Transfer pricing adjustments – how to mitigate the risk of challenges?

As the financial year-end approaches—bringing tax closures and financial audits—it’s the last chance to thoroughly review settlements, pricing, and contractual terms and make any necessary adjustments.

Taxpayers often ask:

• What are transfer pricing (TP) adjustments?
• Why are TP adjustments necessary?

If you have any doubts about these topics, we invite you to read our latest article on transfer pricing adjustments > link

This article explores the risks associated with TP adjustments and provides insights on how to manage them effectively.

What risks are associated with transfer pricing adjustments?

Errors in TP adjustments can lead to:

Failure to recognise the adjustment as a TP adjustment – Proper classification of an adjustment as either a TP adjustment or a general accounting correction is crucial for tax recognition and determining the appropriate reporting period. Additionally, TP adjustments must be separately reported in the Transfer Pricing Report (TPR).

Disqualification from tax-deductible income/expenses – If the adjustment does not meet the statutory conditions, it may not be recognised for tax purposes.

Tax authority scrutiny – Significant TP adjustments may trigger tax audits, raising questions about whether the original pricing was at arm’s length.

Double taxation – If the jurisdiction involved does not accept the adjustment or it cannot be recognised for tax purposes, this may result in double taxation.

Consequences of a TP adjustment being challenged by tax authorities

Failure to properly document or justify a TP adjustment may lead tax authorities to reject it, resulting in the adjustment being disregarded for tax purposes.

To ensure TP adjustments are safely recognised for tax purposes, specific conditions must be met:

Condition 1

• The terms of controlled transactions during the tax year must align with those that unrelated parties would have agreed upon.

Condition 2

• A material change in circumstances must have occurred (e.g., extraordinary market fluctuations, changes in interest rates), or actual costs and revenues forming the basis for transfer pricing calculations must have become known, necessitating a TP adjustment to maintain arm’s length conditions.

Condition 3

• A statement from the related entity or accounting documentation must confirm that the TP adjustment is recorded at the same amount on both sides of the transaction.

Condition 4

• A legal basis for the exchange of tax information must exist between the taxpayer’s country and the jurisdiction of the related entity.

For upward adjustments, only the first two conditions need to be met. However, for downward adjustments to be recognised as tax-deductible, all four conditions must be satisfied. If an adjustment significantly exceeds the transaction value, tax authorities may scrutinise whether Condition 1 (arm’s length pricing) was met at the outset.

Another risk in cross-border transactions is the potential rejection of the adjustment by foreign tax authorities or differences in its interpretation, which could lead to double taxation.

How to properly document transfer pricing adjustments?

Proper documentation of TP adjustments is a key challenge for taxpayers. Incorrect reporting increases the risk of scrutiny by tax authorities. To minimise uncertainty, taxpayers should refer to the Ministry of Finance’s tax guidelines, which outline the acceptable forms of documentation:

• Accounting notes (debit or credit) adjusting the related entity’s revenues or costs in aggregate for a specific controlled transaction, without reference to a specific invoice or document.
• Consolidated adjustment invoices.
• Correction invoices linked to a specific invoice or line item within the relevant reporting period.

The appropriate documentation method should be chosen based on the nature of the transaction and the relevant legal framework, particularly VAT regulations.

How to effectively reduce risks related to transfer pricing adjustments?

1. Price setting at the start of the year – Incorporate market assumptions and forecasts, and continuously monitor transaction performance to anticipate potential adjustments.
2. Statutory compliance documentation – Prepare evidence to demonstrate compliance with legal requirements for recognizing TP adjustments.
3. Choice of documentation method – Analyse the VAT implications of the adjustment and choose the most appropriate form of documentation.
4. Consideration of the counterparty’s jurisdiction – Consider the perspective of the other jurisdiction to mitigate the risk of double taxation.
5. Impact on customs obligations – Evaluate the impact of TP adjustments on customs duties, particularly in transactions involving goods outside the EU.

It is advisable to review these key areas, as highlighted by auditors and tax authorities, through a TP adjustment audit. This not only minimises the risk of adjustments and penalties but also streamlines future TP documentation and TPR reporting.

March is also an ideal time to request the necessary calculations and documentation from the group, greatly facilitating compliance with tax obligations.