In our previous newsletter, Transfer Pricing Data Reporting and beyond – Who are affected? What data does the tax authority receive? we briefly summarized which taxpayers are subject to documentation and data reporting obligations related to determining arm's length prices. Most of the taxpayers concerned have a fiscal year that corresponds to the calendar year, so they have already fulfilled their data reporting obligations for 2023. Their 2024 fiscal year is still ongoing, and they are currently carrying out related-party transactions that may be subject to data reporting obligations in the corporate tax return.

Fulfilling documentation obligations during the year?

According to Decree No. 32/2017 (X.18.) of the Ministry for National Economy, taxpayers subject to transfer pricing documentation obligations must prepare documentation that includes a Master File, which provides a general transfer pricing-oriented overview of the group, and a Local File. From the fiscal year starting in 2023, the Local File consists of a common part at the taxpayer level and one or more transaction-level part(s).

The common part at the taxpayer level includes, among other things, a description of the taxpayer's management, organizational chart, strategy, a presentation of its main competitors, transfer pricing agreements, or other tax rulings related to transactions carried out by the taxpayer, including cases where tax authorities audit the related party and make findings regarding transactions carried out with the taxpayer.

The transaction-level part includes, among other things, a description of the transaction subject to the documentation obligation, a list of the related parties involved in the transaction, a presentation of the written contract or oral agreement underlying the transaction, a functional analysis, the name of the most appropriate transfer pricing method, the identification of the tested party (either the related party or the taxpayer), a presentation of comparable data, and the determination of the arm's length price, price range, or profitability.

In our previous newsletter, we highlighted that transactions exceeding HUF 100 million (calculated at arm's length price excluding value added tax) with related parties are subject to documentation and data reporting obligations, and we also described the presentation of the data reporting obligation. As briefly summarized above, the documentation obligation involves preparing transaction-level documentation and presenting information related to the transaction.

If a one-off but high-value transaction occurs within the group during the year, all the information necessary to prepare the transaction-level documentation is already available. The transaction is based on an oral or written agreement, the terms of which are already known, and the price has already been determined by the parties, with the amount unlikely to change due to the ad-hoc nature of the transaction. In such cases, it is possible to determine during the year whether the arm's length principle has been applied. If it has not, there is still an opportunity to negotiate price adjustments with the related party - even during the year - to ensure compliance with the arm's length principle through the correction of invoices.

Prepared for the end of the year – without increasing the corporate tax base

Examining one-time transactions during the year can help prepare for year-end closing, but so can the preliminary collection of information on regularly carried out transactions. Just as risks are assessed during preliminary reviews for companies subject to audit, we can also prepare for the financial close process in transfer pricing.

For transactions where the total annual value is not yet known but it is expected that it exceeds HUF 100 million calculated at arm's length price, and the terms of oral or written agreements are already known for transactions covering the larger part of the year, documentations can be prepared in form of drafts.

The arm's length price can be determined using the comparable uncontrolled price method, resale price method, cost-plus method, transactional net margin method, or profit split method, or if these are not appropriate, other method. Depending on the transaction and the method used to determine the arm's length price, we have different options for how to examine during the year whether the arm's length principle has been applied.

For example, the arm's length price of loan transactions is often determined using the comparable uncontrolled price method. Comparable data can be available from agreements made by the taxpayer or other group members with independent parties, but data can also be extracted from databases. Therefore, it can be known during the year whether the parties have agreed to apply an interest rate which would have been accepted by independent parties or whether they have deviated from it.

In other transactions, - if the profitability is examined for the transaction - identifying potential losses in time can provide important information for the taxpayer and for the group. For contract or toll manufacturers, limited risk distributors, and generally those companies within the group that are not independent decision-makers, the tax authority typically does not accept loss-making operations.

Especially not long-term losses, as an independent company that is not part of a group would cease operations if it were continually loss-making. However, within the group, it is conceivable that another group member benefits from the loss-making operation of the company, increasing its own profit. The tax authority's audit program for the year 2024 highlights not only the examination of loss-making companies but also those achieving low profitability. Therefore, it is crucial to assess in time what justifies the loss or lower-than-normal profitability.

Examining both one-off and regular transactions during the year can reveal that the parties did not settle the transaction at arm's length price, and the taxpayer does not achieve the expected profitability based on the functions performed and risks assumed. This can be corrected during the year by adjusting invoices, thus avoiding a year-end increase in the tax base and double taxation.

Adjustments during and the end of the year

If the taxpayer does not agree with its related party under conditions that independent parties would have agreed to, the arm's length principle is not applied, and this can be corrected during the year by adjusting invoices. The parties involved in the transaction can avoid double taxation with this solution.

Double taxation can also be avoided with a correction under the Accounting Act. According to the provisions of the Accounting Act, the difference between the arm's length price and the applied compensation can be accounted for in the amount in which the corporate tax base would have to be adjusted under the Corporate Tax Act if the difference is not included in the accounting records. Accordingly, the actual correction amount can only be determined when the corporate tax base adjustment item is also determinable, primarily at the end of the year. According to the Accounting Act, the parties account for the year-end correction with an accounting document and settle it financially.

Deviation from the arm's length price can also be settled by adjusting the corporate tax base, in which case no financial settlement occurs between the parties. The taxpayer must increase the tax base if it is lower than it would have been using the arm's length price. However, if the tax base is higher than the tax base determined using the arm's length price, the reduction is only possible if a document and declaration from the related party involved in the transaction are available stating that they will increase their corporate tax base (or the equivalent tax base) by the amount of the reduction. It is important that if the deviation from the arm's length price is corrected with an accounting document or by adjusting the corporate tax base, the midpoint value of the arm's length range, the median value, should be considered as the arm's length price, which can result in a significantly larger correction than invoice correction. Furthermore, ensuring compliance with the arm's length principle through corporate tax base adjustment can lead to double taxation if the taxpayer must increase its tax base according to legal requirements, but its related party does not decrease its own tax base.

Avoiding double taxation is a fundamental interest of any group of companies, so it is important to take the necessary steps in time to avoid it. The requirements of the Hungarian tax authority regarding purchases and sales and the expectations, that the parent companies of the Hungarian entities of the multinational groups face abroad, will be detailed in our next newsletter!