INSIGHT: Managing Transfer Pricing Disputes in Asia—Challenges and Opportunities

Asia presents an increasing source of complexity and challenge when it comes to the successful resolution of audits (which at minimum we define as the avoidance of double taxation, but preferably the successful defense of current policies and the avoidance of any transfer pricing adjustment). Managing the process and defending your position may give rise to traps and pitfalls for the unwary.

Audits

Audits occur as Asian tax authorities seek both to protect their tax base from declining through perceived non-arm’s length transfer pricing, and to expand their collections based on a thorough enforcement of the arm’s length standard. More often than not, this is a vital issue for the tax authorities: the scale of cross-border transactions within multinational corporations (“MNCs”) pertaining to a jurisdiction is often large relative to the gross domestic product. Consequently, making transfer pricing adjustments of even small magnitudes can have a significant impact on tax revenue collection. For taxpayers, the materiality of adjustments and potential penalties may raise cash flow issues that need to be addressed.

Tax authorities have been known to have specific targets for tax collections (particularly in developing economies) and this filters down to the actions and processes tax auditors follow, which in turn directs their scarce resources to where additional tax collections will be most likely.

Transfer pricing is therefore a common topic for audits, given its inherent subjectivity. Tax authorities can and do employ various measures to maximize that subjectivity, as in principle defining an arm’s length price always allows for an “arm’s length range” of results that tax authorities may exploit in their favor when considering adjustments to related party transaction prices.

The significance of the substantially more detailed information tax authorities currently (or will soon) have access to compounds the trend of Asian tax authorities focusing on transfer pricing issues as a means of collection. It is unsurprising that most Asian tax jurisdictions have enacted or are enacting legislation or introducing administrative procedures that enforce transfer pricing and align their documentation standards—in part or in whole—with Action 13 of the OECD’s BEPS project.

This requires MNCs to provide tax authorities with at least three tiers of documentation (with variance between different countries, including the requirement in some jurisdictions for local comparables):

• a master file containing high-level information on their global business operations and transfer pricing policies;
• a local file containing detailed transactional transfer pricing documentation specific to each country; and
• a country-by-country (“CbC”) report containing information on the amount of revenue, profit before income tax, income tax paid and accrued, and other indicators of the location of economic activity within the group. Tax authorities will access information from these documents to assess transfer pricing risks, and the information may be exchanged with other jurisdictions, either automatically or upon request.

The provision (and, where not provided domestically, potential exchange between countries) of some or all of these sets of information to tax authorities will provide them with a more robust basis to assess the arm’s length nature of the transfer pricing policies of MNCs, to conduct risk assessments, and to target taxpayers to raise further tax revenue.

Further, the information requested by tax authorities often extends significantly further than the reach of the transfer pricing documentation itself. For example, in routine tax audits we already see detailed requests for information based on the value chain of entities in the group, including their (at times segmented) financial information and headcount data to augment the information provided in the transfer pricing documentation of the taxpayer. When providing information requested, its relevance to the audit is an important point to consider.

The combination of these factors presents a situation where transfer pricing audits are more frequent, and require more resources to manage. Further, technical issues add to the complexity of defending your position and managing the process.

From a technical perspective, this could mean that tax authorities disregard certain facets of the economic analysis put forward by the taxpayer, for example, the choice of method or of the comparables used to defend the position, and replace this with their own choice of method or of comparables to use. For example, the imposition of a profit split method by a tax authority, which we often see, may not require the use of comparables (if a contribution profit split, or alternatively it may rely on more routine comparables to support a residual profit split basis)—tax authorities may assert that this is the “best method” on the basis of their rejection of the comparables set provided by the taxpayer. One consequence of this imposition is to make the potential range of negotiations broader, and resolution more difficult, so the calculation of the transfer pricing based on an equivalent profit split in transactions may be a helpful risk management tool where this approach may be deployed by a tax authority.

Where no transfer pricing documentation is available or the comparables are rejected, we have seen the use of “secret” comparables, with the taxpayer having little recourse to push back from the arm’s length range the suggested comparables other than to assert non-comparability, which may leave little basis to assert an arm’s length price at all, and may be harder to substantiate. In addition, tax authorities often challenge the factual basis of any transfer pricing analysis prepared and assert different facts based on principle, and will be even more likely to do the same if there is no transfer pricing documentation to assert your position.

Technical standards (and the capacity to evaluate transfer pricing policies) are also divergent in Asia, and sometimes these are integrated into local law. Many Asian countries are not Organization for Economic Co-operation and Development (“OECD”) members, and need not—and do not—follow the precepts of the 2017 OECD Transfer Pricing Guidelines completely, despite nominally doing so and using guidance from the OECD when helpful to their positions. Asian tax authorities often have their own transfer pricing guidelines, which in some cases significantly diverge from the OECD standards. In addition, tax authorities have their own interpretation of the issues that may not allow for certainty and consistency in planning and defending transfer pricing positions.

Given the above facts (and in particular when they are present), adjustments are more frequently being asserted domestically and protracted disputes may arise over the application of transfer pricing principles. Unfortunately, in many jurisdictions (particularly developing economies), once a potential adjustment is proposed it is more difficult to avoid an adjustment entirely, although having a robust transfer pricing analysis may be a reasonable means to stop disputes becoming more protracted.

Litigation

In our experience, if an audit may not be settled on reasonable terms, an MNC should be prepared for at least the potential to litigate over a transfer pricing dispute, relative to the alternative of MAP. The viability of litigation would depend on various tax and business considerations as well as the underlying facts. For example, a transfer pricing audit may end up in litigation if the MNC is unable to arrive at a mutually agreeable position with the tax authority even after protracted negotiations, especially if the tax authority vigorously contests the choice of comparables or the factual analysis provided by the MNC. It would then be necessary to show to the court that the MNC’s selection and application of transfer pricing methods can be substantiated based on sound transfer pricing principles, and that this is consistent with the domestic law. If a matter proceeds to litigation, the court will consider how the domestic transfer pricing law underpinning the dispute is to be interpreted.

Transfer pricing controversies often involve a number of complex issues that require the collation of much data on suitable comparables and economics analyses. Litigation is usually time and cost intensive, necessitating the preparation of voluminous amounts of evidence to support the MNC’s transfer pricing position and rebut the tax authority’s position. The evidence adduced in court may include information and documentation that were provided to the tax authority prior to and during the course of the audit process, and it is important that some level of consistency be maintained unless there is a reasonable explanation to justify the deviation.

An MNC may rely on the contemporaneous documentation that it previously prepared to substantiate its transfer pricing position, assuming that these will bolster its legal arguments before the court. However, the existing documentation may be inadequate for litigation purposes. The MNC must deal with multiple, subjective variables during the litigation process, adducing sound and compelling evidence to prove its case, as well as rebut the tax authority’s arguments and evidence.

During litigation (but depending on the jurisdiction involved), the burden of proof is often placed on the taxpayer, which must adduce detailed evidence to persuade the court. The Hong Kong court, for example, will decide, on the basis of the facts and evidence, whether the taxpayer is able to substantiate its reported amount. In Malaysia, under Schedule 5 of the Income Tax Act, the appellant is required to prove that the assessment raised by the Director General of Inland Revenue is excessive or erroneous in order to succeed in its appeal.

If a matter is litigated, transfer pricing economists may be called as expert witnesses, who are required to find and present relevant data and perform economics analyses on comparable transactions. Evidence that is vital to establishing the MNC’s case may be disregarded if it is not aligned with local laws and practices.

Chevron Australia Case

If the court considers that the MNC has failed to identify and argue the correct legal questions, and support them with appropriate evidence, the MNC may find defending the position more challenging. For example, in Chevron Australia Holdings Pty Ltd v. Commissioner of Taxation (No. 4) [2015] FCA 1092 (“Chevron Australia case”) the Australian Federal Court judge who heard the matter at first instance stated that “I give no weight to the opinions of transfer pricing economists where those opinions appear not to be founded in the statutory language which the Court must apply.” The first instance decision was upheld by the Full Federal Court (see Chevron Australia case). From another standpoint, there may be opportunities to successfully rebut the tax authority’s expert evidence if it is deficient or based on the wrong assumptions.

Many transfer pricing disputes are often driven by differing transfer pricing methods sought to be used by the taxpayer and tax authority in substantiating or asserting the arm’s length pricing principle and this is even more prevalent, for example, in the context of financing arrangements. As an example, in the Chevron Australia case, it was found that before October 2015, OECD guidelines provided very limited guidance on arm’s length pricing for financing. Therefore, the approach is to consider on what terms and pricing would independent parties have transacted on as an arm’s length standard, or at least what can be reasonably expected, assuming the transaction is between two independent commercial parties.

However, litigation may not be used everywhere, or may not be the best option in the circumstances. For example, litigation as a tool to solve transfer pricing controversies is less frequently used in China compared to some other jurisdictions in the region and around the world, and Singapore has never heard a transfer pricing case. The vast majority of the transfer pricing controversy cases remain resolved through settlement between the taxpayers and tax authorities. But even in China, this does not mean that litigation should be excluded as a potential option for the taxpayer to defend its transfer pricing position. In fact, it may, or even should, be considered as an alternative approach by the taxpayer when the transfer pricing analysis and underlying fact pattern strongly supports the taxpayer’s position, and negotiation alone is not sufficient to protect the taxpayer’s position.

Mutual Agreement Procedure (“MAP”)

Additionally, MNCs may consider using MAP, if an adjustment has been concluded. Many Asia Pacific countries such as Australia, China, Hong Kong, Indonesia, Korea, Malaysia, and Singapore are members of the Inclusive Framework on BEPS Implementation—they are required to implement BEPS minimum standards, including the Action 14 minimum standard in relation to MAP. This may lead to more effective MAP procedures.

In Hong Kong, for example, the new section 50AAB of the Inland Revenue Ordinance formally adopts a statutory dispute resolution mechanism to ensure the effective and efficient resolution of treaty-related disputes by way of MAP or arbitration. If a taxpayer raises a complaint that it is not being taxed in accordance with the provisions of a treaty, this may result in government to government negotiations to resolve the case by mutual agreement. In a recent Bills Committee report (i.e. LC Paper No. CB(1)1116/17-18), it was stated that the “IRD will seek to protect the interests of Hong Kong taxpayers when dealing with such disputes with other tax authorities.”

However, the use of MAP remains infrequent in many intra-Asia disputes given its relative ineffectiveness to date. MAP is more frequently used where transactions are between large trading partners with transactions of significant scale, but even then many are in fact unresolved.

Planning Points

In managing their global transfer pricing projects, MNCs should consider the other possibilities open to them for resolving their transfer pricing disputes.

Many Asian countries such as China, India, Indonesia, Korea, Malaysia, and Singapore have advance pricing agreement (“APA”) mechanisms, and APAs on the tax consequences of proposed transactions are increasingly common. Bilateral APAs should in particular be considered, given its potential to eliminate double taxation concerns.

It would be advantageous for an MNC to consider its negotiation strategy ahead of engaging in APA discussions with the tax authority, and offer data to support its transfer pricing policy and arm’s length price, including the transfer pricing method to be applied. Whilst the MNC may need to make some concessions during the negotiation process, the benefits of arriving at a mutually agreeable position, which includes the certainty afforded by the APA, can outweigh the potential costs of being audited and suffering a full-blown dispute later on.

Michael Nixon is Principal, Economist at Baker McKenzie Wong & Leow; Krystal Ng is a Partner at Wong & Partners and Ning Liu is a Senior Economist, Tax at Baker McKenzie, Shanghai.