The OECD has released for comment a draft handbook in respect of transfer pricing risk assessment. This is intended to be a practical resource for tax administrations to follow in developing a risk assessment approach to transfer pricing issues. Comments are invited from interested parties by 13 September 2013.

The need for a risk assessment approach is driven by the need to make efficient use of the resources available within a tax administration. This depends on an informed selection of cases for audit based on an effective risk assessment process. If the risk assessment process is performed correctly the result should also be a more focused audit.

An important point made is that a transfer pricing risk assessment is not just to be performed before the commencement of the audit but can be a continuing activity throughout the course of the audit. The audit itself constitutes a process of risk identification and assessment. However the draft handbook concentrates on the risk assessment to be performed in the course of selecting cases for audit.

The first feature that would be looked at in a transfer pricing risk assessment process is the existence of material controlled transactions with related parties.  This may not be evident just from the company’s accounting records. For example, there could be substantial transfers of intangible assets including know-how for which no payment has been made and no record is therefore kept. In respect of transactions between a head office and a branch there may be a need to attribute profits even though there are no recorded transactions with respect to certain dealings. These dealings may be related to allocations of capital or interest. An assessment of whether a related party transaction is material should take into account the size of the transaction and of the company, but also the size of the transaction in the context of the jurisdiction where it takes place.

The tax administration then needs to look for indicators of transfer pricing risk to the tax administration. This risk would occur where income is shifted to other tax jurisdictions, eroding the tax base in the home country. In looking for this risk the tax administration may consider if the profitability of the taxpayer is consistent with that of similar enterprises in its industry; whether it engages in transactions with related parties in low tax jurisdictions; or where persistent losses are reported over a number of years. Another indicator is the existence of large payments to related parties of items such as royalties, rentals, management fees, insurance, or other intragroup services. Other transactions that may indicate higher risk are large payments in respect of financial derivative transactions or interest on related party loans.

Having identified such transactions the tax administration must look at the effect on the income of the taxpayer, consider the size of the transactions and look at their consistency with the global policy of the multinational group to which the taxpayer belongs. Policies with regard to allocation of risk within the group should also be examined. The group may claim that the local member is a low risk entity, earning a low return for routine activities. This low income could then be reduced further by transactions such as royalties, rents or management fees with the result that the income is reduced to a very low level. The scale of the potential loss of tax revenue should be considered in relation to the cost of a large scale transfer pricing audit.

Where the tax administration considers the above questions and determines that there should be a transfer pricing audit the information gained during the risk assessment process may be used to focus the direction of the audit.

The draft handbook sets out common practices in respect of evaluating risk factors. Risk may arise because the taxpayer is undertaking recurring cross-border transactions that could erode the tax base in the home country. The tax administration could decide on quantitative thresholds in respect of gross annual transactions or income within which risk is considered low. Consideration must be given to the type of intercompany transactions involved. The sale of commodities to related parties in high tax jurisdictions might not be considered to give rise to concern whereas payments for items that are difficult to value should be examined more closely. Examples are interest or insurance payments, management fees or royalties for intangible assets. Risk may also be present if payments for such items are too small.

The recipients of the payments must be examined in relation to the type of transaction and the jurisdiction where the recipient is located. The tax administration must take into account that the recipient could be a conduit company and the payments are in fact being paid on to a third jurisdiction.

Large or complex transactions that are performed just once may pose a different risk. For example, payments in respect of business restructurings may change the relationships between the parties and the pattern of intragroup payments into the future. The risk is therefore much larger than just the risk arising from the quantity of the one-time transactions in the restructuring.  Especially transactions in intangibles require special scrutiny owing to problems such as the uncertainty of valuation of intangibles. Cost contribution arrangements for the development of intangibles also warrant special scrutiny.

A further category of transfer pricing risk arises from taxpayer behavior, which could be evidenced by insufficient effort on tax compliance. Taxpayer risk may arise from governance issues within the entity or from aggressive tax strategies. Where a taxpayer is not compliant with tax requirements, putting complex tax structures into place or not cooperating with the tax authorities, the tax administration should take into account the corporate culture and the general behavior in the business sector in which the taxpayer operates.

The tax authorities need to quantify the amount of tax potentially at stake and prepare a cost benefit analysis. This should consider the amount of tax administration resources that would be needed to perform the transfer pricing audit and also consider if these resources would be more effectively devoted to another case. There is also the possibility of systemic risk that may need to be addressed, where a large number of taxpayers in a particular sector are engaging in certain low volume transactions that may represent a large revenue loss when viewed in aggregate across the business sector.

Some items that could be seen as a sign of transfer pricing risk include levels of profit that are different to those of related parties or group results; a different level of profitability to that in the business sector generally; recurring losses, low profits or low returns on investment; fluctuation of profits that runs contrary to trends in the market; or substantial income in low tax jurisdictions.

The draft handbook suggests the usefulness of various sources of information that could be used in the transfer pricing risk assessment. The first evidence to examine is the tax return or transfer pricing informative returns, contemporaneous transfer pricing documentation and replies given by selected taxpayers to questionnaires sent to them. The tax administration may also consider the audit records for previous years and the files held in respect of the taxpayer. Then other publicly available information could be considered, including internet searches of government databases or taxpayer websites; press reports, trade journals, commercial databases, meetings with employees of the taxpayer, records from the customs or patent authorities or the exchange of information with foreign jurisdictions under tax treaties.

Tax administrations need to consider whether a centralized team or a decentralized model is appropriate for conducting risk assessments, taking into account the number of cases, availability of resources and effectiveness of communication within the tax administration. The risk assessment should follow a consistent procedure and result in a risk assessment report setting out the risk indications identified and reasons why an audit should be undertaken. The risk assessment report should contain an audit plan including the specific issues identified, thereby using the information gained during the risk assessment process to guide and direct the transfer pricing audit procedures.

The draft handbook looks at the draft engagement approach which involves building constructive relationships with taxpayers. This could involve engaging with taxpayers in real time by for example holding pre-filing meetings with the taxpayers to identify key issues. Potential transfer pricing disputes may thereby be resolved while the relevant employees and the important information are still available. The tax administration involved in this process must take a decision on whether to share the transfer pricing risk assessment with the taxpayer. Businesses generally welcome this move although not all tax administrations follow the policy of sharing risk assessments. The handbook concludes by setting out the practice in some major jurisdictions including the US and UK.