.

Certain information needed for the transfer pricing audit may already be in the hands of the tax authorities:
►    Tax returns: tax returns of the taxpayer are the most basic information documents;
►    Financial statements: financial statements of the taxpayer under generally accepted accounting practice (GAAP) are often required to be submitted to the tax authorities together with the
tax returns and constitute important financial documents for the transfer pricing audit;
►    Documents attached to the tax returns: taxpayers may be required to attach schedules or other forms containing informa-tion on their transfer pricing practices to a tax return; and
►    Other information returns: information returns may be required for transfer pricing purposes.

Other necessary information may be requested by the audit team. The audit team’s authority for making the information request is based on the tax authorities’ general investigation authority or information powers provided for in a country’s taxation law. Certain countries have specific stat-utory provisions for requesting information regarding transfer pricing issues.

When implementing APAs, tax administrations have to bear in mind that the APA process is, in practice, a service to taxpayers. Consequently, appropriate capacity must be available in the tax administration to adequately respond to demand for APAs, including in terms of response time, volume of requests, complexity of cases, etc. In addition, within a legislative design context, taxpayers may be required to pay fees when filing an APA request to cover the actual costs of processing APA requests.

It should be noted that the taxpayer’s cooperation in providing the required information is essential in a transfer pricing audit; in this respect it differs from many ordinary tax audits. In the case of an ordinary tax audit, the taxpayer usually has no obligation to create a document for tax examin-ers. Further, it is often necessary in a transfer pricing audit for the taxpayer to
explain its business operations. Taxpayers are expected to cooperate with the audit team in providing the necessary data and explanations, and a cooperative atmosphere during transfer pricing audits is desirable and to be encouraged.

The principal means for the audit team to collect the neces-sary information is through written information request(s). The informa-tion request is usually backed up by civil or criminal penalties for failure to comply. Multiple information requests are likely to be issued by the audit team during a transfer pricing audit. The time given for responding is usually a few weeks, unless the taxpayer is expected to take a longer time to obtain and/or prepare the required information. Tax authorities can also utilize the exchange of information provision in an applicable tax treaty.

It should be noted that a common problem is the challenge in enforcing an information request which seeks a document or information not held by the taxpayer under investigation, but rather by a related but legally distinct party outside the country. In the case of Japan, for example, the Japanese taxpayer is required to make efforts to obtain the documents and accounting books held by its related party outside Japan. The Japanese tax authorities have the statutory authority to impose presumptive taxation if the requested data is not submitted by the taxpayer.

The United States has more forceful means of obtaining docu-ments located outside the country. Firstly, the Internal Revenue Service (IRS) may issue a Formal Document Request (FDR) to a taxpayer to request foreign-based documentation under Section 982 of the Internal Revenue Code (IRC) after normal request procedures have failed. If the taxpayer fails to substantially comply with the FDR within 90 days, it may be precluded from introducing any foreign-based documentation covered by the FDR as evidence at a trial where the documentation is relevant. Secondly, the IRS can request a taxpayer to obtain authority from a foreign related entity to act as an agent of that entity for the purposes of a summons under Section 6038A(e) of the IRC. Where the taxpayer fails to obtain the authorization, the IRS may determine the amount at issue based solely on the information avail-able to it. Thirdly, the Third-Party Summons procedure is available to the IRS under Section 7602 of the IRC. The IRS must provide “reasonable notice” to the taxpayer before contacting any other party regarding the taxpayer’s tax liability and must provide to the taxpayer a list of the persons contacted by the IRS periodically or upon the taxpayer’s request.

It may be useful to interview the personnel of the taxpayer engaged in marketing and sales and those in the accounting and financial depart-ments. It is often useful to visit the taxpayer’s premises (e.g. shops, factories, etc.). to understand the taxpayer’s business. During the audit, the audit team may want to arrange this visit with the taxpayer.

Some consider adequate levels of experience to be necessary before APAs become appropriate, while others see the experience gained in concluding APAs as an important part of capacity-building on transfer pricing issues. Matching operational capability to offer APAs with the general operational capability of the transfer pricing regime is thus an important factor in the design of the domestic legal framework.

Necessary information can also be collected from other sources such as the taxpayer’s website, the taxpayer’s submission of periodic financial data to the securities regulatory agency (if relevant), business journals, other tax filings (related and unrelated to the taxpayer), etc. If the information is publicly available, the audit team can freely use the contents of such infor-mation but if it is confidential the audit team must exercise care in disclos-ing such information.

As noted above, the principal information source is the taxpayer. The taxpayer’s books, records and other written documents, and its directors and employees are the principal sources of information.

A former employee or director of the taxpayer may also be a source, if necessary. In this event the former employee or director may be bound by a contract with the taxpayer not to disclose any secret information. This often raises a difficult legal question as to whether the former employee is obliged to disclose the requested information to the tax authorities. This question must be resolved in light of the domestic law of the country concerned.

A third party is also a possible source of information. For example, Japanese tax law authorizes the Japanese tax authorities to request information from a corporation engaging in a business activity which is of the same type or examine the accounting books and documents of that person or corporation.¹³⁴ Tax returns of a third party in the same business will also be useful sources of information. When a third party’s information is used, the tax authorities are confronted with a statutory obligation of confidentiality when dealing with the taxpayer. This is often discussed in the context of secret comparables.

The documents a taxpayer possesses with respect to its transactions with a foreign related party are often written in a foreign language that tax auditors may not understand. Tax law in most countries is generally silent as to which side should translate the foreign language documents necessary for a transfer pricing audit. If the documents are voluminous the cost of transla-tion may be substantial.

Some countries choose not to have APAs, at least for some time after their transfer pricing regime is put in place. For example, they may feel that they need to develop capacity and skills before they can properly evaluate what is an appropriate APA system for them.¹⁰² Other countries are concerned that APAs are not useful in a transfer pricing regime because they tend to be sought by companies that are in broad conformity with the arm’s length principle and may divert scarce resources from achieving compliance in the worst cases of avoidance. As with any such mechanism, checks and balances must be provided to ensure that the APA process is applied consistently between taxpayers and is not subject to abuse or integ-rity issues. The issues involved in balancing resource issues and priorities with the potential benefits of APAs are discussed in more detail at 15.3.4.

When the relevant documents are written in a foreign language, the examiners frequently request the taxpayer to translate the foreign language into the domestic language at its own cost, and the taxpayer is often cooper-ative as a matter of practice. However, the legal basis for the practice is not always clear. See 12.4.5.

If a document necessary for a transfer pricing audit is written in a foreign language and cannot be understood by the examiners, it will gener-ally be the party with the burden of proof that will suffer a disadvantage.

The English language may have a unique position as a foreign language in this context. In most non-English speaking countries tax exam-iners in charge of transfer pricing taxation are trained to understand English and may be able to read documents in English.

General information required for a transfer pricing audit includes:
►    A corporate profile;
►    The organization of the taxpayer and the related parties;
►    The transactions or business flows;
►    A list of manufacturing and/or sales facilities;
►    A list of directors and employees; and
►    A diagram of group affiliates indicating capital relationships.

Much of this information can now be found in the taxpayer’s trans-fer pricing documentation, assuming it has been prepared in compliance with the recommended standard described in Chapter 12.

It may sometimes be more advantageous for tax purposes to finance a company by way of debt than equity, as the interest paid on debt may be deducted for tax purposes while dividends on equity may not be tax deductible. In many countries, thin capitalization or other interest limitation provisions have been introduced to deny a deduction for excessive interest payments. This is done by prescribing a maximum debt-to-equity or (net) interest to EBITDA ratio and disallowing a proportion of interest payments if the ratio is exceeded (see section 9.5). These rules protect the tax base by discouraging cross-border shifting of profits through excessive interest payments on debt. From a policy perspective, failure to tackle base eroding interest payments gives MNEs an advantage over purely domestic businesses which are unable to gain such tax advantages.

The taxpayer’s financial statements provide basic financial infor-mation. However, the transfer pricing audit is often focused on the sales or purchases of particular products, the provision of particular services or the licensing of particular intangibles. It then becomes necessary to segment reve-nues, expenses, gross profit and/or operating profit. A segmentation of the profit and loss statement is thus often conducted, focusing on transactions under review by the tax auditors. The preparation of segmented profit and loss state-ments will require additional work by the taxpayer, who knows the details of the profit and loss statements. The accurate review and assessment of the financial results will often be impossible without segmented profit and loss statements.

Third-party information required is basically comparable data. The sources of the third-party information may vary depending on the possibility of finding appropriate comparables. See further Chapter 3 on Comparability Analysis.

In order to correctly ascertain whether any issue exists in relation to the transactions in the examination process, each case should be exam-ined carefully, bearing in mind the circumstances of each transaction. In conducting a transfer pricing audit, the following points should be taken into consideration along with the functions performed, risks assumed, and assets used or contributed used by the taxpayer and by the persons compared:
►    Whether the gross and operating profit margins arising from related transactions of the taxpayer are significantly different compared with those of other transactions conducted by the tax-payer with unrelated persons in a similar market and which are similar in quantity, market level and other respects;
►    Whether the gross and operating profit margins arising from related transactions of the taxpayer are significantly different compared with those of other unrelated persons engaged in the same category of business that are similar in quantity, market level and other respects; and
►    Whether the taxpayer’s gross and operating profit margins arising from related transactions are significantly different com-pared with those of the related persons arising from the same transactions.

Prior to the calculation of arm’s length prices, examinations should be conducted from different viewpoints in order to determine whether there are any issues regarding transfer pricing and to ensure that the examinations are conducted effectively. The following methods could be used:
►    Verification of whether or not the gross and operating profit mar-gins of related transactions under the examination are within the range of the profit margins of uncontrolled transactions
in the same business category and substantially similar to the related transactions in terms of quantity, market level and other respects; or
►    Use of the average value of the consideration or profit margins for related transactions or transactions deemed comparable with the related transactions during a reasonable length of time before and after a taxable year under examination. This may be done if it is considered inappropriate to examine the price of inventory products and other aspects of the related transactions based only on the information for each relevant taxable year, due to considerable fluctuations in prices reflecting changes in public demand, product lifecycle or other such factors.

Once the transfer pricing audit starts, various aspects of arm’s length pricing will be involved and will consume a considerable amount of time. After the above examinations, it may be useful to pause to reflect upon the audit in general. This will occur before starting the calculation of an arm’s length value, which will consume the biggest part of the transfer pricing audit resources. The auditor should review whether it is likely that continuing the transfer pricing audit would produce a fruitful result from the viewpoint of efficiency.

Some countries that do not have detailed transfer pricing rules in place may deal with abusive forms of transfer pricing through the use of a general anti-avoidance rule (GAAR). Abusive non-arm’s length transactions may come within the scope of the GAAR. This may be useful in the early stages of introducing a transfer pricing regime; however, use of the GAAR in transfer pricing issues may create uncertainty for business and detailed transfer pricing legislation, regulations or guidance may thus be preferable.

Contemporaneous documentation is explained in detail in Chapter 12. The contemporaneous documentation the taxpayer has prepared will be important for the examiners and should be among the first items they request.

The taxpayer is usually required to provide the examiners with the contemporaneous documentation within a specified number of days after a request from the tax authorities. Such documentation should demonstrate that the transfer pricing method and its application provide the most reliable measure of an arm’s length price. This represents the first opportunity for the taxpayer to persuade the examiners that the transfer pricing is appropriate.

The following is a sample list of information documents required from a corporation engaged in the distribution of products on the assump-tion that the taxable period under audit is five years. The requested informa-tion should be the most up to date unless otherwise required.
►    Corporate profile information (including the corporate group’s history);
►    Organizational chart (setting out the number of employees);
►    Transactional structure: a business flow chart (invoicing and set-tlement, and actual delivery flow);
►    List of distribution channels and retail outlets if applicable: location, size, opening hours, sales revenue, staffing, prices, contractual terms with customers (consignment/cash sales etc.) including data on the latest three years for sales, revenue and staffing;
►    List of directors;
►    Equity structure of group companies;
►    Basic business agreements, distribution agreements and other agreements with related parties;
►    Corporate profile of the related parties;
►    Documents related to determination of arm’s length price;
►    Transfer pricing method and list of margins by categories of product for five years;
►    Latest financial data regarding the sales, cost of goods sold, oper-ating expenses, operating profits and profit before tax for the past five years;
►    Group global consolidated profit and loss statement and ratio of taxpayer’s sales to group global sales for the past five years;
►    Segmented profit and loss statements from the related transac-tions of the related party (if the taxpayer is the purchaser) or the taxpayer (if the taxpayer is the seller) for the past five years;
►    List of gross and operating profits by category, by product and by distribution channel with detail of losses on disposal of assets and losses from obsolescence for the past five years; and
►    Top ten products in sales by category (name of product, purchase price and retail prices, personnel expenses, advertising expenses and sales promotion expenses) for the past five years.

As the transfer pricing examination progresses many more ques-tions will arise in the minds of the examiners and, accordingly, supplemental information requests will likely need to be issued by the examination team. This part of the examination process tends to be lengthy.

It is common in a transfer pricing audit for the examination team to request interviews with key company personnel involved in transactions with related parties. The interviews assist the examination team’s func-tional analysis for purposes of determining the functions performed by the taxpayer and related parties and evaluating potential comparable transac-tions. Transfer pricing economists and the international examiners on the examination team will almost always participate in the interviews, and a lawyer may also be involved. The aspects noted below are pertinent to the taxpayer’s responses to the requests for interviews.

This section provides information to developing countries about resources available to follow the latest developments in international tax rules and initiatives. It also provides guidance on the mechanisms avail-able for developing countries to obtain training, information updates and to engage in international tax dialogue upon implementing transfer pricing rules. Such resources will assist countries to keep abreast of developments, exchange peer experiences and keep their transfer pricing regimes updated.

The examination team will choose the personnel to interview after reviewing organization charts. The personnel to be interviewed are decided by the examination team based on mutual discussion of the functions of the personnel in the organization charts.

The interviewees should be made familiar with the process and should understand the procedures, purpose and importance of the interview.

Interviews are usually conducted in a cooperative manner. The taxpayer may work with the examination team to agree on the rules of the interview in an advance agreement, to avoid confusion. For example, the taxpayer may wish to arrange for the examination team to meet with a group of employees, rather than meet each person separately. In this way the employees have an opportunity to consider the responses of other individ-uals. On the other hand, the examination team may want to interview each person separately.

If the person to be interviewed is not a native speaker of the language of the interview it is advisable to use an interpreter even if he/she can speak the language fairly well. The use of an interpreter will avoid the possibility of misunderstanding questions and allow the interviewee time to formulate reasoned responses.

If an interview is recorded, both parties should keep a copy of the record. It may be useful to have a transcription of the interview record rather than merely an audio recording, considering the possibility and ease of future use. If no recording of an interview is taken, the examination team may produce a summary of the interview and provide this to the interviewee. A careful review of the written summary is needed in such event.

One of the suggested approaches to keep up to date with devel-opments in international transfer pricing rules is to engage with regional intergovernmental agencies such as Cercle de Reflexion et d’Echange des Dirigeants des Administrations Fiscales (CREDAF), Intra-European Organisation of Tax Administrations (IOTA), Inter-American Center of Tax Administrations (CIAT), the African Tax Administration Forum (ATAF), Study Group on Asian Tax Administration and Research (SGATAR), the Pacific Islands Tax Administrators Association (PITAA), and the Commonwealth Association of Tax Administrators (CATA).

The extent of cooperation for the tax examiners’ visit to a taxpay-er’s facilities will vary from case to case. Representatives of the examination team could be accompanied on the visit by an employee of the taxpayer who can describe the activities at particular locations and respond to questions. This guide should consider the exercise as being similar to an interview or an opportunity to present factual portions of the taxpayer’s case as this explana-tion may affect the taxpayer’s position in describing objects or operations on the tour. Ensuring integrity of such contacts with taxpayers is as important here as in other cases of dealing with taxpayers.

There is an issue concerning secret comparables which often surfaces in connection with transfer pricing audits. Confidential infor-mation from other taxpayers may be reviewed for general information or suggestions for further investigation. However, using such information to establish comparables will be a problem. Secret comparables are discussed in detail at 3.6.7.

The attorney-client privilege and the work product doctrine are well developed in the United States and other countries, although such priv-ilege and doctrine may not exist or be so developed in other countries. The attorney-client privilege protects the confidentiality of communications between the client and the attorney or the attorney’s agents. Where legal advice is sought from a lawyer, the communications relating to that purpose made in confidence by the client are protected from disclosure by the client or by the lawyer unless the protection is waived by the client.

The attorney work product doctrine protects materials prepared for trial or in anticipation of litigation by an attorney or the agent of the attor-ney. When litigation is reasonably anticipated in relation to the transfer pric-ing examination, the due consideration of the attorney-client privilege and the work product doctrine would be important, where they are applicable.

In the process of examination, it may be useful to prepare a comparison table of the tested party and potential comparable(s). A simple example of a comparison is shown in Table 14.T.1 below.

Table 14.T.1 Comparison Chart
 

These are non-profit international public organizations that may be able to provide specialized technical assistance for the modernization and strengthening of tax administrations in different regions of the world, through conferences, targeted field missions, exchange of information, and sometimes even targeted training. As their names indicate, they tend to cater for a specific geographic region, or a particular group of countries. Some countries are members of more than one regional organization:¹⁰³
►    CIAT’s predominant membership is from the Americas;¹⁰⁴
►    ATAF’s membership is primarily of African countries;
►    SGATAR’s membership is located in the Asia-Pacific region;
►    PITAA’s membership is drawn from the Pacific Islands; and
►    CATA’s membership draws from a number of Commonwealth countries spread over all geographic regions of the world.

During the examination process the examination team needs to review information it has obtained concerning the taxpayer’s business in the light of responses to information requests and other information gathering activities. This will lead to a refined understanding of the taxpayer’s business and such information will affect the choice of potentially comparable trans-actions or companies and of the most appropriate transfer pricing method.

Similar efforts will be needed in refining the understanding of the taxpayer’s industry. The examination team would typically review additional information, including, for example, product line financial statements for multiple years to detect unusual fluctuations or deviations from industry norms that may not result from business or product life cycles.

The examination team will need to accurately delineate the tested transactions, including understanding the relevant functions, assets and risks before attempting to find appropriate comparables or evaluating the taxpayer’s choice of transfer pricing method. The examiners will need to identify the economically relevant characteristics of the transaction, focus-ing on those that are most important in creating value. The examiners use information obtained in information requests and interviews to trace and understand the flow of transactions.

The examiners will need to determine the effect of any unique and valuable intangibles on the transactions. As higher risk justifies a higher expected return, the examination team will need to consider the economi-cally significant risks in relation to the tested transaction(s). Such risks might include market risks (arising from fluctuations in cost, demand, pricing, etc.), foreign exchange risks, credit and collection risks, product liability risks and general business risks.

Once the relevant transactions have been accurately delineated, the examiners will seek to identify comparable uncontrolled transactions (or more often, uncontrolled companies engaged in such transactions). The taxpayer will typically seek to participate in this step to ensure that only appropriate comparables are used. See further Chapters 3 and 4.

After accurately delineating the transaction, the most appropriate transfer pricing method should be selected. See further Chapter 4.

Toward the end of the examination procedure, the examination team often produces a written report or interim opinion; unless the exam-iners judge that no adjustment should be made. It is often helpful to resolve factual issues important to the analysis or agree to disagree on certain issues while the information is fresh rather than delaying the resolution until the end of the examination process. This will help to narrow the scope of any points of disagreement as much as possible.

The taxpayer may challenge the report or opinion, suggest modifi-cations, or accept the report as accurate.

When the examination team considers that it sufficiently under-stands the transfer pricing issues and has concluded discussions with the taxpayer, it may set out the proposed adjustments, if any. In some countries, the proposed adjustments may be combined with the examiners’ interim report described above.

This will, in some jurisdictions, be the last chance for the taxpayer to determine whether or not to reach a settlement with the examination team.

Unless the taxpayer and the examination team can reach agree-ment, the formal notification of the proposed adjustment will be issued.

In some countries, the issuance of a formal notification of proposed adjustment is required and the taxpayer is given the opportunity to accept the notification within a stipulated time (for instance, 30 days) and/or notify of any set-offs.

The final step in the audit process is the issuance of an adjust-ment notice (i.e. a notice of deficiency). In some countries this final notice of correction may be issued without going through the formal notice of proposed adjustment, while in others the process may include such notice. The issuance of the adjustment notice may also trigger a requirement for the taxpayer to pay the additional tax owing within a certain period.

Appeal and dispute resolution mechanisms will typically apply thereafter; see further Chapter 15. Suspension or postponement of the collec-tion of the additional tax liability may also apply, depending on the domestic rules of the country concerned.

There should be the opportunity for settlement with the examination team throughout the process of the transfer pricing examination. Appropriate planning and documentation combined with active involvement in the examination process may facilitate a settlement with the examination team.

Settlement processes may be explicitly provided for in the trans-fer pricing rules, or applied through a broader system of tax dispute settle-mentThe Mutual Agreement Procedure and other aspects of dispute settlement are addressed in Chapter 15 of this Manual.

The case closure needs to be properly documented, as every decision taken can potentially be subject to litigation. The table below provides a clear documentation process to ensure the information needed is recorded and to guarantee that the required process has been followed. The audit report is also captured in the table with all the required details.

Table 14.T.2
Audit Closure Template
 

 take a screeonshot start from 507 - 509

Certain aspects of transfer pricing audits (and tax audits in general) are relevant in the context of dispute resolution. Understanding how tax audit practices, audit settlements and joint audits may be useful in avoiding and resolving tax disputes is crucial for tax administrations and taxpayers. These issues are discussed at Chapter 15.

Dispute avoidance and resolution procedures are essential to the effective and efficient functioning of all tax administrations. Such proce-dures, if well designed and implemented, can enable fair and efficient reso-lution of differences between tax administrations and taxpayers regarding interpretation and application of transfer pricing rules.

The goal of dispute avoidance and resolution procedures is to facili-tate the efficient and equitable determination and collection of tax revenues that are properly due. Ideally, this determination and collection should be done in ways that minimize controversy, cost, uncertainty and delay for both tax administrations and taxpayers. The most efficient method of addressing disputes is to prevent them from arising. Tax administrations should there-fore first focus on avoiding disputes; they should also ensure that appropri-ate dispute resolution procedures are available should they become necessary.

In the cross-border context, dispute avoidance and resolution proce-dures are particularly important to avoid double taxation of the same income for a taxpayer or for associated enterprises. These procedures can also help avoid the imposition of tax not in accordance with the provisions of the applicable tax treaty, if any. When a tax treaty applies, both tax administrations involved in a tax dispute should give effect to the provisions of that treaty. They should also provide rules and procedures for departing from the domestic law result where necessary to resolve disputes in accordance with relevant tax treaty provisions.

The number of Mutual Agreement Procedure (MAP) disputes world-wide has been rising rapidly according to the MAP data published by the OECD available at the OECD website.¹²⁹

15.2.2    However, tax administrations often face resource limitations regarding the handling of (cross-border) tax disputes and such limitations may be even greater for the tax administrations of many developing countries. Such limitations may affect staffing levels, training budgets, access to commercial databases needed for transfer pricing analyses and other research materials, access to outside experts, travel funding and other factors. It should be recognized that such resource limitations may put tax administrations at a real (or perceived) disadvantage when dealing with betterresourced administrations. It is thus particularly important for developing countries to ensure that dispute avoidance and resolution procedures are designed to operate as efficiently as possible. Efficient dispute avoidance and resolution procedures should benefit taxpayers as well. Access to properly functioning dispute avoidance and resolution procedures is particularly important for multinational enterprises as they are called on to comply with tax laws and reporting requirements of multiple countries and may need to address any audits or disputes that may arise in any of the countries where they do business.

There are various administrative procedures that could be applied to minimize transfer pricing disputes and to help resolve such disputes when they arise between taxpayers and their administrations, and between different tax administrations. Where two or more tax administrations take different positions in determining arm’s length conditions, double taxation may occur. This means that the same income is included in the taxable base by more than one tax administration. Double taxation is undesirable and should be eliminated wherever possible as it constitutes a potential barrier to international trade and investment flows.

This chapter discusses several approaches to resolving disputes arising from transfer pricing adjustments and for avoiding double taxation. The respective procedures all call upon domestic tax administration resources. If resource mobilization is a key concern or limiting factor for a country’s tax administration, it should consider the approaches that can be realistically made available, are appropriate, and the provision of the investments in facilities that may be required to expand the available dispute resolution procedures.

As in other areas of law, clear guidance in advance regarding any legal transfer pricing requirements that apply can serve to reduce tax disputes. This is equally important both for tax administrations, which need such guidance to apply the law properly and equitably, and for taxpayers, which must comply with the law. Clear guidance can help avoid unexpected results and therefore help minimize controversy.

Guidance can serve these purposes only if it is clear and detailed enough to be properly understood by both tax administrations and taxpayers. Countries that have adopted transfer pricing legislation have to strike various balances between the provision of general principles and detailed rules in that legislation and accompanying guidance. Where general principles are preferred it is often advisable, for the sake of clarity, to supplement them with examples illustrating their application.

As described in Chapter 10, developing countries seeking to adopt transfer pricing legislation or revise existing legislation generally base such legislation on the arm’s length principle, which is adopted in both the UN and OECD Model Conventions and in most national legislation throughout the world. As long as this remains the case, departures from the arm’s length principle will create an increased risk of double or unexpected taxation, with no realistic prospect of crossborder relief. This could make the costs of doing business in the country concerned prohibitive and discourage crossborder trade and investment, with negative effects on sustainable development. While it is for each country to determine its own tax system, the desire to avoid double taxation has been an important factor in the broad acceptance of the arm’s length principle internationally.

Developing countries whose tax systems are at an early stage of development or who face severe resource constraints may choose, for practical reasons, to adopt an approach to transfer pricing that is simplified in comparison to that adopted by more developed countries and recommended by the OECD Transfer Pricing Guidelines. Where a simplified approach is adopted care should be taken, for the reasons noted above, to avoid results that depart from the arm’s length principle. Where a country decides to adopt a simplified approach, it may be advisable to reevaluate that decision periodically. A simplified approach may not continue to meet the needs of the tax administration as it addresses more complex transactions, or the approach may no longer be needed for practical reasons.

The setting of legislative priorities is obviously a matter for each country to decide for itself, in view of its particular circumstances and policies. Transfer pricing legislation may, for example, not be seen as a first priority by developing countries whose tax systems are still in a relatively early phase of legal development, especially if crossborder trade and investment are not yet significant in volume.

However, where a country that has not adopted specific transfer pricing legislation decides that it is appropriate to challenge a company’s intercompany pricing it may find that it lacks a clear legal basis for such a challenge. While some countries may have general legal provisions or principles, such as general antiavoidance rules or substanceoverform doctrines, they may find it difficult to successfully challenge intercompany pricing on this basis as transfer pricing is a specific fact oriented tax issue.

Such an approach may also raise issues of fairness to the taxpayer, if the application of general principles to intercompany pricing is not sufficiently clear and predictable. In such a case, this lack of certainty may create significant controversy.

Due to the abovementioned considerations it is normally advisable for developing countries to adopt transfer pricing guidance as soon as they are in a position to do so and to examine transfer pricing practices to the extent possible.

Tax Audit Practices
Tax audit practices and policies play a key role in any effort by a tax administration to avoid or minimize disputes with taxpayers. To the extent that a tax administration’s audit practices and policies are seen as fair and are implemented equitably it becomes less likely that taxpayers will see a need to pursue dispute resolution options.

Conversely, where a tax administration has systematic integrity or confidentiality issues or applies the law in a manner that is not seen as fair and equitable, or is regarded as unpredictable, taxpayers are more likely to see a need to seek resolution of the dispute elsewhere. All tax administrations seeking to avoid or minimize disputes with taxpayers should therefore devote significant attention to the operation of their tax audit practices and policies. Issues relating to tax audits are discussed in more detail in Chapter 14.

Advance Tax Rulings
Some countries have a practice of issuing advance rulings regarding the application of a country’s laws to a taxpayer’s particular facts (sometimes structured as unilateral Advance Pricing Agreements (APAs) in some countries— discussed in more detail below in the section on crossborder dispute avoidance procedures); see further 15.3.4. These advance determinations can often be very helpful in avoiding disputes between that taxpayer and the tax administration.

When considering new issues tax administrations may initially prefer to provide guidance by a system of casespecific rulings so that they have an opportunity to consider the issues more fully before committing themselves to a general approach. On the other hand, where the issue is one of general application it may be more efficient for the tax administration to issue general guidance.

A heavy reliance on ad hoc rulings may also give rise to integrity concerns and associated equity issues unless there is a robust ruling review process in place. Where guidance is routinely provided by way of rulings it may prove difficult to strike an appropriate balance between legitimate taxpayer confidentiality concerns and the level of transparency that may be desired to issue an effective ruling.

While it is generally best practice to maximize transparency, it would normally be inappropriate for the tax administration to publish casespecific rulings in their entirety as this would risk divulging sensitive taxpayer information to competitors. Many countries have a policy of publishing rulings after removing sensitive taxpayer information; this approach may however effectively disclose the identity of the taxpayer if these taxpayers operate in smaller markets, with negative consequences for the taxpayer’s competitive position. It may therefore make sense for tax administrations to use casespecific rulings primarily to provide guidance on issues that are unique, novel or particularly difficult, or as an interim measure, while adequate published guidance is being developed.

An alternative means of promoting transparency and consistent treatment of taxpayers, reportedly used by Nigeria, for example, is to publish generally applicable guidance on issues of broad application after analyzing them in a cooperative relationship process with a particular taxpayer. Another possibility would be consultation processes with the business or industry sectors involved.

Some countries publish redacted copies of advance rulings in order to give guidance on current interpretations of the law as well as to provide transparency. In the case of unilateral advance rulings (including unilateral APAs) it should be noted that Inclusive Framework members are required to notify the affected state(s).

Cooperative Compliance Relationships
In addition, tax administrations may wish to consider whether they should move towards a more cooperative relationship (sometimes referred to as an “enhanced relationship”) with some taxpayers and their advisors in order to get a better understanding of their business and transfer pricing practice. The Netherlands and the United Kingdom are widely seen as having already successfully implemented cooperative relationship programmes and other countries (such as Nigeria) are currently testing this approach.

A cooperative relationship can benefit tax administrations and taxpayers by offering greater certainty and transparency, an earlier and more efficient discussion on and resolution of any tax issues and lower administrative and compliance costs. It can also be used to resolve tax disputes or uncertainties for prior years more efficiently.

From a tax administration perspective, interest in a cooperative relationship follows from the understanding that:
►    Effective risk management requires current, relevant and reliable information regarding the taxpayer’s facts and potential tax issues, for which the taxpayer is the best source;
►    A cooperative relationship makes the collection of any taxes owed more efficient, saving audit and litigation resources; and
►    Tax payments will be received more quickly if disputes are avoided or resolved early in the process.

From the taxpayer’s perspective, a cooperative relationship may be worthwhile because it can:
►    Provide greater certainty and predictability regarding the taxation of the taxpayer, which is essential especially where significant investments are being considered;
►    Expedite the resolution of tax issues; and
►    Save costs by streamlining compliance and dispute resolution processes.

A cooperative relationship initiative tends to be administration resource intensive, however, and must be carefully implemented to ensure the consistent application of legal provisions, to protect taxpayer rights and to avoid integrity issues. While the manner in which tax administrators, taxpayers and tax advisors deal with each other is modified, applicable tax provisions should continue to be applied impartially. It is also important to implement cooperative relationship initiatives efficiently so that adequate audit resources can be devoted to less compliant taxpayers.

Development of a successful cooperative relationship requires that all parties engage on the basis of the following parameters:
►    A genuine commitment to developing a relationship of mutual trust;
►    A transparent and open approach;
►    An understanding of commercial and industry aspects;
►    An implementation process agreed at the start, including the designation of responsible persons at relevant levels of both the tax administration and the taxpayer; and
►    Clear agreement in advance on the period to be covered.

Tax administrations may find it useful to adopt an industrybased focus where feasible, so that the experience gained can be leveraged and used to provide consistent and transparent treatment to similarly situated taxpayers (taking relevant differences into account).

Many tax administrations, both in developing and developed countries, rely heavily on casebycase audit settlements to resolve disputes with taxpayers. To the extent audit settlements are based on clarifications and better understandings of relevant facts, this may be an effective use of limited resources.

A disadvantage of audit settlements is that such settlements are often not very transparent, they are not necessarily coordinated to provide similar treatment to similarly situated taxpayers, and they are therefore not always perceived as being fair by stakeholders. Audit settlements may also raise more integrity concerns than some other dispute settlement procedures.

Multinational businesses have often relied on Advance Pricing Agreements (APAs) (or “Advance Pricing Arrangements”, as some countries prefer) with tax authorities, especially in the framework of the Mutual Agreement Procedure. APAs are so named because pricing methodologies are agreed in advance in relation to certain types of transactions, often called the “covered transactions”. APAs provide greater certainty for the taxpayer on the taxation of certain crossborder transactions and are considered by the taxpayers as the safest way to avoid double taxation, especially where they are bilateral or multilateral. The possible advantages and disadvantages of APAs for developing country administrations and taxpayers, including some implementation issues, are addressed below.

APAs were initially created by the National Tax Agency of Japan in 1987. Agreements reached with taxpayers under the preconfirmation system were unilateral in nature. In 1991, the IRS of the United States introduced APAs. The APA introduced by the IRS could be bilateral in nature, utilizing the MAP provided in the applicable tax treaties to reach bilateral or multilateral agreements.

APAs have been introduced in many countries. When APAs are bilateral or multilateral, they confirm the arm’s length result in advance by agreement between taxpayers and tax authorities in the relevant countries. They define agreed outcomes on certain sets of criteria (transfer pricing methods, comparables and appropriate comparability adjustments, critical assumptions as to future events, etc.). APAs are adopted not only by OECD member countries, but also by nonOECD countries. The OECD Transfer Pricing Guidelines strongly endorse bilateral and multilateral APAs as a supplement to the traditional administrative, judicial and treaty mechanisms for resolving transfer pricing issues.¹³⁰

Some countries also issue unilateral APAs. These unilateral APAs only involve the tax administration in one country and are therefore categorized as only partial solutions for double taxation. Unilateral APAs can be considered useful in specific cases depending on all the facts and circumstances, but they usually do not provide a full solution to the problem of double taxation.

Tax administrations generally find APAs to be a more amicable process than the audit process followed by MAP. To the extent that there is advance agreement on key transfer pricing issues neither country faces the prospect of refunding taxes already collected. Furthermore, as the taxpayer provides extensive information in advance, the APA process is usually efficient in determining relevant facts. Perhaps for this reason many tax administrations have a general practice of suspending examination activity during APA discussions. Tax administrations may wish to clarify in their APA procedures that all information pertaining to the APA request should be shared simultaneously with both countries.

Tax administrations have also found APAs to be useful tools for developing a deeper understanding of business operations, which can be used to inform their general guidance and examination processes. Most tax administrations have found that APAs are more widely embraced if APA and examination functions are kept separate. Alternatively, they may impose limitations on the use of some or all of the information provided by the taxpayer in the APA discussions for other purposes such as subsequent examinations or future litigation if an APA cannot be successfully concluded.

Tax administrations with severe resource limitations may wish to weigh the advantages of APAs against other resource needs. It may be difficult for a tax administration that is still developing its general audit capabilities to feel comfortable diverting substantial resources to an APA programme at that stage. Such countries may also be concerned that they will be at a disadvantage in negotiating APAs with MNEs or more experienced countries until they develop more experience, including experience with MAP cases. On the other hand, APAs can be useful on an interim basis as an efficient means of collecting tax in the short term, particularly in countries with a small number of large foreign investors. An APA can conserve resources but cannot replace the need for trained audit staff, so it can be beneficial for training to proceed in parallel while outside technical assistance and APA expertise is available.

Countries with limited experience in applying a transfer pricing regime may initially prefer to limit the terms of their APAs; they can then evaluate the experience more quickly and adjust their practices as needed. A term of perhaps three years could be applied, rather than the five years more commonly used by experienced countries. Alternatively, they may wish to negotiate a few APAs in a pilot programme before committing themselves to a generally available, permanent programme.

It is important to establish an appropriate operational framework for an APA programme, to promote a consistent, principled approach and to ensure adequate review. Ideally, APA programmes should be established with a special unit comprised of trained staff designated only for that function. This would maximize the benefits of experience and promote an attitude of cooperation and transparency. If, due to resource limitations, APA programmes need to draw on expertise from other parts of the tax administration, it is important to establish safeguards to ensure that the APA process is not managed in the same way as a typical audit. Failing to do so may result in the loss of many of the benefits typically enjoyed by tax administrations in APA proceedings.

At the same time, it is important to ensure that the APA programme operates in an appropriate manner within the framework of the tax administration as a whole. Procedures should be set up, for example, to prevent the APA programme from being used primarily to challenge the position of an audit team for past years. This may be achieved by requiring that the APA applies primarily to future years rather than past years. Organizationally, most tax administrations have tended to manage their APA programmes together with their MAP programmes and to organize them so that all cases with a particular treaty partner are handled by the same team. This facilitates the formation of closer working relationships between the teams from the two countries and promotes a better understanding of the other country’s economy, legal provisions and administrative procedures. On the other hand, benefits may also be derived by comparing experiences on different cases within an industrial sector or by comparing the approaches of various treaty partners to similar issues. It is also important to establish procedures to facilitate the sharing of such knowledge, to strengthen technical analysis and to provide consistent treatment.

Most tax administrations have found that an APA term of approximately five future years strikes the best balance between efficient use of resources and the uncertainties associated with prospective agreements. The risks associated with uncertainties can be minimized by specifying critical assumptions, based on which the APA will be renegotiated if necessary. It is fair to expect a renegotiation of the APA if the applicable law or the covered transactions change materially, but care should be taken not to impose excessively strict requirements on the continued application of an APA.

A tax administration’s resources are normally best used to conclude APAs on complex issues. However, in the interest of fairness to smaller taxpayers who also need certainty, tax administrations may wish to consider establishing special simplified APA procedures for SMEs. A 2011 OECD survey of OECD member and observer countries found that a number of countries have adopted simplified measures for SMEs (see 11.4.3.3), small transactions and/or low valueadded services and that Canada, France, Germany, the Netherlands and the United States have simplified APA procedures for SMEs. These programmes generally require SME taxpayers to provide less information and may also lower the application fee, if there is one.¹³¹

Some administrations charge taxpayers user fees for the conclusion of an APA, as a means of funding the programme. If reasonable in amount, these fees have generally been accepted by taxpayers as outweighed by the advantage of the certainty provided by the APA. To avoid integrity issues, it is important that the fees be charged on a consistent basis (ideally reduced for small taxpayers), that they are paid into government funds and that they are refunded in the rare circumstances where an APA cannot be concluded. The Guide to the Mutual Agreement Procedure under Tax Treaties provides more guidance on best practices in the structuring and operation of APA programmes, and was approved by the Committee in October 2012.¹³² Tax administrations may also want to refer to the Manual on Effective Mutual Agreement Procedures,¹³³ the Guidelines for Conducting Advance Pricing Arrangements under the Mutual Agreement Procedure (MAP APAs) in Annex II to Chapter IV of the OECD Transfer Pricing Guidelines,¹³⁴ and to the work of the EU Joint Transfer Pricing Forum on dispute resolution and APAs.¹³⁵ Finally, some national tax administrations, including those of Canada, India,¹³⁶ Japan, the United Kingdom¹³⁷ and the United States¹³⁸ have published detailed internal APA procedures. These may also provide useful comparative information.

Developing countries may also want to consider participating in joint audits. These are conducted by two or more tax administrations together to share information, save resources and minimize or expedite the resolution of controversies.

Joint audits are still relatively new procedures, but they may prove useful for developing country tax administrations with fewer resources and less experience or subjectmatter expertise in the industry or issues concerned. On the other hand, issues such as different languages, authority to access foreign taxpayer information and differing accounting years and audit cycles may need to be addressed.

A welldesigned administrative appeals procedure can help ensure that the tax administration resolves its disputes with taxpayers in an efficient and fair manner. This will provide an added level of assurance to investors. To operate well and to be perceived as fair, an appeals procedure must be independent of other parts of the tax administration, so that it can provide an independent review of the dispute. It may not be as effective, from an institutional perspective, to have the case heard by the persons responsible for issuing the assessments or by their peers.

Countries seeking to avoid integrity issues may wish to consider using panels of decisionmakers, as in India’s Dispute Resolution Panel programme, or implementing additional levels of reviews, as in Nigeria’s rulings practice. Brazil’s Administrative Court of Tax Appeals (CARF) is an example of a successful administrative appeal procedure. Appeals are processed in three steps, the first step being within the tax administration while the second (the appeal) and the third (the special appeal, which is accepted under certain conditions) are decided by the CARF. The CARF is housed within the Ministry of Finance but is separate from the tax administration, even though that is part of the same ministry.

Mediation and conciliation are sometimes mentioned as potential procedures to resolve disputes. Mediation has proven successful in resolving tax disputes within developed economies. The most significant benefit of this approach towards dispute resolution is seen as the quick time frame within which disputes have been resolved. The mediation option may be made available as an administrative process within the tax administration, rather than as a separate independent mediation procedure outside of the administrative process.

The process may be particularly promising in those situations where the tax auditor and taxpayer are no longer willing to communicate with each other and mutually resolve a dispute. In this environment, a mediator may be able to help overcome relationship challenges that prohibit the parties from reaching an agreement. While it may be worth testing these approaches, it should be noted that they are not automatically effective in a crossborder context, as they would still require an additional administrative step to obtain avoidance of double taxation. Potential utilization of similar processes in the treaty dispute resolution process is noted at 15.5.6 below.

An independent judicial system that provides a forum for unbiased consideration of disputes, including tax disputes, can do much to improve a country’s reputation among investors as a jurisdiction where tax disputes can be fairly resolved.

However, owing to the call in the modern business world for realtime certainty regarding tax obligations, the perceived benefit of such a judicial system declines as the length of time to obtain a final decision grows. It is therefore important to ensure that the judicial system has adequate resources and that it is not unduly burdened by tax disputes due to real or perceived deficiencies at the audit and administrative appeals stages.

Tax treaties significantly reduce the scope for crossborder disputes. Without a tax treaty, income from crossborder transactions or investment is subject to potential double taxation whenever the laws of the source and residence countries differ. Tax treaties seek to eliminate this double taxation by allocating between the contracting states the taxing jurisdiction over such income and by providing procedures for the relief of any residual double taxation. Treaties also typically require tax laws to be applied without discrimination based on nationality or capital ownership and without discrimination against the conduct of business through a permanent establishment.

Treaties therefore offer significant reassurance and certainty to potential investors, as well as greater certainty for tax administrations, by reducing the risk of crossborder disputes. In considering whether to make the negotiation of tax treaties a priority and which treaty negotiations to prioritize, developing countries may wish to weigh these advantages against the resources and the balance of bilateral concessions required to achieve an agreed treaty.

Tax treaties also provide for the MAP, a crossborder dispute resolution procedure under Article 25 of both the UN and OECD Model Tax Conventions. The MAP is operated by designated tax administration officials of each country who are referred to as “competent authorities”, and it enables tax administrations to reach bilateral agreement on issues of general interpretation or application and to thereby avoid double taxation on crossborder transactions and the resulting disputes. The MAP is separate from, and additional to, domestic law remedies for dispute resolution. However, in many countries domestic law (and in particular a final court decision) can limit available solutions under the MAP.

The MAP agreements may relate only to the assessments made in past years, or they may take the form of APAs that provide for agreement on a transfer pricing methodology for future years (and in many cases past years as well) as explained in 15.3.5. The MAP also applies to resolve crossborder disputes that have arisen in particular cases.

The UN Commentary on Article 25 (Mutual Agreement Procedure) provides useful guidance on dispute resolution through the MAP, which is relevant for both transfer pricing and other tax disputes. The UN Committee of Experts on International Cooperation in Tax Matters (UN Committee) has adopted a Guide to the Mutual Agreement Procedure under Tax Treaties, which provides additional guidance on best practices in the structuring and operation of MAP programmes based on practical experience, which developing countries may wish to evaluate and draw upon.¹³⁹

Some tax administrations, including for example those of Canada,¹⁴⁰ Germany, India, Japan,¹⁴¹ the Netherlands, the United States¹⁴² and the United Kingdom,¹⁴³ have published detailed internal MAP guidance. These may also provide useful comparative information for tax administrations that wish to learn more about the MAP. It is useful for tax administrations to indicate their intention to follow published guidelines or to publish their own MAP guidance. This promotes consistency in case handling and transparency regarding the expectations of the tax administration. It may be advisable to enact provisions in domestic law allowing for MAP and APA procedures and, if necessary (and possible), an amendment to the constitution, in order to provide juridical certainty to such procedures.

The purpose of a MAP programme is to provide an effective means of reconciling differing positions of treaty partners, so that the treaty can operate as intended to avoid double taxation or other taxation not in accordance with the provisions of the treaty. Experience has shown that this purpose can best be achieved if the MAP programme is structured so that tax administrators implementing the MAP programme are able to make decisions independently of those implementing the audit programme and are free from outside influence.

Structural independence may be more difficult to achieve in smaller tax administrations, which may have a limited number of subject matter experts available to advise on such issues. Where, because of resource or other constraints, the same experts must be used for both audit and MAP programmes, it will be important to provide a procedure for effective independent review of proposed MAP positions in order to ensure that they are not unduly influenced by the views of auditors.

Freedom from political influence on the MAP process is equally important. Many tax administrations have found that this can be best achieved by placing the MAP function within the tax administration, rather than within the Ministry of Finance or other tax policymaking function. Such tax administrations believe it is helpful to establish procedures or practices preventing involvement by those outside the tax administration in decisions regarding particular MAP cases. Other countries believe that placing the MAP function within the Ministry of Finance is preferable, to reduce undue influence by the tax administration, or to facilitate coordination by policymakers.

The importance of developing and operating wellfunctioning MAP processes was recognized and highlighted in Action 14 of the OECD/ G20 BEPS Project, resulting in the Action 14: 2015 Final Report Making dispute resolution mechanisms more effective.¹⁴⁴ The report contains a number of minimum standards and guidance on best practices some of which are discussed in the Commentary on Article 25 of the UN Model Convention in its 2021 update.

Given their purpose, it is important for MAPs to be operated in a consistent manner rather than handling each case in an ad hoc fashion. This will provide for similar treatment of similarly situated taxpayers and help the MAP programme to be viewed as equitable and effective. Both operational structure and training and other capacitybuilding of the workforce can play important roles in promoting such consistency. For similar reasons, it is important for a MAP programme to apply principled approaches to resolving cases. In the first instance, the approaches taken should be consistent with the provisions of the treaty and any relevant interpretative guidance. It is essential that foreign and domestic taxpayers and “inbound” and “outbound” transactions be treated in the same manner. This will help produce consistent, predictable results and further contribute to a view of the MAP programme as equitable and effective. Training and other capacitybuilding will also be important.

It is also essential to implement a policy of broad access to the MAP, if it is to serve the purpose of resolving crossborder disputes and be regarded by potential investors as equitable and effective. This calls for the elimination of factors that could otherwise prevent or discourage the use of the MAP, including unreasonable time limitations or unilateral attempts to exclude selected issues from the MAP. Consideration should be given to suspending the collection of disputed tax assessments on cases pending in the MAP, as these assessments can otherwise present serious cash flow difficulties for taxpayers that have already been taxed on the same amount in the other country. If necessary, this can be done in exchange for a bank guarantee to ensure the payment of any tax due upon the conclusion of the MAP. Similarly, consideration should be given to preventing the imposition of interest or at least preventing the imposition of higher interest rates that may effectively operate as penalty measures, while cases are pending in the MAP programme.

The MAP generally commences with a request by a taxpayer addressed to the designated competent authority of a country for consideration of an issue for dispute resolution and/or relief of double taxation, because the taxpayer believes his tax treatment is not, or will not be, in accordance with the treaty. Alternatively, the process can be initiated because there are questions of interpretation or application of the convention or to eliminate double taxation in cases not otherwise provided for in the convention.

The MAP process is intended to be used also to resolve economic double taxation, such as in the case of transfer pricing disputes. The case should be presented to the competent authority of the country where the taxpayer is resident within three years from the (first) time the person is notified (for example by way of a notice of assessment) of the action that will result in taxation not in accordance with the convention. The threeyear time limit is determined by the treaty article and may differ in certain cases. The definition of what constitutes (first) “notification” may be provided in domestic regulations. The form of the MAP request to be filed may be prescribed under domestic regulations as well. Alternatively, the commentary to the treaty or the model convention may be consulted in this regard or the OECD Manual on Effective Mutual Agreement Procedures (MEMAP)¹⁴⁵ could also be consulted.

Once the MAP request has been received, it needs to be ascertained that the foreign competent authority is properly informed as well and that all relevant information to decide and agree on the matter is made available to both competent authorities. Considering the time limit within which competent authorities are expected to address and resolve a filed request, it is relevant to determine if further information is required from the taxpayer(s) involved or not, and if so, to request this information as soon as practicable. It would not be prudent to wait to ask for this information at the last minute and to extend or overrun the time limit provided by the applicable treaty. The competent authorities may wish to meet in person to compare notes on the matter and to explore available solutions or may wish to handle the matter through (electronic) correspondence or a combination of both of those approaches.

It is generally understood that the competent authority of the country that made the primary adjustment leading to the double taxation (or taxation not in accordance with the convention) has the burden of proof towards the other competent authority that the primary adjustment is justified. That competent authority traditionally will send a letter (a socalled position paper) to the other competent authority informing the latter of its position with respect to the issue for which the competent authority request was filed. Based on the position paper, the other competent authority can respond and explore to what extent it agrees with the position and is able to provide for avoidance of double taxation or not.

If the competent authorities agree on a way to avoid double taxation and the taxpayer agrees to the suggested solution as well, a bilateral agreement is entered into between the two taxing authorities and an agreement is entered into between the respective competent authority and taxpayer of the country where the primary adjustment was made. Careful consideration is required on how the solution is to be implemented; in what taxable year and whether the statute of limitations is still open as regards that year in the other jurisdiction; or whether the treaty allows for an override of the domestic statute of limitation provisions. Consideration should also be given to whether the issue decided is a recurring issue (that applies to later years as well) or not. If the issue is a recurring issue and additional adjustments are to be expected for later years, the taxpayer and competent authorities may wish to explore to what extent they have the authority and means to resolve those years as well, or whether a new MAP request ought to be filed for later years.

In accordance with the mandate of Action 14 of the BEPS Project, the concerned countries worked to “develop solutions to combat the obstacles that prevent countries from resolving disputes related to agreements through [MAP], including the absence of provisions on arbitration in the majority of countries’ agreements and the fact that access to mutual agreement procedures and arbitration may be denied in some cases.”

The measures agreed upon under Action 14 sought to strengthen the effectiveness and efficiency of this procedure by minimizing the risks of uncertainty and unintentional double taxation and ensuring consistent and appropriate implementation of tax treaties.

As a result of the final report of this action, a significant number of countries agreed to important changes in their position on dispute resolution regarding tax treaties and the commitment of countries in this regard represents a minimum standard. Through the minimum standard it will be ensured that:
►    The obligations of the fiscal treaties related to the MAP are fully implemented, in good faith, and that MAP cases are resolved in a timely manner (in an average of 24 months);
►    Administrative processes that promote the prevention and timely resolution of controversies on tax treaties, such as guides for taxpayers about the requirements to access the MAP, are implemented; and
►    Taxpayers will have access to the MAP when they are eligible.

Being a minimum standard of the Inclusive Framework, the implementation of this commitment by countries is constantly monitored through peer review, which seeks to ensure that all countries that are part of the project comply with this standard.

The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (Multilateral Instrument) developed pursuant to Action 15 of the BEPS Project, will facilitate compliance with the Action 14 minimum standard since it allows signatory countries to incorporate into their existing treaties, among other measures, those derived from Action 14 of the BEPS Project, which imply modifications to the Article on MAP. In other words, this Multilateral Instrument will make it possible to modify the existing agreements of the signatory countries, avoiding a large number of bilateral negotiations and the burden that the procedures for signing and ratifying separate amendments to treaties may present.

The UN Model Convention provides for optional treaty text that allows the competent authorities to resolve disputes by way of arbitration, if no solution can be obtained within the time frame provided by the mutual agreement article. Competent authorities that cannot find an acceptable solution for a dispute within the requisite time frame must invoke the arbitration procedures if that text is included in the relevant treaty, or agreement exists between treaty partners to resort to arbitration pursuant to that article. The procedures to be followed are those provided by the UN Model Convention or that may have been agreed to by the treaty partners otherwise.

Mandatory arbitration provisions have been added to many treaties in recent years as a last resort method of resolving MAP issues that cannot be resolved by the competent authorities within a specified time frame. The European Union began this trend in 1990 with the multilateral EU Arbitration Convention and the OECD amended its Model Convention and Commentary in 2008 to recommend the inclusion of mandatory arbitration provisions in bilateral tax treaties.

OECD statistics show that the MAP process succeeds in avoiding double taxation in 90 to 95 per cent of the cases to which its member countries are a party. While that is an impressive success rate for a dispute resolution programme that does not legally require the parties to reach agreement, the risk of double taxation in the remaining cases is still a serious concern for taxpayers and tax authorities, especially given the growing amounts in controversy. Both taxpayers and competent authorities tend to view arbitration very much as a last resort method. However, the inclusion of mandatory arbitration provisions in treaties has been widely supported by taxpayers as they guarantee resolution within a specified time frame and provide certainty that double taxation will be avoided. In the vast majority of cases the practical effect of mandatory arbitration provisions has been to encourage the competent authorities to reach agreement by the specified deadline. Only a handful of cases out of the many hundreds of MAP cases submitted have been taken to arbitration under agreements concluded thus far.

Mandatory arbitration provisions have already been added to many treaties between OECD member countries, even where one country has a general preference for residencebased taxation and the other a general preference for sourcebased taxation. However, the UN Committee has endorsed arbitration only as an option and not as an affirmative recommendation. The envisaged arbitration process is described in the Commentary to Article 25 of the UN Model Convention.

As reflected in the UN Commentary on Article 25, members of the UN Committee have identified arguments both in support of and against the adoption of mandatory tax treaty arbitration by developing countries. These arguments are summarized below.

It has been suggested that mandatory tax treaty arbitration may have the following potentially negative aspects from a developing country perspective:
►    only a small number of cases are submitted to the MAP under paragraphs 1 and 2 of Article 25 and very few of them remain unresolved;
►    domestic legal remedies can resolve the few cases that the competent authorities are not able to resolve through the mutual agreement procedure;
►    due to the lack of experience with the MAP in many developing countries, arbitration would be unfair to those countries when the dispute occurs with more experienced countries;
►    the interests of countries, which are so fundamental to their public policy, could hardly be safeguarded by private arbitrators in tax matters—arbitrators cannot be expected to make up for the lack of expertise in many developing countries;
►    the neutrality and independence of possible arbitrators appears difficult to guarantee;
►    it is very difficult to find experienced arbitrators;
►    mandatory arbitration is costly and therefore not suitable for developing countries and countries in transition; and
►    it is not in the interest of a State to limit its sovereignty in tax matters through mandatory arbitration.

Those who support the inclusion of mandatory arbitration provisions in tax treaties have argued that these provisions will have certain benefits for developing countries and can be designed in the following ways to address their concerns:
►    despite the fact that only a small number of cases remain unresolved, each of these cases represents a situation where there is no resolution for a case where one competent authority considers that there is taxation not in accordance with the Convention and where there may be significant double taxation;
►    arbitration provides more certainty to taxpayers that their cases can be resolved under the MAP and contributes to the promotion of crossborder investment;
►    domestic remedies may not adequately and rapidly resolve disputes concerning the application of bilateral conventions (risk of inconsistent court decisions in both countries and of unilateral interpretation of the Convention based on domestic law);
►    the obligation to submit unresolved cases to arbitration after a given period of time may facilitate the endeavours of the competent authorities to reach an agreement within that period of time;
►    on the basis of the experience under the EU Arbitration Convention, the effective recourse to mandatory arbitration should be rather unusual and the costs relating to that mechanism should be low; moreover, as arbitration provides more certainty to the taxpayers, it reduces the number of costly “protective” appeals and uncertain domestic proceedings;
►    arbitrators have to reach a wellfounded and impartial decision; consequently, they can adjust for the levels of expertise of countries and overcome the possible lack of experience of some countries;
►    skilled and impartial arbitrators can be drawn from various backgrounds (government officials, judges, academics and practitioners) and from various regions (including from developing countries); and
►    it is in the interest of a State to limit its sovereignty in tax matters through mandatory arbitration.

One of the main challenges in the framework of Action 14 was the question of mandatory arbitration as a means to ensure the resolution of disputes. This mechanism gives legal certainty to taxpayers about the resolution of a case in which they consider that a measure not conforming to the agreement was applied. Likewise, it encourages the competent authorities not to postpone the discussion of the case, in order to avoid mandatory
 

arbitration. Notwithstanding the foregoing, most of the countries participating in the BEPS Project have not chosen to include this alternative, with some of the main reasons similar to those addressed above. It should be noted that the arbitration provision can be adopted through the Multilateral Instrument as an option and grants great flexibility with respect to the cases that may be subject to arbitration by allowing countries a reserve mechanism to exclude certain cases from the application of the same.

The UN Committee in October 2015 approved the formation of a Subcommittee to address, consider and report back on dispute avoidance and resolution aspects relating to the MAP, with a view to reviewing, reporting on and, as appropriate, considering possible text for the UN Model and its Commentaries, and related guidance, on a variety of issues, including:
►    Options for ensuring the MAP under Article 25 (in either of its alternatives in the UN Model) functions as effectively and efficiently as possible;
►    Other possible options for improving or supplementing the MAP, including the use of nonbinding forms of dispute resolution such as mediation;
►    Exploration of issues associated with agreeing to arbitration clauses between developed and developing countries; and
►    The need or otherwise for any updates or improvements to the Guide to the Mutual Agreement Procedure under Tax Treaties.¹⁴⁶

On 20 October 2017, the Subcommittee on Dispute Avoidance and Resolution was established and has been discussing dispute avoidance and resolution without focusing on transfer pricing. The work of the Subcommittee will result in a manual on dispute resolution, a useful guide for developing countries on the design and implementation of various dispute resolution mechanisms.

Multilateral approaches are important tools to avoid crossborder disputes on transfer pricing and the resulting risks of unrelieved double taxation.

As noted above many countries have historically relied primarily on the guidance provided by the OECD Transfer Pricing Guidelines, which interpret Article 9 (Associated Enterprises) of the OECD Model Convention and have been developed by transfer pricing experts over the past several decades. A number of economies in transition and developing countries have adopted domestic transfer pricing laws that extensively draw upon the provisions of the OECD Transfer Pricing Guidelines. These include, for example, China, Egypt, India, Malaysia and South Africa.

Although the provisions of Article 9 of the UN Model Convention are very similar to Article 9 of the OECD Model, the interpretation provided by the OECD Transfer Pricing Guidelines may not be fully consistent with the policy positions of all developing countries. However, in recent years, representatives of China, India, and other nonOECD economies have begun participating actively as observers in the development of transfer pricing guidance at the OECD level. NonOECD/G20 countries also participated on an equal footing in the revision of OECD transfer pricing guidance as participants in the OECD/G20 Inclusive Framework initiative.

The Commentary to Article 9 of the UN Model as revised in the 2017 update also recognizes the importance of maintaining a common understanding of how the arm’s length principle should be applied in order to avoid international double taxation of corporate profits. To that end the Committee of Experts considered that the OECD Transfer Pricing Guidelines contain valuable guidance relevant for the application of the two Model Conventions, and consistency with the OECD Transfer Pricing Guidelines has been sought when developing this Manual. Therefore, developing countries may wish to consider the relevance of the OECD Transfer Pricing Guidelines, along with the growing body of UN guidance and other available sources, when establishing their own domestic and crossborder policies on transfer pricing.

Each country will have its own domestic dispute resolution procedures in addition to crossborder procedures. It is important that these be properly coordinated for two reasons.

First, tax administrations, especially developing country administrations with limited resources, may want to minimize duplication of effort by avoiding the simultaneous operation of two parallel dispute resolution processes. Most tax administrations prefer to deal with an issue either through the MAP or through domestic procedures, but do not generally operate both procedures simultaneously (with the exception of certain simultaneous MAP and domestic appeals programmes).

Second, notwithstanding such resource concerns, it is important to manage any duplication issues without forcing taxpayers to make a premature choice between domestic and crossborder procedures. For example, taxpayers should not be required to give up their MAP rights under treaties in order to access domestic administrative appeals procedures. To avoid such results, while addressing resource constraints, many tax administrations permit taxpayers to preserve their rights to domestic procedures during MAP discussions by placing them on hold (usually after filing an initial notice of objection) so that they can later pursue their domestic rights if no MAP agreement is reached. Alternatively, tax administrations may wish to provide flexibility in the timing of MAP by not setting a deadline for MAP requests under their treaties or domestic laws, so that appropriate domestic procedures can be explored first. Some tax administrations prefer instead to set a deadline for the filing of a MAP request.

Taxpayers should be permitted, however, to pursue MAP consideration of a relevant crossborder issue or issues while pursuing domestic dispute resolution procedures for separate issues that are not appropriate for the MAP.

In some countries there is a view that the tax administration, including the competent authority, is bound by a final decision of a domestic court and that MAP consideration is not available in such circumstances. Some other countries view this as inconsistent with the obligations of the treaty MAP provisions. Where a competent authority takes the view that it cannot or should not depart from domestic court decisions it should clearly state this position in public guidance for the information of treaty partners and taxpayers.

The competent authority of one country is, of course, not obligated in any way to accept either a court decision or an administrative settlement of another country. The competent authority may however choose to provide relief on a unilateral basis if it agrees with the result reached, but it should not be expected to provide relief solely because it is otherwise unavailable.

Transfer pricing rules were introduced in domestic legislation by the United Kingdom in 1915 and by the United States in 1917. However, transfer pricing was not an issue of great concern until the late 1960s when international commercial transactions expanded greatly in volume. The development of transfer pricing legislation was historically led, in terms of implementation, by developed countries. In recent years, due to the growth and complexity of international “transfers” within MNEs, both developed and developing countries are introducing legislation to address transfer pricing issues.

Domestic transfer pricing legislation worldwide shows some harmonization in basic principles, in accordance with the arm’s length standard, even if the application is not identical across jurisdictions. The introduction of transfer pricing rules has taken place within different legis-lative frameworks, and in the context of the sovereign right of countries to address taxation matters. The reasons why there has been increased consist-ency in approach include:
►    The benefits of similar approaches between countries in terms of avoiding double taxation or double non-taxation;
►    The broad acceptance of the arm’s length principle as the best current alternative for dealing with transfer pricing issues; and
►    The adoption by many countries of the UN or OECD forms of Article 9 in their bilateral tax treaties, so that they are already committed to the fundamental principle(s) set out thereunder.

With the increase in controversy regarding adjustments by tax authorities to transfer prices set by related entities, taxpayers increasingly seek practical dispute resolution mechanisms to avoid double taxation. As a result, the mutual agreement procedure (MAP) as set out in bilateral treaties⁹¹ is evolving as a more effective mechanism through supplementary domestic regulations, as well as through increased practice regarding the management of the MAP.

Many countries have implemented advance pricing agreements (APAs) in their legal and/or administrative procedures as a bilateral dispute prevention / resolution mechanism to avoid double taxation. Other countries have introduced an arbitration procedure to give certainty that a dispute will be resolved. The advantages and disadvantages of these approaches are dealt with at Chapter 15; however, their application will be shaped by the legisla-tive mechanisms of each country, and thus will take place in a variety of ways.

This chapter reviews the legal environment of transfer pricing legis-lation in a global context and seeks to identify the key practical issues from the perspective of developing countries. It should be emphasized that there is no “template” or model legislation that works in every situation. Transfer pricing legislation must be appropriate to the needs of a particular country. This means that any legislation of another country which is examined as a source of ideas should be considered closely as to why it has worked or has not worked in its original context. The ease of practical administration and the burdens of compliance with the rules of any model being considered should also be carefully analyzed. Those considerations and the “environ-ment” of the legislation should be compared with those in the country introducing transfer pricing rules. This analysis will help indicate what notions or concepts, if any, the provisions are relevant to and adequate for, and how they could work effectively in the conditions of a particular country.

Drafters of transfer pricing legislation should take into account the outcomes of the BEPS Project, especially regarding Actions 8, 9, 10 and
13 (8 — Intangibles; 9 — Risks and capital; 10 — Other high-risk transac-tions, and 13 —Transfer pricing documentation and Country-by-Country reporting).⁹² These issues are intended to have a more harmonized legal approach in a post-BEPS Project era.

This chapter also addresses the practical implementation of transfer pricing rules in a particular jurisdiction. As such, guidance is provided on:
►    How the considerations and the substantive issues regarding leg-islative design can be implemented in a national transfer pricing regime through (substantive) laws and subsidiary regulations;
►    How national transfer pricing regimes relate to other domes-tic tax laws;
►    The position of transfer pricing rules in the overall framework of international tax rules within a particular domestic regime; and
►    How to keep the newly implemented transfer pricing regime updated.

The rest of the chapters in Part C deal in greater depth with specific areas of implementation and administration. Chapter 11 sets out impor-tant considerations in establishing transfer pricing capability in developing countries. Chapter 12 covers the documentation requirements central to a transfer pricing regime, transparency issues and exchange of information, in an increasingly complex business environment. Chapter 13 provides a useful framework for risk assessment for transfer pricing purposes, and 14 discusses transfer pricing audits and provides guidance on approaches to managing audit programmes. Chapter 15 provides insights into approaches and techniques for dispute resolution, including how to access dispute resolu-tion systems. Part C thus aims to provide a set of approaches by which a tax administration in a developing country can introduce and sustain a transfer pricing regime that meets international standards.

As already noted in Chapter 2, “transfer pricing” is essentially a neutral concept. However, the term is often used, incorrectly and in a pejora-tive sense, to mean the artificial shifting of taxable income from one company within an MNE to another company of the same MNE, in another jurisdic-tion, through incorrect transfer prices. The aim of such practices is to reduce the overall tax burden of the group. In such instances, the issue is the fact that the transfer price is not at arm’s length. In this Manual “transfer mis-pricing” is used to denote instances when the transfer price set is not at arm’s length. See section 2.1.1.6.

Many countries have introduced specific domestic tax rules to prevent possible tax base erosion through mispricing of transactions between related parties. As noted above, this legislation almost invariably requires that intragroup transactions are priced in accordance with the arm’s length principle. The arm’s length principle is generally accepted as the guiding principle for allocating income not only among related entities (MNE compa-nies) but also among cross-border units of a single entity. Under the arm’s length principle, it is generally necessary to conduct a comparability analysis of third-party transactions. However, where the taxpayer fails to provide the tax authority with the required information to enable a proper determina-tion of an arm’s length price in particular circumstances, some countries have adopted a presumptive taxation method (discussed at 10.1.9). Presumptive taxation is generally subject to rebuttal by the taxpayer, which may present counter-evidence to show that the results of the transaction are at arm’s length.

Another approach to transfer pricing income allocation is referred to as global formulary apportionment (GFA). However, such a system cannot operate at a global level, in a way that fully avoids double taxation, without prior global agreement on a suitable uniform formula, which has not yet been achieved. This Manual addresses transfer pricing rules based on the arm’s length principle. Virtually all developing countries accept the arm’s length principle as part of their bilateral tax treaties and have adopted the arm’s length principle as the basis for their domestic transfer pricing law. This Manual does not deal with the advantages and disadvantages, in the longer term, of other possible ways of dealing with transfer pricing, including GFA.

Some countries have formally recognized the guidance provided in this Manual in their domestic law. Even where this is not the case, the guidance in the Manual may provide useful reference for the application of the domestic legislation, unless there is inconsistency between the guidance in the Manual and the requirements of the domestic law.

An example of a country’s legislation that recognizes the guidance in the Manual is Tanzania’s Transfer Pricing Regulations of 2018 which provide that the Regulations are to be interpreted in a manner consistent with the arm’s length principle in Article 9 of the UN Model Convention and the guidance in this Manual. The Regulations also provide that they are to be interpreted in a manner consistent with Article 9 of the OECD Model Tax Convention and the OECD Transfer Pricing Guidelines.

Another example is Zimbabwe which enacted transfer pricing legislation in 2016. The provisions there formally recognize the Manual and the OECD Transfer Pricing Guidelines as guidance documents.

Two different broad approaches may be seen in domestic legislation relating to transfer pricing. Both of these approaches seek to implement an arm’s length approach in relation to controlled transactions.

The first possible legislative approach simply authorizes the tax administration to distribute, apportion or allocate gross income, deductions, credits etc. when the tax administration determines that such distribution, apportionment or allocation is necessary in order to prevent tax avoidance or clearly reflect the income of any organizations, trades or businesses.⁹³ Under this system there is no reference to the taxpayer’s compliance obligation in determining the arm’s length price, while the arm’s length principle may be stipulated in either the general primary legislation or within regulations or secondary legislation supporting the primary legislation.

The second legislative approach stipulates that, based on a self-assessment system, any foreign affiliated transaction shall be priced for tax purposes as if it had been conducted at arm’s length.⁹⁴ In other words, a non-arm’s length transaction is reconstructed as an arm’s length transaction for the purposes of calculating taxable income and taxing such income. This legislative approach effectively requires taxpayers to conduct their initial tax accounting based on the arm’s length principle.

A country’s choice between these two approaches will depend on the basic principles of domestic tax law in that country. This will include issues such as the form of any applicable anti-avoidance legislation, time limits for application of the legislation, and where to place the burden of proof. However, the choice of styles of domestic legislation has generally made no substantial difference in the legal procedure of implementing the arm’s length principle. The manner in which arm’s length methodologies are stipu-lated in each country’s legislation differs to some extent, as described below.

Depending on the legal system of the country concerned, tax laws may set out in great detail issues such as the definition of related parties, transfer pricing methodologies, documentation, penalties and the procedures for APAs. Other countries might opt only to identify the basic structure of tax base allocation among the related parties under the arm’s length principle. In the latter case, detailed practical guidance will normally be available in subordinate legal materials, such as regulations, administra-tive rules and public notices. Even if such matters are defined in great detail in the primary tax law, there is a need to provide clear operational guidance. Tax administrations should consider the level of guidance available in their countries and determine if further detail is needed.

There remains substantial risk of double taxation even when two countries follow the same arm’s length principle approach. For example, double taxation may occur where specific guidance on the implementation of the arm’s length principle is different from one country to another, and countries do not bridge this gap with any specific understanding or interpre-tative guidance. The following paragraphs demonstrate potential significant differences in domestic law which may result in major differences in how countries interpret or apply the arm’s length principle.

The definition of which persons (companies, trusts, individuals and other entities) and therefore transactions are covered by transfer pricing legislation is a key issue since the arm’s length principle applies to transac-tions between related parties. Article 9 of both the UN and OECD Models considers enterprises to be “associated” (i.e. “related parties”) if one of the enterprises meets the conditions of Article 9, Subparagraph 1(a) or 1(b) with respect to the other enterprise. These subparagraphs cover so-called parent-subsidiary relationships and brother-sister relationships.

The requirement of control in each subparagraph is satisfied if one entity “participate(s) directly or indirectly in the management, control or capital of [another] enterprise.” There is no specific common guidance on this matter either in the Commentaries on Article 9 in the UN and OECD Models, or in the OECD Transfer Pricing Guidelines. This is mainly because transfer pricing issues are relevant only if special conditions have been made or imposed between two parties. Thus, the degree of control required to trigger the application of transfer pricing legislation has in effect been left to domestic legislation.

Some countries apply a 50 per cent shareholding threshold as the degree of participation required for “associated” status; some countries employ a lower threshold or place more reliance on other factors relating to de facto management or control. However, countries with higher thresholds usually employ substantive rules on control as a fallback, or subsidiary, test. These may focus on elements other than shareholding, such as dependency of input materials, distribution networks, voting rights, entities included in consoli-dated financial statements, financial resources and human resources in relation to other group members. Thus, there may be more commonality in country practice than would appear from a superficial comparison of shareholding thresholds.

Nevertheless, differing threshold criteria can result in disputes in certain circumstances. For example, if in Country A, the domestic law stipu-lates that a shareholding of 50 per cent or more is the threshold to qualify as an “associated enterprise”, transactions between an entity owned 50/50 by two otherwise independent parties and one of its shareholders would be covered by the transfer pricing rules. However, if in Country B, the domestic law provided for a shareholding threshold of above 50%, the same transac-tion would not, prima facie, be subject to the transfer pricing rules in that jurisdiction.⁹⁵

In South Africa, transfer pricing rules are applied to cross-border transactions between related persons, referred to under domestic law as “connected persons”. A connected person is defined in relation to natural persons, trusts, members of partnerships and companies. Companies could be connected persons based on prescribed criteria if one of the companies holds at least 20 per cent of the equity shares or can exercise at least 20 per cent of the voting rights in the other company.

As an additional example, in Brazil, foreign companies and companies domiciled in Brazil are considered as associated companies when at least 10 per cent of the share capital in one (or both) of the compa-nies is owned by the same individual or legal entity. The transfer pricing legislation also applies concepts of the Company Law to other situations to characterize two companies as associated or controlled companies. In fact, Brazilian transfer pricing legislation is very broad regarding the concept of “related persons”, e.g. it also considers the kinship of an individual resident in a foreign country which has commercial relations with companies in Brazil that are controlled or managed by his or her relatives (depending on the kinship grade); and all transactions performed with listed jurisdictions (low-tax and non-cooperative jurisdictions) are deemed related persons.

For developing countries, an analysis of control might be an impor-tant element in ensuring that the transfer pricing rules can be administered effectively. In addition, factors for identifying control should be carefully examined because evaluation of those factors may require complicated fact-finding procedures, which might differ depending on industry sector, geographic characteristics, product cycle, etc.

Transfer pricing rules generally cover all cross-border intra-group transactions, regardless of whether participants are residents or non-residents for tax purposes. Thus, transactions conducted between a permanent establishment (PE) of a foreign company located in a jurisdiction and an affiliated company located in another jurisdiction are also subject to transfer pricing rules under the domestic law of that jurisdiction. In contrast, a transaction between a domestic PE of a foreign company and its affiliated company resident within the jurisdiction may not be subject to the transfer pricing rules in certain jurisdictions, such as Japan, because there is no substantial risk of income shifting beyond the legislating country’s borders, see further 10.2.1.1.

However, transactions between local branch offices and their headquarters (and vice-versa) may be regulated by specific legislation, such as the non-resident/foreign company taxation rules, and consequently be affected by Article 7 of tax treaties (usually based upon the UN or OECD Models). Although under such circumstances the arm’s length principle generally prevails, the legal framework of taxation could be different. For example, the dispute resolution mechanism might be different depending on each country’s domestic law and the relevant treaty regarding this type of transactions. Nevertheless, in general, the same domestic transfer pricing legislation may be applicable both to transactions between a local branch (PE) and its headquarters (see Article 7 of the UN and OECD Models), and to transactions between associated enterprises (see Article 9 of the UN and OECD Models), even though a tax treaty may exist between the countries involved in the transaction.

The availability of different types of transfer pricing methods, the choice of method and the priority to be given to various different transfer pricing methods are matters often covered by domestic legislation. This is often done through administrative guidance or other subsidiary materials instead of taxation laws. Many countries have followed the OECD Transfer Pricing Guidelines, and/or this Manual in developing their domestic legis-lative frameworks, and have adopted the traditional transaction methods as well as the transactional profit methods when establishing whether a transfer price was at arm’s length. See Chapter 4 for detailed discussion of transfer pricing methods.

Ease of administration is another important issue in the design of legal frameworks. Documentation requirements supported by penalties or other deterrents against non-compliance are the main instruments used by tax authorities for collection of sufficient information to test whether or not taxpayers have established an arm’s length result. Transfer pricing documen-tation is a significant compliance cost for MNEs, especially where there are differences in countries’ requirements. There is value in seeking to align documentation requirements with those of other countries, unless there are good reasons in terms of reducing compliance and collection costs, or specific features of local legislation, that require differences. Action 13 of the OECD/G20 BEPS Project specifically focused on transfer pricing documen-tation and Country-by-Country reporting, and guidance has been published on the implementation of relevant measures.⁹⁶ See Chapter 12 for guidance on transfer pricing documentation and Country-by-Country reporting.

Some differences in the coverage of transactions or in the legal form (statutes with penalty provisions or administrative guidance on self-assessment) will remain. It is therefore appropriate to continuously evaluate documentation and penalty legislation for effectiveness and propor-tionality. The experience of countries that have introduced transfer pricing rules may be helpful to developing countries just starting to introduce transfer pricing legislation.

A critical issue for developing countries as well as developed countries when applying any methodology will often be the lack of third-party comparables, particularly comparables from the domestic market. As this Manual has shown, however, in many cases it may be the case that foreign comparables will be appropriate for the transfer pricing case at hand. Where this is not the case, for instance where it is found that the most appropriate method involves a local tested party and there are particularities in relation to the domestic market that mean foreign comparables are unlikely to be reliable, practical guidance in applying the arm’s length principle and the transfer pricing rules without sufficient domestic information on independent comparables should be a key focus in domestic legislative frameworks. This Manual as a whole is intended to assist especially in this area; users should refer to Chapter 3 on Comparability Analysis in particular. Domestic legis-lative frameworks and administrative guidelines should generally address the analysis of comparables as a benchmark of the arm’s length principle. Such frameworks should seek to establish useful and effective guidance on matters such as comparability analysis (use of foreign data, adjustment of differences, profit split etc.), access to data, safe harbour rules, if any, and burden of proof. It is worth paying attention to the sixth method outlined in section 4.7 (Chapter 4).

In addition, the PCT Transfer Pricing Toolkit (see 2.5.3.2) contains a number of useful suggestions that could be considered in cases where there is a systemic problem involving a lack of comparables. For example, the toolkit:
►    Suggests ways in which government agencies can increase the pool of available comparables data, for example, by instituting requirements to publish audited financial statements;
►    Recommends focusing on risk assessment approaches that con-sider the arm’s length nature of related party transactions, so as to ensure scarce audit resources are concentrated on cases most likely to yield results;
►    Suggests consideration of safe harbours (see 10.2.2), fixed mar-gins or other prescriptive approaches (see 10.1.9);
►    Discusses the application of the PSM and the use of valuation techniques which do not directly rely on comparables data, where it is found that such approaches constitute the most appro-priate means of determining arm’s length prices or profits;
►    Suggests consideration of cooperative compliance approaches in appropriate cases as a means of helping tax administrations to access industry information which may otherwise be difficult to obtain; and
►    Suggests the use of anti-avoidance measures as a backstop to the transfer pricing rules in the most egregious cases, or those where there is a high risk of systemic abuse.

The burden of proof in tax litigation refers to the need to affirma-tively prove the truth of facts alleged by a litigant based on a preponderance of evidence. It is also sometimes referred to as “the risk of non-persuasion” or the “burden of persuasion”. A litigating party meets this burden by convincing the fact-finder to understand the facts as proposed by that party.
The party with this burden stands to lose if its evidence fails to convince the judge during a trial. A concept that precedes, but is different from, the burden of proof is “the burden of allegation”, which means a party’s duty to plead a matter in order for that matter to be heard in the lawsuit. A litigant who brings a suit needs to satisfy both the burden of allegation and the burden of proof to win a lawsuit.

The burden of proof operates in litigation. However, it is important to be able to consider which party has the burden of proof during a tax audit exercise or when transfer pricing assessments are made because the case may ultimately end up in court.

The burden of proof for transfer pricing litigation may be deter-mined in accordance with the burden of proof rules of civil procedure or tax litigation in general in the relevant jurisdiction. If there are many court decisions on transfer pricing, the burden of proof for transfer pricing cases may be formulated in more detail through those precedents, depending on the general status of precedent in a given jurisdiction. The burden of proof rules for transfer pricing cases differ among countries.

In several countries the burden of proof rests originally on the taxpayer, as they are obliged to prepare, maintain and present documen-tation demonstrating that the terms and conditions of their related-party transactions are consistent with the arm’s length principle. The position that the taxpayer bears the burden of proof is taken, for example, by Australia, Brazil, Canada, India, South Africa and the United States.

Once the taxpayer discharges this burden, it may shift to the tax authorities to evaluate and prove if the controlled prices have been deter-mined in accordance with the arm’s length principle or if the information or data used in the computation are unreliable or incorrect. Therefore, countries may assess and determine transfer pricing adjustments in the following situations:
►    The related-party transaction was not determined in accordance with the arm’s length principle;
►    The taxpayer did not supply sufficient information or proof to properly examine the related party transaction;
►    The taxpayer did not present tax returns; or
►    The arm’s length price cannot otherwise be determined.

Subsequently, the burden of proof may return to the taxpayer in order to explain and document if the assessment is incorrect, unfounded or unreasonable, and to confirm that the related-party transaction was conducted at arm’s length. This situation can occur as part of an audit process or in defence procedures (e.g. litigation process).

Tax administrations and taxpayers may encounter several challenges in meeting their respective burdens of proof. As a practical matter, associated enterprises normally establish the conditions of a transaction at the time the transaction is undertaken. In auditing these transactions, the tax administration may have to engage in a verification process perhaps some years after the relevant transactions have taken place. Moreover, at some point the associated enterprises may be required to prove that these transactions are consistent with the arm’s length principle. As a part of the due diligence process, the arm’s length principle may result in a compliance burden for the taxpayer and an administrative burden for the tax adminis-tration in evaluating significant numbers and types of the transactions. The tax administration would review any supporting documentation prepared by the taxpayer to show that its transactions are consistent with the arm’s length principle. The tax administration and the taxpayer may also need to gather information on the comparable uncontrolled transactions and the market conditions at the time the transactions took place, for numerous and varied transactions. Such an exercise usually becomes more difficult with the passage of time. In such instances, both taxpayers and tax administrations often have difficulty in obtaining adequate information to apply the arm’s length principle.

It should be noted that in practice the burden of proof is not always a deciding factor. The burden of proof requirement nevertheless plays an important role in deciding who should disclose what. Since burden of proof is a general issue emanating from the law of each country, the issue of whether the taxpayer or tax administration has the initial burden to prove that the pricing is in accordance with the arm’s length principle should be handled within the domestic legal framework.

Another important point that should be addressed in transfer pricing domestic legislation is the “statute of limitations” issue— the time allowed in domestic law for the tax administration to complete transfer pricing audits and make necessary assessments. Since a transfer pricing audit can place heavy burdens on the taxpayers and tax authorities, the normal “statute of limitations” period for taking action is often extended compared with general domestic taxation rules. However, too long a period during which adjustment is possible leaves taxpayers in some cases with potentially very large financial risks. Differences in country practices in relation to time limitation should not lead to double taxation. Countries should keep this issue of balance between the interests of the revenue and of taxpayers in mind when setting an extended period during which adjustments can be made.

A “presumptive taxation” approach has been provided in the laws of some countries. Presumptive taxation provisions give tax authorities the power to “presume” an arm’s length price based on information gathered by the authorities, and to reassess the taxpayer’s taxable income on that basis. Such provisions are generally only regarded as applicable in case of the taxpayer’s failure to provide relevant documentation on the arm’s length price within a reasonable time (such as when information is requested of a taxpayer during an audit). Presumptive taxation is usually provided for as a last resort.

This methodology may be common in legislation related to domestic taxation and transfer pricing adjustments. However, transfer pricing adjustments in relation to cross-border transactions generally create a risk of international double taxation and may be contentious. Countries should therefore structure legislation on presumptive taxation carefully and in a manner that is as consistent as possible with the arm’s length principle.

The effectiveness of presumptive taxation depends on the approach adopted by the country concerned i.e. the choice between self-assessment and being assessed by the tax administration. On the one hand, under a self-assessment system where the tax authorities have the burden of proof whenever they propose an adjustment, presumptive taxation may appear more attractive when there is not enough relevant information to compute the arm’s length price. On the other hand, in an anti-avoidance focused system where taxpayers have an initial burden of proof on the authorities’ adjustments, a penalty system may play a more effective role than presump-tive taxation to avoid the generalized mispricing of related party transactions.

Another issue closely related to presumptive taxation, but also relevant to other systems, is the use of “secret comparables”. See further 3.6.7.

As a policy choice, governments should decide when, how and in what format they want to receive transfer pricing information. The form should be the most convenient format for the tax administration to process and respond to the information received, if required.

Disclosure requirements included in legislation may be part of the regular submission of annual returns at the end of accounting/assessment periods or be required as a result of the conclusion of a transaction. In these cases, taxpayers are required to inform the tax administration of the existence of a related party transaction, and to provide the details of that transaction.

On the other hand, the legislation may require the taxpayer to retain the information and provide it to the tax administration only upon request. In that case the taxpayer has the responsibility to have adequate documentation to prove that the transaction was effected at arm’s length if required or challenged by the tax administration.

An example of information requirements on transfer pricing in filing the annual income tax return is a related party transactions reporting form. One specific example is the Australian International Dealings Schedule that has to be filed together with the annual corporate income tax return. Another example is the Brazilian Certified Digital Tax Bookkeeping (Escrituração Contábil Fiscal – ECF) where the taxpayer is required to report all transfer pricing transactions taking place on an annual basis. The South African transfer pricing questionnaire, required to be submitted with the annual corporate tax return, is another relevant example.

The mandatory disclosure of key information is the most suitable option for tax administrations with capacity constraints— it may, as a result, be the preferred option for a developing country with limited resources to gather taxpayer information. Under this option, it is important for the regula-tion in force to make disclosure of information a function of the transfer pricing legislation so that the obligation to report derives directly from the main legislation (without any additional administrative requirements). That will provide tax administrations with taxpayer information which would allow them to better target audit procedures. Tax administrations should make sure they have human and technological resources in place to be able to process and benefit from this information, as well as balance the informa-tion request with the level of burden to taxpayers.

Documentation requirements for transfer pricing are described further in Chapter 12.

As mentioned in 10.1.4.8 above, some tax systems contain a general recognition of the basic aspects of a tax obligation, and then issue more extensive regulations explaining how the rules should apply in practice. For the purposes of this chapter, this essentially means recognizing the arm’s length principle and the basic principles applicable to transfer pricing through the primary legislation.

There are some countries where all transfer pricing rules are provided in the domestic substantive/primary tax legislation without further provisions in subsidiary regulations. Such provisions are binding on the taxpayer and the tax administration.

In some jurisdictions the substantive provisions to observe the arm’s length principle are included in statute but details are then set out more comprehensively in subsidiary regulations. Depending on the country, subsidiary regulations may have the weight of law and are therefore binding for tax authorities and taxpayers.

Sometimes domestic tax systems are not able to confer the appro-priate weight of authority to the accompanying regulations (as a result of the way the domestic tax system is organized or due to the legal system), or the bulk of the interpretative provisions are only prescribed through administra-tive guidelines (circular letters). These may be binding for the tax authorities, but not taxpayers. That is, the taxpayer can rely on, but may not be bound by, those rules.

Developing countries should assess which system is most suitable considering their own domestic tax legislation. Objective statutory provi-sions tend to provide greater certainty because they are binding on all parties. Consideration should also be given to the status of rulings provided to specific taxpayers where applicable. See further section 10.3.2.2 and following for details on advance rulings.

Article 9 (Associated Enterprises) of the UN and OECD Models sets out the basic conditions for transfer pricing adjustments and for corre-sponding adjustments where economic double taxation arises. Although Article 9 endorses the application of the arm’s length principle it does not set out detailed transfer pricing rules. The Article is not considered to create a domestic transfer pricing regime if this does not already exist in a particular country. Countries must therefore formulate domestic legis-lation to implement transfer pricing rules. Generally, countries apply
 

their domestic transfer pricing rules to cross-border transactions, but some countries opt to apply transfer pricing rules also to domestic trans-actions. For such countries, this might be in recognition of the fact that their tax bases can also be eroded through domestic transactions between related parties within the country, particularly where there are a number of different tax regimes in the jurisdiction (e.g. certain types of businesses or transactions that may be subject to different tax rates or special rules). Therefore, it is worth considering that when designing transfer pricing legislation, attention may also need to be given to compliance with the arm’s length principle for transactions between related parties within a given jurisdiction.

Another aspect worth taking into account when introducing or updating domestic transfer pricing legislation relates to the time lag between the conception and introduction of legislation and its approval by the legisla-tive bodies and entrance into effect.

As mentioned in section 10.1.5, there are variations between countries in the definition of an “associated enterprise”. The definition often uses a number of factors such as a minimum shareholding level and/or effec-tive control of personnel, financial or trading conditions, or other factors. There may also be a de minimis criterion which means that related party transactions only come within the transfer pricing rules if they exceed a certain threshold. Although international consistency in the definition of associated enterprises and application of the arm’s length principle is benefi-cial, each country must design its transfer pricing legislation in a way that is consistent with its legal and administrative framework, treaty obliga-tions and resources. This can also be an evolutionary process; as the country develops its transfer pricing regime, it will also need to ensure that the administrative rules in other relevant domestic legislation are simultane-ously kept up to date.

Some countries may include safe harbour rules to exempt taxpayers who have met certain criteria from the need to comply with specific aspects of the transfer pricing rules. This reduces taxpayer compli-ance costs, increases certainty and also reduces costs of tax collection. The tax administration can focus audit resources on higher risk cases in terms of revenue at stake and risk of non-compliance. Safe harbours may however encourage tax planning and avoidance if they are not carefully designed in terms of scale and scope and/or are incompatible with the arm’s length principle. There is also a risk of double taxation and double non-taxation where rules differ between countries. For further discussion see section 10.2.2.

Safe harbour rules are rules that apply to a category of transactions, allowing the application of simplified transfer pricing rules, or an exemption from the transfer pricing rules. In other cases, the safe harbour may exempt certain transactions or taxpayers from the application of transfer pricing documentation rules, as discussed later. Ideally safe harbour rules approx-imate outcomes under the arm’s length principle to avoid double taxation or double non-taxation, or to avoid creating market distortions. These rules could be limited to taxpayers with a magnitude or amount of controlled transactions below a threshold amount, expressed as a percentage or in absolute terms. A safe harbour rule can be relied upon by a taxpayer as an alternative to a more complex and burdensome approach, such as applying a comprehensive transfer pricing analysis, including a search for appropriate uncontrolled comparables. There are other types of simplified mechanisms for transfer pricing that certain countries also categorize as safe harbours. A safe harbour is normally made available at the option of a taxpayer— it is generally regarded as a condition that the taxpayer can choose to apply or not; see also 10.2.1.4. Other simplified or prescriptive rules which operate similarly to safe harbour rules, but which operate on a presumptive basis rather than at the option of the taxpayer may also apply.

Safe harbour or other prescriptive rules can be an attractive option for developing countries with limited access to resources and data (e.g. on comparables), mainly because they can provide ease of administration and predictability of the transfer pricing regime, using simplified rules to estab-lish transfer pricing outcomes. There would be cases where information sourced from tax returns of taxpayers can support the design of safe harbour rules, for instance when the information is in aggregated format and can be made available publicly without breaching confidentiality. Supporters of these types of rules point to the advantages of streamlining compliance, focusing compliance efforts on higher risk or more complex transactions, and providing certainty for taxpayers, as well as administrative simplicity for tax authorities.

It is often stated that safe harbour rules allow tax administrations (especially those that are just beginning to administer transfer pricing laws) to focus limited resources, including audit resources, on the more complex and higher risk cases. Given the difficulties of information availability, collec-tion and analysis, many developing countries might consider that at least for SMEs or less complicated transactions, safe harbour rules can contribute to minimizing the complexity and burden of establishing transfer prices. These burdens might be disproportionate to the size of the taxpayer or its level of controlled transactions that are subject to the transfer pricing rules.⁹⁸

Notwithstanding the notions reflected in the paragraphs above, when considering the introduction of safe harbours, it is necessary to analyze the pros and cons of the proposed measure. This can include e.g. contrasting the benefits in terms of a reduction in administration costs versus forecasted levels of tax collection, as well as the trade-off and impact of the measure on factors such as foreign direct investment, etc.

Safe harbour rules may also be useful in relieving SMEs of compli-ance burdens that disproportionately affect them as compared to larger MNEs (and may affect their ability to compete). Such rules may also relieve similar compliance burdens on taxpayers in relation to small or less risky transactions (e.g. transactions with no unique and valuable intangibles or significant risks). For example, safe harbours can decrease the compliance burden to some extent by their application to a certain class of transactions within a certain defined threshold, such as low value-adding services and interest rates in respect of short-term inter-company “plain vanilla” (i.e. on standard terms) loans of moderate value.

There are at least three concepts that safe harbour rules may prescribe: the category of eligible transactions, the transfer pricing method and the corresponding range or result to be used. In this context, even though the first two concepts may be introduced by regulation, administrations may publish the applicable range or result in administrative regulations, in order to ensure that the benchmark can be updated periodically.

There are possible downsides to safe harbour and other prescriptive rules, including the possibility of abuse or that the rules diverge from arm’s length outcomes. An example of such abuse could include breaking down what is in reality a large transaction into several smaller ones in order to remain within the safe harbour threshold. There is also a risk that taxpayers’ lobbying efforts could make it difficult to remove safe harbours when they are no longer needed, or when conditions have changed so that such rules are no longer appropriate. There is also the possible risk that safe harbour rules are too generous; this can result in revenue being unnecessarily foregone. This will also be the case if transactions that would otherwise have been concluded at market prices are priced at the limit of the safe harbour. Or there may be a distortionary impact in that such a regime may encourage and perpet-uate an economy based on small-scale or low-profit transactions rather than higher-risk/higher-reward transactions (e.g. technology based) to which the safe harbours will not apply. Safe harbours may thus even discourage invest-ment in high-margin activity as compared to low-margin activities.

The UN, OECD, World Bank Group and the IMF are all agencies which consistently engage with countries on international tax issues and provide capacity development assistance. Countries generally need to request training which may be specific to the requesting country, or may be provided regionally, in the context of a larger group of tax administrators.

The UN and the OECD have standing committees which meet regularly to discuss existing and emerging issues in transfer pricing. Following these processes is key to keeping domestic transfer pricing regimes updated. Engaging in international tax dialogue is also a means to obtaining updated information with respect to the latest developments in transfer pricing.

The UN and the OECD have standing committees which meet regularly to discuss existing and emerging issues in transfer pricing. Following these processes is key to keeping domestic transfer pricing regimes updated. Engaging in international tax dialogue is also a means to obtaining updated information with respect to the latest developments in transfer pricing.

The PCT, a joint initiative of the UN, OECD, World Bank Group and the IMF, has issued a number of toolkits on international tax issues of particular relevance to developing countries, including transfer pricing.

Some national and regional tax administrations also provide very good guidance in the field of international taxation in general, and transfer pricing specifically, in areas where they themselves face difficulties in compliance and policy formulation, as well as providing their interpretation of certain international tax provisions. These national tax administrations, regional organizations and others could be followed and even consulted by developing countries wishing to resolve perhaps similar problems arising as a result of the application of their own transfer pricing rules.

Finally, some academic institutions, research centres and think tanks have funds to invest in capacity development in developing countries and encourage their experts to provide such assistance.

Like-minded tax administrations should come together to share experiences and tax information which they consider useful for other tax administrations. That is particularly relevant for countries that share borders, have similar legal backgrounds or may be part of a regional economic group.

By acting within an organized group, tax administrations can share training expenses while promoting capacity development, disseminating knowledge, and sharing training content received from intergovernmental institutions.

In general, tax authorities in developing countries lack suffi-cient qualified and experienced personnel to deal with controversial transfer pricing issues, especially in view of global developments around new, rapidly developing topics such as BEPS. Regular training, information exchange and experience sharing and even foreign language skills, are all examples of aspects that are necessary for capacity development. A knowledge sharing platform with other tax authorities (a regional institution, or a clearing house institution) could be an important step in this regard. International secondments to gain more experience at the UN, the OECD or in another tax administration should be considered if possible. An independent external consultancy body might also be an option, as explained below. Other capacity development issues are covered in detail in Chapter 11.

A risk of miscommunication between taxpayers and revenue authorities is one of the main challenges in countries where transfer pricing regulations are relatively new. A greater pool of transfer pricing experts would be helpful to revenue authorities and taxpayers who are trying to address complex transfer pricing issues in such countries. A pool of experts might be found from engagement with regional intergovernmental organiza-tions, neighbouring countries, countries sharing the same language or from active participation in South-South dialogue. These experts could assist, e.g. revenue authorities and taxpayers in advanced dispute resolution processes to provide expert perspectives. This could be a short-term solution to help to reduce the number of protracted enquiries where taxpayers have tried to apply approaches that are consistent with international principles.

The joint UNDP-OECD initiative called Tax Inspectors Without Borders (TIWB) may be an additional source of expertise combining exper-tise from both developed and developing country tax administrations.

This section seeks to provide advice on the instruments that exist for tax administrations to introduce policies that draw upon the current international discussions, without having to go through the whole legislative process in modifying tax legislation.

Tax rulings work very similarly to APAs. One of the differences between them is that a tax ruling can be granted on any tax issue, and an APA relates only to the application of the transfer pricing rules. Another differ-ence is that a tax ruling is unilaterally issued by the tax authority, while an APA reflects an agreement of both the taxpayer and tax authority. As under an APA, tax rulings tend to grant greater legal certainty by establishing, a priori, the correct tax treatment in relation to a particular issue or transac-tion. A ruling may also be used to attract foreign direct investment, assuming that the tax administration uses the tax ruling to bring certainty.

Tax rulings also help create an active tax dialogue between taxpayer and tax administration and may stimulate greater cooperation by encour-aging taxpayers to come forward with queries in exchange for early certainty. Since tax rulings are tailored to a specific taxpayer or group of taxpayers, they can also be used to clarify the interpretation of domestic tax legislation as it applies in a particular situation, without having to make changes to the statute or supporting regulations. To that extent, and because the legisla-tive process runs a lot more slowly than the conferral of an administrative decision, a rulings programme might be helpful in allowing countries to follow the trends set in the international scene. A country wishing to grant tax rulings needs to have the legal basis for it in its domestic tax legislation.

In accordance with the minimum standard, Action 5 of the BEPS Report also establishes a commitment to transparency through the compulsory spontaneous exchange of relevant information on taxpayer-specific rulings.

Depending on the design of tax rulings, they can be a useful starting point in avoiding disputes between the taxpayers and tax adminis-trations as discussed in Chapter 15.

Developing countries might benefit from establishing an independent organization (an expert body, composed of academics, industry experts, and/or government officials) to advise them on the ways through which they might be able to fine tune or update their legislation. An independent advisory group could suggest updates, point out controversial issues in the country’s legislation, suggest action in certain transfer pricing areas, and even audit the country’s tax legislation for improvement.

Developing countries could, through participation in regional and global dialogues, benefit from the use of existing consultancy bodies used by countries with similar legislation, or countries located within the same geographic region. This may help manage costs if countries opt to be evaluated contemporaneously with each other. The effort could be hosted in an existing cooperation organization, as mentioned above, or within a UN specialized organization to further manage costs. Regional organizations, such as ATAF and CIAT, are known to have also provided similar capacity for their member countries.

This Chapter addresses issues involved in setting up a dedicated transfer pricing unit in the tax administration to administer the country’s transfer pricing rules. There are important opportunities as well as chal-lenges in setting up such a unit for the first time. The design of such a unit, its vision and mission statement and the measurement of whether it has been successful must take into account factors such as:
►    The relationship between the tax policy function and the tax administration function;
►    The need to evaluate current capabilities and gaps to be filled;
►    The need for a clear vision, a mission and a culture that will facilitate effective administration of the law;
►    Organizational structure;
►    Approaches taken to building team capability;
►    The need for effective and efficient business processes;
►    The advantages of staged approaches to reaching long-term goals; and
►    The need for monitoring to assess effectiveness and for ongoing fine tuning of the organizational structure and administrative processes.

These points provide a useful framework when setting up a transfer pricing unit. There is no perfect “template” that will be suitable for all coun-tries in every respect. These issues will all need consideration in the context of the country’s overall tax administration and legal structures.

In most countries, the tax policymaking function generally resides with the Ministry of Finance rather than with the tax administration. The other revenue collecting organs of government (e.g. the Customs service)¹⁰⁵ are also often separate from the tax administration. There is, however, a particular need to bridge the gap between the policymaking function and the tax administration in order to implement an effective transfer pricing regime. This need arises due to:
►    The complexity and resource intensiveness of administering a transfer pricing regime;
►    The potential costs of compliance for taxpayers and of collection by tax administrations;
►    The large amounts of money that may be at stake; and
►    The international dimension given the link to binding tax trea-ties through provisions based upon Article 9 of the UN and OECD Model Conventions, issues of potential double taxation, and the interests of other countries.

The respective responsibilities and functions relating to tax adminis-tration and policymaking should be clear. Mechanisms for contact and coor-dination between the two should be well understood. Duplication and overlap of functions should be avoided, and processes for coordination between the two should be streamlined.

Some factors that could improve cooperation between the functional areas include:
►    Recognition of the need to have a “policy feedback loop” so that the policy reasons for a transfer pricing regime are properly reflected in the design of that regime and in its administra-tion, and so that practical lessons from the administration of the regime can provide feedback in order to fine tune policy.
Examples are:
►    Where aspects of the policy are expensive or otherwise very resource intensive to administer, and the likely revenue return is not commensurate with these costs;
►    Where a wider treaty framework and strong exchange of information provisions would be beneficial; or where there is a need to ensure that the framework of thresholds, deterrence mechanisms, and penalties is effective and up to date; and 
►    Where the experience of the administration in taxpayer ser-vice, education, enforcement, and case resolution can aid in improving legislation or implementing regulations;
►    Cross-secondment of tax administrators and policymakers to each other’s teams can help ensure that administration officials understand the policymaking process and the objectives of the legislation, and that policymakers understand the practical issues of tax administration. Good tax policy must be capable of being administered and good administration must have sound policy underpinnings; and
►    Involvement of the tax administration in developing investment policies, including involvement in discussions about tax incen-tives that may affect transfer pricing and other aspects of tax administration.

Different tax administrations require different types of admin-istrative arrangements when it comes to implementing a particular coun-try’s transfer pricing policies. The level of development/capability in the tax administration should be a key factor to consider when formulating policies. In many cases, there is an unrealistic expectation that increases in capabil-ity across many areas can be achieved in a short time. Skill in administer-ing transfer pricing rules can only be developed by practical experience in addressing actual transfer pricing cases.

In addressing the issue of building transfer pricing capability, it is important to realistically evaluate the actual level of existing knowledge and the best organizational approach. The focus in this Manual is on coun-tries with little or no existing experience in transfer pricing, so there are initial start-up issues. There is also a recognition that not everything can be achieved at once and that the system and the administrative capability will need to evolve over time through practical experience and as part of a capac-ity building plan. This is sometimes termed a “life cycle approach”. A possi-ble approach is outlined below in Figure 11.D.1.

Figure 11.D.1
 

Source: Choo, C. W., & Bontis, N. (Eds.). (2002). The Strategic Management of Intellectual Capital and Organizational Knowledge. Oxford: Oxford University Press.

Factors to consider when assessing the level of development/capabil-ity of the tax administration include:
►    Levels of education and expertise of personnel involved with administration of transfer pricing rules;
►    The legal environment or framework (as addressed in Chapter 10.) including the characteristics of the transfer pricing legisla-tion and responsibilities for and the scope of regulations. A clear and transparent legal framework is important to the functioning of the administration as a whole;¹⁰⁶
►    Whether or not a network of comprehensive bilateral tax trea-ties exists, including articles relating to Associated Enterprises (usually Article 9), the Mutual Agreement Procedure (usually Article 25) and Exchange of Information (usually Article 26). Additionally, the existence of any more limited exchange of information agreements should be evaluated—especially with the countries of residence of key participants in the economy and their related parties;
►    Availability of necessary economic and financial information within the country/tax administration; and
►    Availability of information technology systems that allow for the most effective strategies to encourage compliance, develop and support audit strategies and facilitate collection and litigation where necessary, as well as availability of personnel skilled in using such systems.

The objectives of the transfer pricing team should be clear, both to team members and to others they are engaging with. This includes other persons in the administration, those involved in the tax policy function, and stakeholders such as taxpayers and their advisors. Often this is put in terms of developing a “mission statement” reflecting what the transfer pricing unit will do in its daily operations and a “vision” representing what an ideal future will look like when the unit carries out its mission properly. Many tax admin-istrations also have a “Taxpayer’s Charter” which reflects what taxpayers can expect from the administration, and what is expected from taxpayers in their relationship with the administration.

Documents reflecting the mission and the vision should become part of the culture and be “lived out” by the unit on a daily basis. This will be assisted by, for example, developing a team charter aligned with the wider organizational charter agreed by senior managers in the transfer pricing unit and key persons in the tax administration as a whole, preferably after input from stakeholders. This could usefully draw upon the experience of other coun-tries, though it must be tailored to each country’s own realities. It is of course necessary to monitor the achievement of the mission and vision in practice and, if the mission and vision have not been achieved, to identify the reason for that.

An important part of defining the unit’s objectives involves identi-fying and recognizing the limitations on available resources. Clearly deter-mining what is inside and outside the competence of the unit will help clarify what resources are needed to meet the objectives of the unit and encourage the best use of such resources.

A central consideration to be borne in mind is that a transfer pric-ing unit will have important taxpayer service and education functions as well as an enforcement function. These functions are interrelated: better educa-tion and taxpayer service reduces the cost, resource-intensity and “pain” of compliance. This, in turn, helps increase compliance (those wanting to comply find it easier to do so) and allows the administration to focus enforce-ment measures on the greatest risk areas (in particular, on taxpayers that are unwilling to comply with their obligations).

Understanding the functions and environment of MNEs will further the tax administration’s service, education, and enforcement activ-ities. Handling their taxation issues will inevitably lead to more contacts between MNEs and the transfer pricing unit. For instance, MNEs have to disclose their documentation and systems, while tax administrations have to be aware of the dangers of unnecessarily high administrative burdens, and therefore compliance costs, for MNEs. High compliance costs are inefficient and may unnecessarily give a negative view of a country’s investment climate, deterring potential investors.

On the other hand, increased focus on transfer pricing issues will inevitably lead to some disputes with MNEs and the possibility of double taxa-tion. For example, in a related party transaction involving entities in two coun-tries (A and B), Country A might assert that more profits from the transaction are subject to its tax jurisdiction in accordance with a bilateral treaty, resulting in fewer profits being (in Country A’s view) subject to tax in Country B. This is an increasingly common issue in transfer pricing and tax administrations need to devote sufficient resources to avoid unnecessary differences of opinion. They need to ensure, where possible, that those differences do not lead to unneces-sary disputes and they need to deal with formal dispute resolution procedures as expeditiously and effectively as possible when a dispute cannot be avoided.

Most double tax treaties contain a Mutual Agreement Procedure (MAP) article (usually Article 25), based upon the UN or OECD Model Tax Conventions, that is designed to avoid double taxation. However, MAP can be very resource-intensive and costly for both tax authorities and MNEs. As such, it is especially worthwhile to put sufficient energy and resources into risk assessment and establishing contact points between the tax administra-tion, the competent authorities under tax treaties, and policymakers to avoid unnecessary adjustments in tax assessments. See 15.5 for details on MAP.

Engagement with taxpayers and their tax advisors is necessary to understand the transfer pricing systems and practices of MNEs, and for the MNEs to understand what is required from them in a newly introduced transfer pricing regime. This will help taxpayers and the tax administration to explore shared interests in clarity, transparency, and certainty, to under-stand and reduce the risks of aggressive tax positions, to increase awareness of commercial realities, to promote fairness and consistency between taxpay-ers, and to reduce the costs of compliance and collection.

There is a need for considerable early investment in taxpayer educa-tion. The tax administration also needs to ensure professional and effective relationships with taxpayers as an element of taxpayer service. This is one area where the experience of other similarly placed administrations is likely to be especially helpful.

Overall, there needs to be a sustained commitment to this part of the “set up process”, which is designed to maximize compliance and to assist in risk management (by helping differentiate non-compliance due to lack of understanding from more deliberate and therefore systemically risky non-compliance). A fair amount of institutional patience and sustained commitment is required if the transfer pricing regime is to fully meet its medium- to longer-term goals.

Some specific steps through which this can be achieved by tax administrators include:
►    Knowing taxpayers and their commercial environment, as well as their main issues and concerns, and having in place continu-ous dialogue with taxpayers, tax professionals and their associa-tions or peak representative bodies on tax issues;
►    Being reasonable and proportionate in actions, and open and transparent with taxpayers;
►    Being responsive to requests;
►    Extensive and clear taxpayer education, including making tax guidance notes, information circulars and other guidance on interpretation of tax laws available to taxpayers to help avoid misunderstanding, confusion and surprises to those willing to meet their obligations;
►    An informative and easy to navigate Internet presence that is regularly tested and kept under review for its user-friendliness and relevance;
►    Seeking to avoid disputes arising unnecessarily but also set-ting up clear and fair systems for addressing such disputes that do not unfairly deter taxpayers from pursuing legitimate grievances; and
►    Providing a process for obtaining advance rulings and advance pricing agreements on specific issues as appropriate.

Steps that could be encouraged among taxpayers and their advi-sors include:
►    Being transparent and open about their risks, including by making timely voluntary disclosures to the tax administration;
►    Preparing accurate and complete transfer pricing documentation in accordance with the guidance on documentation (see Chapter 12 of this Manual);
►    Requesting and obtaining advance rulings before embarking on activities with important tax consequences, or participating in advance pricing agreements where they exist;¹⁰⁷
►    Making their transfer pricing policy available to the tax adminis-tration as part of required documentation;
►    Recognizing the resource limitations on the side of the adminis-tration and not “playing games” to tie up those resources unnec-essarily to the disadvantage of the administration and other taxpayers; and
►    Complying with and understanding the requirements and limi-tations of the bilateral double taxation treaty between the coun-try they are operating in and the country of their headquarters or associated enterprises.

A “risk management” approach to the unit’s work is recommended; this is true for the tax administration as a whole, but particularly when deal-ing with a new regime involving the complex and resource-intensive issues of transfer pricing. This means having robust processes in place for:
►    Identifying transfer pricing risks;
►    Analyzing risks (including prioritizing them in terms of their likelihood and their impact should they occur); and
►    Determining what can be done to avoid risks or to limit their adverse consequences if they cannot be avoided.
The obvious risk is that taxpayers do not comply with the law, but other risks, such as risks to public confidence in the system if taxpayers are not seen as meeting their tax obligations also need to be considered.

Issues and procedures related to risk assessment and management are considered in more detail in Chapter 13 of this Manual. In setting up a transfer pricing unit, however, it should be recognized that there is an impor-tant role for officers attuned to the organization’s approach to risk manage-ment and able to implement it systematically for a new area and keep it under review. Consistent risk management strategies will often be developed in conjunction with other areas of the administration, such as those dealing with tax treaties, specializing in the tax affairs of relevant industries or in offices that are differentiated based on the size of a taxpayer.

As part of this risk management approach, it is important to identify the areas of focus. For example, developed countries with long established transfer pricing regimes and administrations tend, in practice, to have crite-ria that define their areas of greatest or least current focus. This often includes thresholds below which they would generally not audit or adjust a controlled transaction for transfer pricing purposes, especially in relation to small and medium-sized enterprises or for transactions below certain values.¹⁰⁸

The criteria referred to above will have to be assessed for each coun-try in the light of its own circumstances and will have to be kept under review to make sure these criteria are not subject to abuse.

An important part of implementing a transfer pricing regime is determining which part of the tax administration should undertake transfer pricing work. The generally observed options include:
►    Creating a transfer pricing department or division, tasked with the responsibility to handle all transfer pricing work;
►    Placing the transfer pricing work within an international opera-tions group within the tax administration; or
►    Considering compliance with the transfer pricing regime a part of the compliance responsibility of all taxpayers subject to these rules, and seeking to train all officers who are likely to face transfer pricing issues.

In addition to one of the three options above, tax administra-tions also have the option of creating specially designated teams or divi-sions within other departments, to deal with high profile cases, special cases or with certain groups of taxpayers. In this case, countries might also consider:
►    Placing the work within a Large Taxpayers Unit/Office (LTU/ LTO) and building up capacity of officials working within that office in transfer pricing.
►    Developing transfer pricing capacity in specific industry-focused units which the tax administration considers to be particularly important to the economy and/or susceptible to transfer mis-pricing—e.g. pharmaceuticals, automotive, oil and gas, mining and natural resources, etc.

The choice to be made by a particular country will depend on its circumstances and capacity. The choice may also be dynamic. For exam-ple, in the early stages of the regime being implemented, the transfer pric-ing work can be concentrated in the part of the tax administration that deals with international tax issues. As capacity is built and more cases are seen, a new section can be created within the LTU/LTO where the most high-profile cases may be expected to emerge. Over time, more specialist knowledge can be built up and spread wider across the tax administration.

Some tax administrations have organized themselves based on taxpayer segmentation according to size or industry sector allowing for the creation of centres of competence or expertise in dealing with issues common to the segment. Such units are often part of an administration structured along functional lines, focusing on the taxpayer as the admin-istration’s “customer”. A principal objective of taxpayer segmentation is to minimize compliance costs. It is quite common to allocate the transfer pric-ing inspection division to the LTU/LTO, which is then considered the central repository of experience.

Such an allocation of responsibilities can foster evolving and increasing learning approaches. A good example is Brazil where the trans-fer pricing programme in the LTO (known as the DEMAC) focuses its audits mainly on specific sectors such as pharmaceuticals and automobiles. However, as the audit teams continue to grow in sophistication in their approaches, and also in number and experience, the focus has become broader.

Finally, the design of a good tax administration must include an effective audit programme capable of detecting and penalizing non-compliant taxpayers. Such an audit programme could grow out of a larger compliance team and could include industry and/or issue-oriented audits, compre-hensive regular audits of specific businesses that fall within risk criteria and fully-fledged tax fraud investigations. Joint investigation programmes to deal with suspected cases of non-compliance for corporate income tax and indirect taxes, such as value added tax (VAT), may also be planned by more sophisticated tax administrations. See further Chapter 14 on Transfer Pricing Audits.

Public consultation with business and stakeholders prior to implemen-tation or modification of legislation, regulations or guidance material may help create more common understanding between the taxpayer and the tax admin-istration. This will help to likely reduce potential future disputes by allowing time for taxpayers to foretell the issues that might cause greatest concern.

Use of information and communication technology (ICT) is a central feature in the delivery of tax administration services. Tax admin-istrations should consider use of ICT to increase transparency in the tax system and to automate processes. An increase in transparency means making information more readily available, without the need for personal contact. An automated communications system can provide relevant inter-nal stakeholders with online access to templates, case studies, step-by-step guides, explanations of legislative changes and relevant information geared towards specific industries or types of taxpayers. Automation of processes could include introduction or extension of electronic filing of transfer pric-ing related compliance obligations, and possibly the use of trusted third-party platforms. These measures have the potential to significantly reduce business compliance costs, improve taxpayer confidence and increase simplicity; they may also support anti-corruption initiatives and improve perceptions.

There are two basic types of structures that can be adopted for establishing transfer pricing capability: a centralized model, with a single transfer pricing unit operating across all industries and geographical areas, or a decentralized model, with separate transfer pricing units by industry or geography. Each has advantages and disadvantages, as follows.

A centralized model presents the following advantages and disadvantages:
►    Advantages: coordination and adjustments to the transfer pricing approach are made easier in the start-up phase; knowledge is built up more quickly; the model is aligned with a centralizing tendency in tax administrations (driven in part by the desire for all-encompassing technological developments and compliance strategies); there are clearer lines of authority, communication and reporting within the unit; and communications with other areas tend to be more coordinated.
►    Disadvantages: there is a risk of being in an “ivory tower”— out of touch with realities on the ground; and a risk that over-centrali-zation may reduce transparency and create opportunities for mis-management and corruption. As transfer pricing experts will need, in any case, to work with experts from outside that group, such as people with various auditing skills, and more general tax auditors with some transfer pricing experience, it is at the very least impor-tant to guard against such an “ivory tower” mentality (and against being perceived as such) and ensure frequent interactions and exchanges of ideas and even personnel between such groups.

A decentralized model presents the following advantages and disadvantages:
►    Advantages: there are shorter lines of communication with tax inspectors; the model more easily allows for combined industry and transfer pricing knowledge; and facilitates a long-term broader dissemination of transfer pricing awareness.
►    Disadvantages: there are risks that team members may lack a single vision and coordination since they need to cover all tax issues rather than focusing on transfer pricing. Such coordina-tion problems may lead to inconsistencies, lack of experience sharing and issues “falling between gaps”; and some taxpayers may take advantage of a lack of coordination by, for example, “picking and choosing” who they approach for rulings.

Whatever model is followed, it is important to have a clear and coordinated approach to transfer pricing issues and their possible solutions, especially as MNEs will generally be far more familiar with transfer pric-ing issues than individual tax officers in a start-up unit. It is impossible to immediately bring the tax administration to a high level of knowledge in all relevant areas, especially when having to deal with many different indus-tries. Measures need to be put in place to ensure good working relations with tax officials who are experts in particular industries, and tax officials in the various regions where transfer pricing issues may arise, including by regular meetings and formal contact points on both sides. This will help ensure the best realistic capability is achieved as soon as possible in terms of educating taxpayers and the administration on transfer pricing; responding to taxpayer requests; identifying compliance issues and their links to other tax issues; and addressing those issues.

It is very important to bear in mind the taxpayer service aspect of the work: the taxpayer should be able to go to a “one-stop” contact point to deal with all issues relating to transfer pricing. That contact point should in turn be responsible for the internal coordination, rather than the taxpayer in effect being forced to act as coordinating agent for the administration. This also helps to promote broader consistency and coherence within the administration.

The benefit of a “one-stop” contact point is also one of the reasons why many administrations have LTOs, often with specific industry contact points, to handle relationships with MNEs and other large taxpayers, espe-cially in key sectors of the economy such as resource extraction. These offices can respond in an integrated fashion to diverse issues across different subject areas (for example: income tax, VAT and resource royalties) as well as issues of particular importance for some taxpayers such as transfer pricing and thin capitalization. They usually have auditing, registration, tax account-ing, collection and taxpayer service roles and are sometimes seen as espe-cially useful when implementing new approaches, including major policy or administrative reforms such as self-assessment or computer modernization of the tax office as an “incubator” for change elsewhere.

In a monitoring and intelligence gathering sense, this sort of structural approach can also enable more proactive analysis and action to deal quickly with emerging issues, such as unexpected falls in revenue from key industries or segments. Such falls may merely reflect economic conditions but could, alternatively, reflect emerging compliance risks¹⁰⁹. Finally, reform of the administration as a whole may be a long-term project, because of a systemic need for skill development or integrity issues that need to be remedied. For example, it is sometimes considered that assembling a well-functioning, trusted and skilled large taxpayer office is the quickest way of safeguarding and monitoring key sectors while preserving relationships with taxpayers. This experience may also provide lessons that can be applied to the reform of the administration more generally.

Many countries adopt a highly centralized model for their trans-fer pricing unit at start-up. This reflects the importance of coordination and uniform approaches at that time; it also recognizes that a transfer pric-ing unit is not designed to have a specific lifespan but rather will become a permanent part of the tax administration’s structure. Several models can be used to take transfer pricing capability further after this start-up phase. It is possible to create teams for every region that can exclusively deal with transfer pricing cases, for example. National coordination is then achieved by ensuring team members from each region work together and discuss the latest developments in transfer pricing.

Another model is to make all corporate income tax inspectors responsible for transfer pricing cases. In that case it is sensible to appoint some regional focal points who have to be aware of all major issues and are responsible for ensuring linkages with policymakers.

As noted above, some countries also have a separate office deal-ing with large MNEs because of their specific characteristics, their relevance in terms of investment, the tax revenue they may generate, and the related tax issues that are of special importance. Such an office can be organized on a national level or within the regions, depending on the number of MNEs that are active in the country. As noted above, this unit should as far as possi-ble act as a central contact point (or “one-stop shop”) for responses on MNE issues and it will therefore need to contain transfer pricing expertise or at the very least work especially closely with the transfer pricing unit.

A new transfer pricing regime may often be created as part of major changes within a tax administration, such as recognition of the impact of globalization and international value chains in that particular country. As with most changes there are potential advantages and disadvantages. While the human resources management strategy for the unit needs to be inte-grated within that of the organization, there are aspects that are likely to be of particular relevance in this area, including the importance of:
►    The unit’s “culture”, focusing on achieving the organizational vision, mission and objectives; motivating and providing incen-tives for performance; measurable goal setting; and mutually agreed and annually updated performance objectives and stand-ards. In a new team, the importance of this work and of good team leaders should not be underestimated;
►    Broadly trained officers who understand the importance of investment for a country’s development (including the impor-tance of avoiding double taxation) and understand the drivers and environment of business, yet believe not only in the crucial importance of collecting the country’s appropriate tax take but also in the necessity of public confidence in the integrity of the system and in their actions as tax officials;
►    Internationally focused officers (including those familiar with the languages most used by international business) who meet routine business needs but are proactive, creative and adaptive to new ideas and challenges, seeing change as an opportunity;
►    Officers who are keen to develop and to explore the most efficient and effective ways of doing their work and are patient in dealing with the large demands, complexity and often slow progress of transfer pricing cases rather than seeking to “cut corners”;
►    A strategy for the identification and development of managers who are respected, have integrity and can motivate staff and help them share the vision of the unit and the organization;
►    A strategy for recruiting and retaining appropriate technical leaders and team managers. This strategy can be furthered by discussions, rulings, meeting clients in teams and forming a database of experience—not to be used blindly, but to encourage consistent and appropriate ways of analyzing issues and reaching conclusions; and
►    Clear career prospects and incentives (such as learning oppor-tunities and secondments) for successful officers, based on per-formance assessments that are fair and objective, and reflecting the aims of the unit. This means that excellent taxpayer service should be rewarded, not merely activity that appears to be more directly revenue generating. In particular, there are clear dangers in incentives based mainly or wholly on the level of adjustments made, as this can encourage unjustified or inappropriate adjust-ments. In any case, it may take years to establish whether an adjustment was justified or not, perhaps long after the officer has moved on. Such unjustified adjustments are, in fact, counterpro-ductive to the success of the unit in establishing confidence in the system and providing taxpayer service.

Practice has shown two particular human resources–related risks at this stage. First, there is the possibility of resentment against those involved with transfer pricing policy and administration by others in more “established” areas. Because it is new, people within the organization do not always know exactly what it is about and feel uncertain. They can be unwilling or dismissive about taking up transfer pricing issues. Further, setting up a transfer pricing unit may require the recruitment of outside expertise in key roles. Existing staff may feel it is a “fashionable” area of work that draws resources and support away from their own equally important areas of work, or unduly rewards “outsiders” and “upstarts” who have not “paid their dues”. The interrelationship and equal importance of different aspects of the organization’s mission and vision need to be emphasized and “buy-in” established with other parts of the organiza-tion. However, it has to be stressed that building up capability in this area will involve new approaches and bringing in some fresh perspectives and new skill sets. The unit should not have a sense of superiority as part of its culture, but rather a sense of the importance of its work and of the opportunities to pursue broader organizational goals while furthering personal development.

The link can be established between an effective transfer pricing response and a more effective response by the organization to more general tax issues. Efforts can be made to have transfer pricing information and training sessions for officers elsewhere in the organization. This can reduce any impression that transfer pricing is a “black box” known only to members of the transfer pricing unit (or worse, that the unit and individual unit offic-ers want to keep it that way) and can emphasize natural linkages to the other work of the administration, such as thin capitalization or treaty negotia-tion and administration. Conversely, training in how particular industries operate, especially ones that are important in a country, will greatly help increase the effectiveness and focus of transfer pricing experts.¹¹⁰

There is, on the other hand, a risk that employees from the tax admin-istration will become overly enthusiastic about transfer pricing as a panacea and may, accordingly, propose unjustified or disproportionate tax adjustments leading to time consuming litigation or MAP. It is often stated that transfer pricing is not an exact science. That inexact quality can be abused by authorities as well as by taxpayers. It is thus important to manage this process, and ensure that any proposed transfer pricing adjustment is justified on purely transfer pricing grounds; it is also important to show that the discretion implicit in such an inexact situation is properly exercised. This involves integrity issues and it is important that decisions taken having a major financial impact are appropri-ately checked and “signed off” in a way that not only ensures (as far as possible) that they are made for the right reasons and consistently with the treatment of other taxpayers, but that they are also perceived as such.

Recognizing the many aspects of transfer pricing and that the unit will have educative and taxpayer service functions as well as an enforcement role, a transfer pricing unit should ideally include, or have ready access to, the following skill sets:
►    Team and project managers—people with demonstrated ability to put together new teams, whether or not they have specific transfer pricing expertise;
►    Economists;
►    Lawyers;
►    Accountants;
►    Auditors;
►    Database experts;
►    Business process experts (using information technology to evalu-ate, automate, integrate, monitor and help improve business processes); and 
►    Those with special public relations and communication skills, including the ability to: listen actively and effectively, solve problems, explain complex issues in terms that are readily understandable and act “diplomatically” with a view to longer-term productive relationships. The increasing scrutiny of transfer pricing policy and administration in most countries makes this especially important.

These various skill sets should be bound together not just by tech-nical knowledge and willingness to learn, but also by a common identifica-tion with the unit and wider administration’s objectives and ways of doing business. In addition, a deep understanding of what drives business and how it organizes itself to meet its own objectives needs to be internalized in the unit’s work. Having regular access to such skills is the ideal situation of course, and many countries with fairly new transfer pricing regimes have, of necessity, focussed initially on legal, economic, accounting, audit and data-base skills.¹¹¹

Dealing with MNEs demands specific characteristics and compe-tences. Transfer pricing is about how business operates and the application of complex tax laws and economic principles to those business operations. Knowledge of international taxation and good judgment is required to select the right areas to focus on and the right cases for an audit, as some transac-tions are more tax-driven than others. The ability to interpret information, and to sort the relevant from the irrelevant is becoming ever more important as opportunities to obtain information from other tax administrations and from MNEs themselves increases. Having information available but being unable to properly interpret it may put an administration in a worse position, espe-cially before the courts, than not having access to information in the first place.

Staff with a background in accounting have often been regarded as easy to train in transfer pricing as they are often enthusiastic about special-izing in this field, but similar enthusiasm can be found in those with other skill sets. Others, such as lawyers and economists have special skills in deal-ing with the often complex law and economics of transfer pricing cases, and one of the challenges in this area is having all those skills working together effectively.

At the initial stages, specific transfer pricing expertise may not be generally available in the country (or at least within the administration) and will in large part have to be developed. At a later stage expertise from outside may be encouraged to join the tax administration by job gradings that reflect the scarcity of skills, and good salaries— perhaps higher than usual salaries, although that can create resentment among other staff. Other non-financial incentives may be important, such as the ability to work on the governmen-tal “side”, perhaps with greater policy or legislative exposure (including at an international level) and improved lifestyle (by creating a more balanced work environment for those with children, for example). Developed countries may be willing to place one of their experts in a developing country as a compo-nent of Official Development Assistance (ODA) or to sponsor a promising officer from a developing country in a placement within their administration.

One study noted the value of having embedded experts seconded from other countries (sometimes the same official a few times each year) who have confronted similar problems and developed pragmatic approaches to deal with them.¹¹² Such experts can share their experience and give auditors more confidence in demanding information from taxpayers.

A key challenge of working closely with taxpayers is that many of the best trained experts from the tax administration may eventually leave to join the private sector. This will have an effect on individual cases as well as on the operation of the unit more generally. As noted in more detail below, a system designed to capture and spread knowledge of transfer pricing issues within the unit, which includes team involvement, effective management, and regular review of cases, will help to minimize the effects of these depar-tures, as will an effective system of recording and filing relevant transfer pricing opinions and material relating to particular cases. In any case, such interplay of “cultures” between the administration and the business sector over time can be useful for each of these entities; it helps each to understand what drives the other and what the expectations are.

In addition to technical expertise, “soft skills” are also important for officers to perform their duties. Negotiation and communication skills are essential since transfer pricing demands a great deal of interaction with MNEs. There will often be a range of possible outcomes in transfer pricing and room for discussion. Skills that help make these discussions as profes-sional and effective as possible are an important component of a successful transfer pricing unit.

Integrity issues may arise from the close contacts between business and the tax administration, the large amounts of money often at stake, the fact that transfer pricing requires the exercise of discretion and judgment in determining appropriate outcomes, and the fact that transfer pricing analy-sis often gives a range of results rather than a single clear answer. These issues can be exacerbated by a trend of many tax officials engaged in transfer pric-ing issues later moving to the private sector. The best way to deal with these issues is by having discussions with MNEs in teams and ensuring that records are kept of those discussions. The records should be internally reviewable to ensure that the proper policies and practices have been followed and to make sure a consistent approach has been adopted between taxpayers. This helps to ensure that working arrangements are transparent, open and incorporate built-in checks and balances that will reduce the risk of temptation on both sides. It is also important to recognize that officers should be given protec-tion from false accusations against their integrity, which may reduce their willingness to approach each case fairly and impartially. The checks and balances should be designed to support officers acting properly and maintain the effectiveness of the unit. A way for officers to bring issues of integrity to management attention (through secure channels that will act on such intel-ligence without punishing the whistle-blower and discouraging such behav-iour in future) should also be considered.

Regular internal audits of the members of the unit can form part of the system of checks and balances. These audits could include reviews of quality, consistency and timeliness of decisions as well as, possibly, of personal assets of individual officers (such as by declarations of assets and interests and checks as to their accuracy). If resources allow, some form of double-checking of audits including rotation of fresh auditors into such roles can prove to be useful in this respect.

A review process of important cases by a formal panel or informal reviews by a senior group is suggested as a way towards achieving coherence and consistency, adherence to administration rulings, integrity, sound tech-nical standards and effective case management. This can also, to some extent, form part of the on-the-job training. Those undertaking the review should ideally comprise not just officers from the unit, but also from other relevant areas. The group could include officers dealing with the type of business or industry (such as officers from the large taxpayer office if it is separate), intel-ligence officers, officers from the economic unit (if there is a separate pool of economists working on transfer pricing issues but not part of the transfer pricing unit— an issue discussed below), tax treaty experts and those deal-ing with potentially related areas, such as thin capitalization. This need for checks and balances is likely to assume even greater importance, with greater scrutiny of transfer pricing issues by civil society and parliaments likely in most countries over the coming years.¹¹³

A well-functioning transfer pricing unit needs both legal and economic expertise. Transfer pricing knowledge is about pricing, economic rationale, market knowledge, and business and industry knowledge. It is, however, also important to understand international taxation issues and the tax rationale underlying relevant transactions.

There are sometimes questions as to whether a group with a specific professional specialization, such as economists, should be distrib-uted within other teams or should comprise, at least in the start-up phase, a separate unit. Some of the same issues arise as in the set-up of a transfer pric-ing unit as a whole. The advantages of distributing economic expertise (as an example) more broadly are that economic issues are treated as just one aspect of the transfer pricing regime. As such, economics expertise is spread more broadly within the tax administration, and the economic perspectives are more easily integrated into the work of multidisciplinary teams.

The advantages of a separate pool of economists, on the other hand, are that greater “quality control” can be exerted, especially in the start-up phase, over the consistency of economic analyses. Further, econo-mists in a new area can discuss new issues and learn from each other more easily. As with any specialist skill, having economists working in groups at the start-up phase may also be seen as promoting integrity and an “aligned” and consistent approach to the issues that arise.

Whichever approach is adopted, efforts will need to be put in place to ensure sufficient linkages and knowledge exchange between the “pool” of economists and other officials that will be part of multidisciplinary transfer pricing teams. It may also be a good idea to consider developing a separate pool of risk assessment officers.

In some countries the educational system provides a steady supply of accountants, auditors, economists and lawyers from which the tax administra-tion can draw. In other countries the situation is more difficult either because the formal educational system does not produce enough qualified graduates or because there is more competition, especially on salaries, from the private sector. This will affect the type of training required and it is of the utmost importance to assess the knowledge, capabilities and competencies of officers.

In developing what might be called a “learning plan” for the unit and its individual officers, it is recommended to first assess existing capabil-ities. This cannot be done without a context, and that context must be the short, medium and longer-term objectives of the unit, so it is essentially a “gap assessment”. Such an assessment considers what needs to be done to go from the current capability to the desired future capability. It will address how to achieve the objectives at various stages of the life of the unit and under various scenarios.

This assessment should be followed by setting up a training programme to operationalize its recommendations. For a start it is good to first have a group of experts with accountancy and legal backgrounds. The pioneer group to be trained should consist of senior tax officials from the administration (and preferably also from the policymaking area). They are the pioneers and champions who should instil awareness in their colleagues of the importance of a transfer pricing capability. They will organize lectures and in-house seminars to train those officials who will become the next group of experts and to increase their skills and knowledge.

Specialist courses will be an important aspect of the training programme. As transfer pricing is a highly specialized field, in-country training from international experts and perhaps some training of experts overseas will be needed, with a plan to ensure they disseminate their new learning more broadly upon return (such as adopting a train-the-trainer approach). As with any training, it needs to be demand-driven, to respond to the needs of the transfer pricing unit, to speak to their current level of understanding and take it forward and ensure commitment. Demand-driven training also requires that those demanding the training are made aware of the opportunities for improving their capabilities and performance (as well as job satisfaction) by undertaking targeted training. International develop-ment agencies, regional tax administration groupings, international organi-zations and training institutions may be willing to assist with this.

The next step is to expand this transfer pricing knowledge and expertise. A possible model is to train several employees, who are given the appropriate level of authority, in each region with the right skills and make them responsible for further training as well as operational activities. However, the disadvantage is that other tax officials may resent this group, especially if they are given financial and non-financial incentives, as some-times happens. In this initial period, it is expected that only a few cases will be dealt with; but transfer pricing experience is nonetheless being developed. These specialists should meet with policymakers to share the latest devel-opments and discuss what is happening in other countries. The policymak-ers will see what the major issues are and have early warning of issues on the horizon that may need swift but considered policy responses.

In the meantime, the same approach can be adopted to train the next generation of specialists. The ultimate aim is that all corporate income tax specialists are able to handle at least some aspects of transfer pricing cases. Before that is achieved, as large as possible a group of those dealing with MNEs needs to be able to at least identify cases where there is a transfer pricing issue, for further consideration by specialist transfer pricing experts. Even though they may not know all the answers, they will be able to iden-tify issues and will know where to go to find the answers. Additionally, their involvement in this process will help enhance their knowledge.

Training should not be merely on transfer pricing issues, of course, as expertise in how a particular industry operates, including the value chains it utilizes, can be especially important if a transfer pricing expert operates predominantly in relation to that industry.¹¹⁴ Training in management, negotiation and inter-personal/relationship building skills will also be very important. So too will be knowledge management, project planning, data-base and other IT skills. Ethics training can be helpful in ensuring that offic-ers are aware of ethical considerations in their new role as well as more formal legal rules of conduct, and of the way in which these interact (especially as to the exercise of discretion).

The unit should have access to basic transfer pricing books and, if finances allow, a subscription to a dedicated transfer pricing journal deal-ing with current issues of interest to countries. As noted elsewhere in this Manual, databases are used by administrations, taxpayers and their advisers when searching for and evaluating possible comparables. They can be used to analyze materials such as:
►    Company annual reports;
►    Auditor’s reports;
►    Profit and loss accounts;
►    Notes to the accounts;
►    Balance sheets;
►    Materials indicating the nature of related party transactions;
►    Materials indicating the nature of the business; and
►    Materials indicating profit margins.

Such databases can provide access to private company data not on the public record, as well as public company data. They can also be helpful in systematizing how the data is used, in keeping a record of what is looked at, who has looked at it, and what decisions have been taken as a result, in serv-ing as a way of ensuring documents are readily accessible and searchable, in providing regular backups, and in providing a help-desk function that may have an educative role.

Private databases tend to be expensive, although sometimes an introductory price can be negotiated that is much lower than the usual pricing. It cannot of course be presumed that the low price will always be offered. One caution is that relevant data from companies operating locally are not available for many developing countries, and the relevance of data-bases based on other markets and environments has to be carefully consid-ered— adjusting the data to be more relevant to your cases may itself be very resource-intensive. That issue is addressed in more detail in Chapter 3 on Comparability Analysis.

Transfer pricing resources of all types tend to be expensive, and there should be a budget line for such materials in any proposal seeking donor assistance for setting up a transfer pricing regime. The PCT Transfer Pricing Toolkit considers some of the issues involved in the use of databases, especially in adjusting comparables from other markets, and some of the skill sets needed (see 2.5.3.2).

The unit will need to have access to the necessary information tech-nology hardware and software to enable them to deal with the complexity and volume of transfer pricing-related information, with necessary security measures in view of the commercially sensitive taxpayer information that will be held.

Information strategies will be needed to deal with such technology and the way information is held. Taxpayer files need to be held securely but centrally, so that it is clear what has been requested of taxpayers and when, as well as what has been received and when. It should also be clear when mate-rials have been accessed and by whom among the authorized persons, as well as whether information has been downloaded. A data back-up policy will be needed, with measures to ensure that no data are lost if there is a corrupted or lost back-up (such as duplicate backups held in different locations, with the immediately previous backups being retained also). It is important that docu-ments are not lost or destroyed and that the large volume of paperwork that is a characteristic of transfer pricing cases is not overwhelming, but is securely held. The possibility of litigation on transfer pricing issues must always be borne in mind, even though it should be seen by both sides as a last resort.

Some countries require material to be provided in electronic form, and others require or encourage an index system for the documents provided and a description of the record-keeping system used. If such information is electronically searchable then, subject to the availability of the necessary soft-ware and skills, there are potentially great resource savings in dealing with often very large files, speedier response times, and less chance of informa-tion being lost. The cost to taxpayers of providing material in certain forms should always be considered in deciding what should be required under rele-vant legislation or regulations.

Streamlining and simplification of procedures is part of tax adminis-tration reform to reduce compliance costs for taxpayers as well as collection costs for administrations. Any such processes being considered in a country should be internalized as part of setting up any transfer pricing capability. This is especially the case because overcomplicated procedures can lead to more informal processes, short-cuts or discretions being used with no legal basis and/or with inconsistency in application between taxpayers. They thus create a severe risk to the integrity of the system as well as increasing compli-ance and collection costs.

A useful approach is to consider what other administrations do in similar circumstances, especially administrations in the same region, and to follow that guidance unless there are reasons why such guidance is not appropriate after a close examination of the options and the engagement of stakeholders. This approach of looking to what is being done elsewhere as a first point of reference will reduce compliance costs for taxpayers and contribute to a positive investment climate without impacting on the abil-ity to deal with enforcement issues. In fact, it should enhance that ability, as the user can draw upon the practice of other administrations and prob-ably deal with those administrations more effectively because of common starting points.

There will generally be discretion provided in the legislation or regu-lations of the transfer pricing regime in any case. Such discretion represents a trade-off between a flexible system that takes account of particular circum-stances and recognizes the inherent scope for differences in transfer pric-ing analysis, on the one hand, and the risk that discretion will be exercised inconsistently across similar cases (thus favouring one taxpayer over another) or may raise integrity issues, on the other. Clear guidance for the exercise of discretion and a system of oversight will be needed.

Owing to the amounts of money at stake in many transfer pricing cases, and perhaps the fact that government transfer pricing experts often eventually leave for the private sector, strong checks and balances are required when decisions are made affecting taxpayer liabilities to tax. Conversely, it needs to be clear that the unit is not anti-business, but recognizes the way business operates, the need to follow the law, as well as the need to recog-nize the duty to provide service to taxpayers and exercise strong enforcement approaches only where warranted and on a fair basis.

Drawing upon the factors discussed above, the start-up phase of pric-ing operations of a Transfer Pricing Unit requires:
►    A critical look at the availability of human resources within the tax administration. Prioritization is essential and choices have to be made concerning the attention to be given to different kinds of taxes. A policy on transfer pricing without sufficient resources being available to the tax administration implementing it “on the ground” will not achieve its objective;
►    Understanding of the country’s economic characteristics. It will be useful to look for statistics on trading volumes and other indi-cators for cross-border transactions. In a start-up phase many countries focus on their main industries (such as mining, phar-maceuticals, telecommunications, breweries and automobiles, and usually on the larger players in those industries in particular;
►    Good, professional relations with business. Acceptance and understanding of the policy will reduce compliance and collec-tion costs. Meetings with all stakeholders will help in effectively building and improving transfer pricing policy and capability. This also means non-compliance is less likely to be due to honest misunderstandings of the regime’s requirements, and that there is more current intelligence on existing and emerging issues. This allows more focussed and efficient guidance and enforce-ment action;
►    Understanding what other countries have done at a similar stage, what they are doing now and where that represents an evolution.
This can include:
     ► Inviting representatives from other countries with a his-tory of transfer pricing to give their views and share their experiences;
     ► Reciprocal placements with countries that offer useful experience and are willing to assist can be an excellent way to learn. It will be necessary to first prepare a clear plan of what knowledge is being sought, why the other country will-ing to host a visit is the right country to learn from, and the expected impact and flow-on effects;
     ► Seeking support from donors to arrange visits to such coun-tries, with rigorous and strategic selection of participants, a strong work programme and an obligation to report on the outcomes and lessons learned. All this will help to ensure that a visit is not perceived, including by the other country or potential donors, as a “holiday” for participants. This can have important additional benefits in personnel management as those who are most open to learning new things and are judged likely to stay with the organization for some time and take transfer pricing technical or managerial leadership roles may be offered such exposure; and
     ► Exploring the training assistance available from international organizations including the UN, the OECD, the World
Bank Group, the IMF, and regional organizations such as ATAF and CIAT.
►    An ability to define, with policymakers and administrators involved in the process, the important areas of focus bear-ing in mind:
►    The main characteristics of the country’s industries, e.g. manufacturers or distribution activities;
►    The main kinds of cases contained in the workload of the tax administration;
►    The main types of activities to start with in developing poli-cies, recognizing the need for policy to be soundly based in reality; and
►    Practical case studies that can provide input for policymak-ing and a focus for discussing administration issues.

After starting the transfer pricing unit, areas of focus will evolve depending on factors including the stage of development of the transfer pricing policy and the administration. In the first years it is often considered helpful to focus on less complicated activities such as contract manufactur-ing, intragroup services etc. When a higher level of experience is reached, the focus will often shift to more complex and challenging areas such as intangi-bles and business restructurings. The same journey has been undertaken by developed countries. However, this does not mean that particularly blatant examples of mispricing in these more complex areas should not be addressed at an early stage.

It is best to set up a system of monitoring based on a performance measurement framework that establishes key performance indicators and outputs. While it is important not to overload staff, who will undoubtedly be very stretched for time and resources, with too much paperwork, possi-ble areas of monitoring (some by raw data, some by questionnaires and inter-views) include:
►    The time schedules involved in transfer pricing disputes;
►    Yield from risk-based audits and the percentage of yield-ing audits;
►    Adjustments in tax assessment;
►    Ability to respond quickly to emerging issues—including meas-urable deterrent effects on taxpayer behaviours;
►    The number of Mutual Agreement Procedures (MAPs);
►    Effectiveness of education campaigns and ongoing contact with business groups and their advisers, as well as evidence such as increasing traffic to the website;
►    Percentage of correspondence and telephone calls dealt with according to previously established customer service standards;
►    Total administration costs of the unit as a percentage of gross collection;
►    Improvements made to process, as well as legislative improve-ments that have arisen out of the areas of work;
►    Training undertaken and given, and the measurable impact; and
►    Evidence of sharing best practice with other government depart-ments and other tax authorities as part of a continuous improve-ment strategy.

As with any such measurement process, if data that is collected is not being used by management to assess progress the reasons should be consid-ered, and the data requirements modified, or the use of the data improved. In other words, the process of review should itself be reviewed for effectiveness on a regular basis.

Japan started its transfer pricing administration with a small unit in the late 1980s. Once the National Tax Agency (NTA) identified the rapidly increas-ing needs for transfer pricing management it expanded a nationwide training course for international taxation step-by-step, now reaching approximately 100 trainees every year; and also reorganized and gradually expanded the national and regional examination division. Currently the headquarters has transfer pricing sections and the MAP office, while the four major regional bureaux have special divisions for transfer pricing (including two divisions specializing in APAs). Although some essential documentation concerning transfer pricing is required by statute to be translated into Japanese, transfer pricing specialists are generally equipped with sufficient language skills to conduct examinations of the original accounting books, documents etc. in English.

In India capacity-building has taken place mainly through on-the-job-training. The Directorate of Transfer Pricing has expanded given that the numbers of cases being referred for audit are increasing annually since 2004, when the Directorate was set up. The National Academy of Direct Taxes, the apex body responsible for training, conducts specialized train-ing for officers. The Directorate has organized seminars and conferences for experience-sharing by officers engaged in audit and for capacity-building of officers joining the Directorate.

In Malaysia, the Inland Revenue Board Malaysia (IRBM) responded to the rise in issues pertaining to cross-border related party transactions in audit and investigation cases by setting up the transfer pricing audit unit, known as the Special Audit Unit, on 1 August 2003.

The unit began operations with five officers based in the IRBM head-quarters, reporting to the Director of the Compliance Department. From 2004 to 2009 IRBM also had two auditors based in each of the Penang and Johor state offices to deal with transfer pricing cases with the assistance of the Special Audit Unit. By 2007, transfer pricing cases had become increas-ingly challenging and the Special Audit Unit had grown to 12; however, it was found that transfer pricing issues were still being taken up by other branches resulting in lack of uniformity in the methods used to settle cases. IRBM then decided that transfer pricing audit activity needed to be centralized in order to increase officers’ expertise as well as to ensure a standardized approach.

The IRBM Multinational Tax Department came into existence with the introduction of transfer pricing regulations under Section 140A and Section 138C of the Income Tax Act 1967 which came into effect on 1 January 2009. In 2008, measures towards centralizing transfer pricing activities were proposed and eventually came into force on 1 March 2009 when the unit was spun off from the Compliance Department into a department of its own. The Multinational Tax Department, headed by a senior director, now reports directly to the Deputy Director General of Compliance. The department is still relatively small, as the intention behind the set-up is to build expertise in a small group who will later be dispersed to provide assistance and knowl-edge to other branches within IRBM. In general, the Department has four divisions as follows, with individual division directors:
►    Policy Division (one auditor), responsible for matters pertaining to regulations and procedures;
►    Multinational Audit Division (eight auditors), which conducts audit visits;
►    Compliance Audit Division (four auditors), which monitors com-pliance of cases previously audited; and
►    Advance Pricing Arrangements Division (one auditor) which deals with the application and processing of APAs including bilateral and multilateral APAs.

Auditors were sent to various training events both inside and outside Malaysia from the initial set up of the Special Audit Unit. The Department continues to send auditors to various courses to increase knowledge and expertise in transfer pricing issues, as well as having the opportunity to share their own knowledge and experience within the transfer pricing community more generally.

In Kenya, whilst resourcing and skills challenges remain for the Kenya Revenue Authority (KRA), active measures have been taken to build capacity in its transfer pricing unit by equipping the unit with enough experienced staff with the required set of skills; capacity building through continuous training and re-tooling; maintaining staff motivation through recognition and promotions, international training and exposure; and retaining multi-skilled staff in the unit. The transfer pricing unit in Kenya has highly skilled transfer pricing teams with different specialists including lawyers, accountants, economists and business analysts to ensure an under-standing of commercial operations.

The main challenge for Kenya in determining arm’s length profits has been the lack of domestic comparables. There are no databases contain-ing Kenya specific, or for that matter, Africa specific, comparable data. As a result, both the tax administration and taxpayers rely on European databases to establish arm’s length levels of profitability. Challenges have been experi-enced in making adjustments for geographical differences or levels of coun-try risk (for example, market, economic and political differences).

Building on the practice adopted in India and China, KRA is currently considering its approach to location savings, location specific advantages and market premiums within certain industries and those factors will be addressed when conducting audits.

Adequate transfer pricing documentation can serve several useful functions. Quality transfer pricing documentation will: (i) ensure that taxpayers give appropriate consideration to transfer pricing requirements in establishing prices for transactions between associated enterprises; (ii) provide tax administrations with the information necessary to conduct an informed transfer pricing risk assessment; and (iii) provide tax administra-tions with useful information in order to enable evaluation of a taxpayer’s transfer pricing position upon audit, thereby contributing to the avoidance of disputes and to the timely resolution of any transfer pricing disputes that may arise.

The OECD/G20 BEPS Project created a more consistent and useful documentation standard for use by countries. Insofar as possible, coun-tries should conform their transfer pricing documentation requirements to established international standards in order to limit compliance burdens imposed on taxpayers. When these international standards are followed, documentation will be characterized by (i) sufficient detail to demon-strate the taxpayer’s compliance with the arm’s length principle, and (ii) the timely delivery of such useful information to tax authorities, enabling them to assess tax risks and begin audit investigations in appropriate cases. A taxpayer should make reasonable efforts to reflect in its documentation an adequate transfer pricing analysis of its material transactions with associ-ated enterprises in order to establish its good faith effort to apply the arm’s length principle.

This chapter first summarizes recent developments regarding the establishment of international guidelines on transfer pricing documenta-tion. It then provides a more in-depth discussion on several topical issues that developing countries will need to address in adapting the international standards to their own needs. The chapter provides practical guidance on transfer pricing documentation related issues.

The OECD first published guidance on transfer pricing documenta-tion in 1995, shortly after the first individual country rules on documentation were developed. The original OECD Transfer Pricing Guidelines contained general principles but did not prescribe a list of specific items to be included in transfer pricing documentation. Numerous countries have adopted trans-fer pricing documentation rules and gained experience administering those rules since then. Several multinational bodies also sought to develop consist-ent transfer pricing documentation standards. Notwithstanding these efforts by multinational bodies to encourage consistency, the various country rules differ from one another in many ways, a fact which complicates taxpayer compliance with global documentation requirements. Accordingly, in 2015, in connection with the OECD/G20 BEPS Project, the OECD guidance on transfer pricing documentation was updated to establish a uniform docu-mentation standard.¹¹⁵

The OECD/G20 BEPS Final Report on Action 13 (2015) guidance sets out a standardized three-tiered approach to transfer pricing documenta-tion. It suggests that documentation should include: (i) a master file contain-ing general information about the MNE relevant to all MNE members; (ii) a local file referring specifically to material transactions of the MNE members resident in the local jurisdiction and setting out the taxpayer’s transfer pric-ing methodology for such material transactions; and (iii) a country-by-coun-try report (“CbC Report”) containing certain information relating to the global allocation among taxing jurisdictions of the MNE’s income and taxes paid, together with certain general indicators of the location of economic activity within the MNE. The Final Report on Action 13 also includes agreed guidance on implementing the new documentation and reporting rules. The OECD work builds on earlier work of other bodies, particularly that of the EU.

Master File. The master file is intended to provide a high-level over-view of the MNE’s global operations. The new OECD/G20 documentation standard calls for the following information to be included in the master file:
►    A chart illustrating the MNE’s legal and ownership structure and the geographical location of operating entities.
►    A general description of the MNE’s business including:
(a)    Important drivers of business profit;
(b)    A description (which may be in the form of a chart) of the supply chain for the group’s five largest products and/ or service offerings by turnover and any other products or
services amounting to more than 5 per cent of group turnover;
(c)    A list and brief description of important service arrange-ments between members of the MNE, other than research and development (R&D) services, including a description of the principal locations providing important services and the transfer pricing policies for allocating service costs and determining prices for intragroup services;
(d)    A description of the main geographic markets for the group’s products and services referred to in (b), above;
(e)    A brief written functional analysis describing the principal contributions to value creation by individual entities within the group; and
(f)    A description of important business restructuring trans-actions, acquisitions and divestitures occurring during the fiscal year.
►    A description of the MNE’s intangibles, including:
(a)    A general description of the MNE’s overall strategy for the development, ownership and exploitation of intangibles, including the location of principal R&D facilities and the location of R&D management;
(b)    a list of intangibles of the MNE that are important for trans-fer pricing purposes and an indication of which entities own those intangibles;
(c)    A list of important agreements among identified associated enterprises related to intangibles, including cost contribu-tion arrangements, principal R&D service arrangements, and licence arrangements;
(d)    a general description of the group’s transfer pricing policies related to R&D and intangibles; and
(e)    A general description of transfers of interests in intangibles among associated enterprises during the fiscal year, includ-ing the entities, countries and compensation involved.
 ►    A description of the MNE’s inter-company financial arrange-ments, including:
(a)    A general description of how the group is financed, including important financing arrangements with unre-lated lenders;
(b)    The identification of any members of the MNE that provide a central financing function for the group, including the country under whose laws each entity is organized and its place of effective management; and
(c)    A general description of the MNE’s transfer pricing poli-cies related to financing arrangements between associated enterprises.
►    The MNE’s annual consolidated financial statement for the fiscal year if otherwise prepared for financial reporting, regulatory, internal management, tax or other purposes.
►    A list and brief description of the MNE’s existing unilateral advance pricing agreements and other tax rulings relating to the allocation of income among countries.

Local File. The new OECD/G20 documentation standard suggests that the local file should contain the following information:
►    A description of the entity or entities in the MNE that operate in the local country, including:
(a)    A description of the management structure of the local entity, a local organization chart and a description of the individuals to whom local management reports and the country where their offices are located;
(b)    A detailed description of the business and business strat-egy pursued by the local entity including a description of recent business restructurings or intangibles transfers in the present or previous year involving the local entity and an explanation of aspects affecting the local entity; and
(c)    A description of key competitors of the local entity.
►    Information related to material controlled transactions involving the local entity, including:
(a)    A description of the transaction and the context in which it takes place;
(b)    The amount of inter-company payments or receipts for each category of controlled transactions involving the local entity, broken down by tax jurisdiction of the foreign payor or recipient;
(c)    Identification of the associated enterprises involved in each category of controlled transaction and how they are related;
(d)    Copies of all material agreements concluded by the local entity;
(e)    A detailed comparability and functional analysis of the taxpayer and the relevant associated enterprises with respect to each documented category of controlled transactions including changes from prior years;
(f)    An indication of the most appropriate transfer pricing method with regard to the category of transaction and the reasons for selecting that method;
(g)    An indication of which associated enterprise is selected as the tested party, if applicable, with an explanation of the reasons that enterprise is selected;
(h)    A summary of the important assumptions made in applying the transfer pricing methodology;
(i)    An explanation of the reasons for using a multi-year analysis if relevant;
(j)    A list and description of selected comparable uncontrolled transactions, if any, and information on relevant financial indicators for independent enterprises used in the transfer pricing analysis including a description of the comparable search methodology and the source of the information;
(k)    A description of any comparability adjustments performed;
(l)    A description of the reasons for concluding that relevant transactions were priced on an arm’s length basis based on the application of the selected transfer pricing method;
(m)    A summary of the financial information used in applying the transfer pricing methodology; and
(n)    A copy of existing unilateral and bilateral/multilateral APAs and other tax rulings to which the local tax jurisdiction is not a party, and which are related to the controlled transac-tions being analyzed.
►    Relevant financial information, including:
(a)    Annual local entity financial accounts for the year concerned;
(b)    Information and allocation schedules showing how the financial data used in the transfer pricing analysis may be tied to the annual financial statements; and
(c)    Summary schedules of relevant financial data for compa-rables used in the analysis and the sources from which that information was derived.

CbC Report. The CbC Report is intended to provide a general overview of the allocation of the MNE’s global income and taxes paid among countries. It is intended to be used for the purpose of assessing transfer pric-ing and other tax risks. The OECD/G20 BEPS guidance contains a template for the CbC Report. On the first page of the template, the MNE is required to report on a jurisdiction-by-jurisdiction basis for constituent entities resident in the relevant jurisdiction:
►    Total revenue, broken down into unrelated party revenue and related party revenue;
►    Profit (loss) before income tax;
►    Income tax paid (on a cash basis);
►    Income tax accrued for the current year;
►    Stated capital;
►    Accumulated earnings;
►    Number of employees; and
►    Tangible assets other than cash and cash equivalents.
On the second page of the template, the MNE should report, on a jurisdiction-by-jurisdiction basis:
►    Each constituent entity in the group that is resident in the jurisdiction;
►    The jurisdiction of organization or incorporation for each con-stituent entity if different from the jurisdiction of residence; and
►    The main business activities for each constituent entity of the MNE.

In addition to prescribing standardized content for the master file, local file and the CbC Report, the OECD/G20 BEPS guidance addresses several important implementation issues.¹¹⁶
► It is recommended in the Final Report on Action 13 that the master file and local file elements of the documentation package be implemented through local country legislation or administra-tive procedures, and that the master file and local file be filed directly by the taxpayer with the local tax administration in each relevant jurisdiction;
► It is recommended in the Final Report on Action 13 that the CbC Report be filed with the jurisdiction of the parent company of the MNE and shared by that country with other interested countries through automatic exchange of information under the Multinational Convention on Mutual Assistance in Tax Matters, under bilateral tax treaties, or under Tax Information Exchange Agreements (TIEAs). It is recognized, however, that backup local filing requirements may be necessary in situations where the country of the parent company does not adopt the CbC filing requirement or where other specified circumstances make it impossible for the local jurisdiction to gain access to the CbC Report through treaty exchange mechanisms. Accordingly, if developing countries are to have access to the CbC Report, they will need to either join the Multilateral Convention on Mutual Assistance in Tax Matters or develop an extensive set of bilateral tax treaties and/or TIEAs that provide a basis for automatic exchange of CbC Reports filed in parent company jurisdictions. Under either of these alternatives, countries should also develop mechanisms for enforcing backup local filing rules in situations where MNE members operating in their jurisdictions may not have ready access to all of the global MNE data contained in the CbC Report to which the tax administrations are entitled. Model competent authority agreements have been drafted to imple-ment the exchange of CbC Reports and numerous countries have already adopted the implementing agreement under the Multilateral Convention. It is expected that most countries will opt to join the Multilateral Convention;¹¹⁷
► It is recognized that important confidentiality concerns arise in connection with the CbC Report. Tax administrations should take all necessary steps to ensure that there is no public disclosure of confidential information contained in the CbC Report or other elements of the transfer pricing documenta-tion package, including adopting appropriate legal measures to protect confidentiality. Protection of confidentiality is one of the principal reasons that countries agreed to use treaty exchange mechanisms as the primary sharing mechanism for the CbC Report;
► It is recognized that the CbC Report will be helpful for high level transfer pricing risk assessment purposes. It may also be used by tax administrations in evaluating other BEPS related risks and, where appropriate, for economic and statistical analysis. However, the information in the CbC Report should not be used as a substitute for a transfer pricing analysis of individual transactions and prices based on a functional analysis and a comparability analysis. The information in the CbC Report on its own does not constitute conclusive evidence that transfer prices are or are not appropriate. The CbC Report should not be used by tax administrations to propose transfer pricing adjust-ments based on a global formulary apportionment of income. Countries participating in the BEPS project commit that if such formulary apportionment adjustments are proposed based on CbC Report data, they will promptly concede the adjustment in
any relevant competent authority proceeding. However, this does not imply that jurisdictions would be prevented from using the CbC Report data as a basis for making further enquiries into the MNE’s transfer pricing arrangements or into other tax matters in the course of a tax audit;
► It is recommended that only MNEs with annual consolidated revenue of at least EUR 750 million (or an equivalent amount stated in local currency using January 2015 exchange rates) be required to file the CbC Report;
► Jurisdictions should utilize the standard template set out in the Final Report on Action 13 for the CbC Report, not requiring either more or less information to be reported;
► It was agreed that all aspects of the CbC Report, including its content and its implementation by taxpayers and tax authorities, would be reviewed again in 2020 after some experience is gained in preparing and using the CbC Report. In early 2020 the OECD released a list of questions that will be examined in this review and requested information from interested persons regarding those questions; and
► The OECD/G20 work has also included the issue of high-level technology standards for the format of CbC Reports to facilitate the exchange of such reports.¹¹⁸

Since the publication of the Final Report on Action 13, the OECD has, from time to time, published guidance on implementing the new CbC reporting regime. This Guidance is contained primarily in two useful publi-cations. These are (i) Country-by-Country Reporting: Handbook on Effective Implementation, published in September 2017¹¹⁹ and (ii) Guidance on the Implementation of Country-by-Country Reporting: BEPS Action 13, published in December 2019.¹²⁰ These documents provide detailed suggestions to coun-tries adopting a CbC reporting requirement and to taxpayers seeking to comply with the requirement.

The guidance contained in these two documents addresses a vari-ety of topics including transitional filing options for MNEs, notification requirements for MNEs during the transitional phase, the consequences of non-compliance with the confidentiality, appropriate use, and consistency requirements by countries and taxpayers, appropriate implementation of local filing requirements, the treatment of partnerships, investment funds and other special entities, the aggregation of data within a particular coun-try, the treatment of dividends for purposes of the CbC filing thresholds, and numerous other questions.

The documents also provide technical guidance for governments on steps that can be taken to implement and simplify the filing and exchange between governments of CbC Reports and provide detailed suggestions for training of relevant government personnel on a multilateral basis. An impor-tant point contained in the implementing guidance is that the CbC regime is premised on the use of company accounting data and that accounting conventions used by taxpayers will therefore be followed in resolving most detailed reporting questions.

For developing countries, the implementation guidance contains useful instruction on complying with confidentiality requirements, report-ing breaches of the rules on appropriate use of CbC Report data, the possibil-ity of suspending the exchange of CbC Reports following consultation where proper use requirements have been violated, the resolution of cases where adjustments are inappropriately based on CbC report data, the technology schema to be used in sharing and receiving CbC Reports through exchange of information processes, and other important topics related to the exchange of CbC Reports between country tax administrations.

The international guidelines above were designed by the countries involved in the BEPS Project for adoption by them in the context of their own transfer pricing legislation, priorities, capabilities and experience. It cannot automatically be assumed that these OECD/G20 guidelines should be adopted in their entirety by every developing country. It is therefore impor-tant to examine these guidelines from the perspective of how they may work in practice in a developing country context, bearing in mind the adminis-trative constraints that may exist in the tax administration and the MNE. In considering these OECD/G20 guidelines, however, all countries should also consider the great benefit of having consistent documentation rules from country to country to minimize transfer pricing compliance burdens.

Developing countries can assume that, in the future, MNEs will prepare the master file and that large MNEs will prepare the CbC Report. Requiring these documents to be delivered to the local tax administration in a developing country should therefore impose no marginal compliance burden on the MNE. The important question for developing countries, there-fore, will likely be whether the local file envisioned by the OECD/G20 guid-ance should be adopted without modification in the local country.

The international standards are not self-executing. As noted above, local laws and/or administrative requirements must be adopted in each country to require local filing of the master file and local file. As many devel-oping countries are engaged in a modernization process for their tax admin-istrations, including in most cases significant investments in automation, countries can consider what new technologies are available in this regard to minimize compliance costs for both tax administrations and taxpayers.

Not all transactions that occur between associated enterprises are sufficiently material to require full documentation in the local file. Individual country transfer pricing documentation requirements based on the OECD/ G20 guidance on the content of the local file should include specific material-ity thresholds that take into account the size and the nature of the local econ-omy, the importance of the MNE in that economy, and the size and nature of local operating entities, as well as the overall size and nature of the MNE. Measures of materiality may be considered in relative terms (e.g. transac-tions not exceeding a percentage of revenue or a percentage of cost measure) or in absolute amount terms (e.g. transactions not exceeding a certain fixed amount). Individual countries should establish their own objective material-ity standards for local file purposes based on local conditions. As discussed in greater detail below, consideration should also be given to rules that exempt small or medium-sized enterprises from documentation requirements or that limit the extent of the documentation to be provided by such entities.

Similarly, in setting out local law requirements related to the master file, it should be recognized that taxpayers should use prudent busi-ness judgment in determining the appropriate level of detail for the informa-tion to be supplied. It should be kept in mind that the purpose of the master file is to provide tax administrations with a high-level overview of the MNE’s global operations and policies. Information should be considered important if its omission would affect the reliability of the transfer pricing outcomes.

The CbC Report is likely to be delivered to the local jurisdiction of the MNE’s parent company and to be forwarded to developing coun-tries under treaty exchange mechanisms. However, as noted above, devel-oping countries may need to adopt the Multilateral Convention on Mutual Assistance in Tax Matters or expand their networks of bilateral tax treaties and TIEAs in order to get access to the CbC Reports. The implementation materials in the Final Report on Action 13 contain model legislation and competent authority agreements that can be tailored to local country needs in adopting the CbC reporting requirement. Substantial detailed guidance on implementing the CbC reporting regime has been developed and published in the documents referenced at 12.2.1.7 and 12.2.1.8, above, and should be considered by developing countries as they implement CbC reporting.

In considering the implementation of documentation rules, develop-ing countries could decide to use a disclosure form as an alternative to the list of required documentation contained in the OECD/G20 description of the local file. If such a disclosure form is used as a substitute for the local file, it should strike a balance between taxpayer effort required and its usefulness for tax authorities to make a proper assessment. The form should only be completed in relation to inter-company transactions of significant size. See the discus-sion of materiality at 12.2.2.4 above. Completing the form (supplemented by the master file and CbC Report otherwise prepared by the taxpayer) could be sufficient to comply with initial documentation requirements. Under this approach a full detailed transfer pricing report may need to be produced only upon request, rather than being filed with the tax return in every case.

The compliance burden and compliance costs for MNEs may be reduced by utilizing such a form, without unduly compromising the infor-mation that is ultimately available to tax authorities. Forms used in Canada and Nigeria may be useful examples. If disclosure forms are to be used rather than the local file format, tax authorities may want to consider that, to the extent these disclosure forms can follow a consistent format (i.e. list the same information as that required in disclosure forms used by neighbouring countries where the taxpayer may conduct business activities), the taxpayer burden in preparing the forms might be reduced. This in turn may serve to help enhance taxpayer compliance.

The documentation compliance burden has increased significantly in the past twenty years with more and more countries introducing specific transfer pricing documentation requirements. In the year 2000, there were approximately 15 countries with specific transfer pricing documentation requirements, rising to almost 60 countries in 2012 with even more countries introducing new documentation rules since then. As noted, there is a risk that countries may introduce transfer pricing documentation requirements that differ significantly from country to country, resulting in a substantial increase in compliance costs for MNEs.

MNEs welcome initiatives to reduce the compliance burden and the related compliance costs by introducing standards of required information that are relevant for multiple countries. The above-mentioned international guidelines should help to harmonize rules so the preparation of documen-tation will not become a business in itself instead of a support to the MNE’s business and global tax compliance.

A large number of transfer pricing reports are prepared annually at present, just to satisfy local requirements, e.g. country-specific nuances, local language, annual searches and increasing focus on local comparables. As many businesses do not undergo major changes and/or restructuring every year the added value of an annual transfer pricing report may be open to question. It is recommended that transfer pricing documentation be peri-odically reviewed in order to determine whether functional and economic analyses are still accurate and relevant, and to confirm the validity of the applied transfer pricing methodology. In general, the master file, the local file, and the country-by-country report should be reviewed and updated annu-ally. It is recognized, however, that in many situations business descriptions, functional analyses and descriptions of comparables may not change signifi-cantly from year to year. In order to simplify compliance burdens on taxpay-ers the tax administration may determine, as long as operating conditions remain unchanged, that the searches in databases for comparables support-ing part of the local file be updated every three years rather than annually. Financial data for the comparables should nonetheless be updated every year in order to apply the arm’s length principle reliably.¹²¹

If more consistency can be achieved regarding the information required, MNEs may develop a system that retrieves (part of) this infor-mation automatically from their financial information systems, ultimately reducing their compliance costs significantly.

It is important that the documentation rules be broad enough to capture the reality of the related party transactions without being excessively burdensome on the mere chance that, though unlikely, a particular piece of information may be relevant.

In a number of countries the tax administration bears the burden of proof with respect to tax assessments unless a tax law specifically provides otherwise. Generally, that means that taxpayers need not prove the correct-ness of their transfer pricing unless the tax administration challenges taxpayers with concrete and clear reasons for such challenges. For further information see Chapter 10.

However, if a country has a set of specific documentation rules in its tax law or regulations, it may be the case that the burden of proof for the transfer price at which a taxpayer transfers goods or services with related parties falls on the taxpayer, unless the taxpayer is believed to have fulfilled the obligations imposed by such documentation rules. Even where the burden of proof rests on the tax administration, the tax administra-tion might require the taxpayer to provide documentation about its trans-fer pricing, because without adequate documentation, the tax administration cannot assess the case properly. In some countries, where the taxpayer does not provide adequate documentation, there may be a shifting of the burden of proof in the manner of a rebuttable presumption in favour of the adjustment proposed by the tax administration.

In countries where the burden of proof generally lies with the taxpayer, the burden of proof may shift to the tax administration if a taxpayer presents to the tax administration (or a court) a reasonable argument and evidence to suggest that the transfer pricing was at arm’s length. Further, in some countries with specific documentation rules, the burden of proof shifts to the tax administration if a taxpayer has reasonably complied with the documentation rules.

Developing countries should ensure that the relationships between documentation rules and the burden of proof are clear in their domestic law. The burden of proof should not be misused by the tax administration or taxpayers as a justification for making assertions that may be difficult to substantiate through an ordinary level of transfer pricing documentation. In other words, both the tax administration and the taxpayer should practice good faith through reasonable documentation that their determinations on transfer pricing are consistent with the arm’s length principle regardless of where the burden of proof lies.

Countries have different timing requirements for production of trans-fer pricing documentation. Any requirement that requires preparation of docu-mentation at the time of the transaction, at the time the tax return is filed, or at the beginning of an audit may be referred to as a “contemporaneous” documen-tation requirement. The Committee has refrained from using the word “contem-poraneous” to describe documentation requirements in this chapter to avoid confusion, as timing rules differ from country to country. Countries should consider what timing requirements best suit their needs and are consistent with their administrative procedures. Types of documentation requirements in use around the world may involve one or more of the following:
►    Prepare information at the time of the transactions, to be sub-mitted at the time of filing the tax return;
►    Prepare information at the time of the transactions, to be sub-mitted upon request in case of an audit;
►    Prepare information at the time of filing the tax return;
►    Prepare information only if requested upon audit; or
►    No documentation requirement.

Taxpayers, in some cases, establish transfer pricing documentation to demonstrate that they have made reasonable efforts to comply with the arm’s length principle at the time their intragroup transactions were under-taken based on information that was reasonably available to them at that point (hereinafter referred to as the “arm’s length price-setting” approach). Such information includes not only information on comparable transactions from previous years, but also information on economic and market changes that may have occurred between those previous years and the year of the controlled transaction. In many countries, however, taxpayers are required to test the actual outcome of their controlled transactions to demonstrate that the conditions of these transactions were consistent with the arm’s length principle, hereinafter called “the arm’s length outcome-testing” approach. Such tests typically take place as part of the process for establishing the tax return at the end of a tax year. See 3.6.2 for a detailed discussion of this area. See also OECD TPG, paragraphs 3.69 to 3.71.

A country that wishes to establish a transfer pricing documenta-tion rule should take into account the existence of the two pricing approaches mentioned above. Whether the arm’s length price-setting or outcome-testing approach is used, data for external comparables may not be readily available at the time of the analysis.

The OECD/G20 documentation standards do not mandate specific rules regarding the time at which documentation should be prepared or presented to the tax authorities.¹²² The guidance contained in the Final Report on Action 13 suggests that the CbC Report be completed one year from the close of the MNE’s fiscal year to which the CbC Report relates.

The OECD Transfer Pricing Guidelines note that it would be quite burdensome if detailed documentation were required on all cross-border transactions between associated enterprises and by all enterprises engag-ing in such transactions. Therefore, it would be unreasonable to require the taxpayer to submit documents with the tax return specifically demonstrating the appropriateness of all transfer price determinations. The local file should, in particular, be limited to material transactions. As noted above, under the OECD/G20 guidance, the definition of materiality is left to local law and should be specified in the light of local conditions.

A country that requires its taxpayers to prepare transfer pricing documentation may operate a penalty system to ensure proper compliance with its documentation requirements. Penalties in relation to the transfer pricing regime can be generally divided into two groups based on the reason for imposing them: (i) penalties for underpayment of tax that is due; and (ii) penalties for non-compliance with documentation requirements.

However, a number of countries also have incentive measures elim-inating penalties for underpayment of taxes in cases where obligations for proper documentation have been fulfilled by taxpayers even in cases where the amount of taxable income turns out to be increased as a result of a tax audit. The principle governing these incentive measures is often referred to as the “no-fault, no-penalty principle”.

In general, penalties can entail civil (or administrative) or criminal sanctions. Penalties imposed for failure to meet transfer pricing documenta-tion requirements are usually monetary sanctions of a civil or administrative, rather than a criminal, nature. In some countries, a failure of the taxpayer to comply with documentation rules may lead to greater scrutiny by the tax administration and risk assessment and adjustments based on other infor-mation available to the tax administration or on the basis of other transfer pricing methods. These cases are more closely scrutinized, and can equally be seen as giving rise to greater risks of non-compliance.

It would be unfair to impose sizeable penalties on taxpayers that exert reasonable efforts in good faith to undertake a sound transfer pricing analysis to ascertain arm’s length pricing, even if they do not fully satisfy documentation requirements. In particular, it would be unproductive to impose penalties on taxpayers for failing to submit data to which the MNE did not have access at the time of the documentation process, or for failure to apply a transfer pricing method that would have required the use of data unavailable to the MNE. However, this does not mean that a transfer price cannot be adjusted retroactively, with interest accruing on that amount.

Some countries consider that a penalty imposed due to a lack of proper documentation can be addressed through the Mutual Agreement Procedure between competent authorities under an applicable tax treaty, as it relates to the taxes to which the relevant treaty applies. Other countries consider that the issue of penalties, especially in relation to documentation, is distinct from the adjustments made and also from the issue of whether taxes have been imposed in accordance with the relevant tax treaty.

However, even where such a penalty is not covered by a tax treaty’s Mutual Agreement Procedure, the penalty should not be applied in a manner that would severely discourage or invalidate a taxpayers’ reasonable reliance on the benefits of the tax treaty. This includes the right to initiate the Mutual Agreement Procedure as provided in the relevant tax treaty.

For example, a country’s requirements concerning the payment of an outstanding penalty should not be more onerous to taxpayers in the context of the Mutual Agreement Procedure than they would be in the context of a domestic law review initiated by the taxpayer.

Comprehensive documentation requirements and related penal-ties imposed on non-compliant taxpayers in a country may place a significant burden on taxpayers, especially on small and medium-sized enterprises (SMEs) or enterprises which engage in only limited cross-border transactions with overseas related parties. A number of countries have, therefore, introduced certain special considerations for SMEs in their transfer pricing documen-tation rules (see 11.4.3.3). Countries that have adopted special considera-tions for transfer pricing documentation in the case of SMEs include Brazil, China, Germany, India, Korea, Mexico, Nigeria, The Netherlands, Poland and Portugal.

The OECD/G20 BEPS guidance on documentation exempts MNEs with global revenues of less than EUR 750 million from the obligation to file the CbC Report, but rules as to whether SMEs should prepare the local file and master file are left to local law.

The accommodations made vary from country to country but may include: an exemption from documentation obligations for smaller compa-nies or for companies that engage in only limited cross-border business, a delay in the time within which the documentation must be prepared and submitted until transfer pricing issues are raised on audit, or a reduction in the level of detail required to be submitted by smaller businesses. These accommodations can be incorporated in legislation or adopted through administrative practice.

The Final Report on Action 13 notes that a requirement to provide transfer pricing documentation in the local language can constitute a compli-cating factor for transfer pricing compliance since both time and cost may be involved in translating documents. The language in which transfer pricing documentation should be submitted should be established under domestic law. Countries are encouraged in the Final Report on Action 13 to permit filing of transfer pricing documentation in commonly used languages where it will not compromise the usefulness of the documents. Where tax admin-istrations believe that translation of documents is necessary, they should make specific requests for translation. Where translation is required, the tax administration should allow sufficient time to make such translations to limit the compliance burden.

Many countries require taxpayers to present transfer pricing docu-mentation in the (country’s) local language and require translation if the documentation was prepared in a different language. The Egyptian transfer pricing guidelines provide that if documents are provided in any language other than in Arabic, the taxpayer may be required to bear the cost of an official translation. However, some countries such as France, Germany, the Netherlands and the Republic of Korea allow presentation of documentation in a language other than their own languages at least on an exceptional basis. It is particularly common to allow documentation to be provided in English.