AUDIT EXPERIENCE IN CONNECTION WITH EXAMINING THE ARM’S LENGTH PRICE

In our previous newsletter, we discussed the importance of transfer pricing documentation and the impact of COVID-19 on transfer pricing documentation, including the fact that the analysis of the impact of the virus on economic operators and the documentation of the decisions taken is particularly important, especially if the situation resulted in a lower than normal market profit for the taxpayer under inspection.

Potential losses and lower than expected profitability are problems not only due to the coronavirus. According to the OECD's general transfer pricing guidelines, it is possible that a company operating as part of a group may incur losses due to high start-up costs, inefficiencies or adverse economic conditions, or for other economically justifiable reasons. However, in the long term, a loss-making non-group company would not be able to sustain its activities and therefore long-term losses are not considered acceptable for related parties.

In the course of tax authority audits, the tax authority decides which reasons are acceptable for loss or lower profitability by assessing the individual circumstances of the transaction under review. It is essential to have quantified supporting evidence that is consistent with the general ledger. In our experience, the authorities do not rule out the acceptance of economically rational cases, but it is necessary to demonstrate that the company's operations are not justified solely by its membership of a group of companies and that it would not cease to exist as a separate company. In principle, an adjustment can be made to income and expenses and, consequently, to additional costs that result in an acceptable loss or an acceptable lower profit, which are non-recurring, extraordinary and non-harmonious and not arising from normal management. It is also important to consider whether the risk of the cost incurred is reasonably borne by which party and is part of the normal business risk. 

The audit practice also shows that the definition of transaction indicators is an important aspect in the proper assessment of transfer pricing. Taxpayers must ensure that credible transaction-level data can be produced. The data necessary to establish the transaction indicators can be provided, for example, by identifying the relevant segment, profit centre, cost centre, cost object, general ledger account or job numbers. In our experience, this is still not the case for many companies, and we would like to draw particular attention to the need for the taxpayers concerned to review whether their accounting records allow for the identification of related party transactions indicators, or whether they need to introduce cost centres to allow for this. 

The audits continued to focus on whether the services received from affiliated parties were justified, whether the basis for the costs was appropriate, whether the taxpayer could bear the costs that it had charged by the related party, and whether it was reasonable for the taxpayer to bear the costs. As discussed above, a relevant consideration in assessing the impact of COVID-19 is whether it is reasonable for the taxpayer to bear the additional costs or not.

Not only the domestic, but the international audit practice are becoming more strict. In particular, there is a strong emphasis on the presentation of the functions performed and risks borne by the parties in the group, which justifies different benefits for each member of the group. For companies with limited risk, low but stable profitability is expected. Therefore, the procedure conducted by the foreign tax authority also includes an examination of the profits made by the Hungarian associated enterprise. Questions may arise if the Hungarian company bears limited risks but achieves higher than normal profits. The foreign tax authority may consider that there is no justification for the Hungarian company to retain excessive profits if the foreign taxpayer under its inspection can be considered a strategic decision-maker and may increase its tax base in view of the excessive profits achieved by the Hungarian company, on the basis that the higher risks assumed by the foreign company would have justified the higher profits being retained there. 

International tendencies point to the prospect of stricter controls in the area of financing. OECD guidelines on financing issues were published in February 2020 and formed the basis for more detailed analysis. It is recommended to prepare for this in time, documenting whether the related party loan transactions were beneficial to both parties, whether the loan transaction was economically rational and what other options taxpayers would have had.