Transfer pricing audit checklist for multinational businesses

If you are a business based in India but deal with your own foreign subsidiaries, every cross-border transaction you're a part of is covered by transfer pricing regulations under Indian and International law. 

Now, to put it simply, transfer pricing is the price you set for goods, services or intellectual property that you exchange with a related company in another country. 

Indian tax authorities and international trade organisations require that you set transfer pricing based on the arm's length principle. They also require you to undergo regular transfer pricing audits to demonstrate that your business follows this principle. 

Let's discuss what transfer pricing audits are, why the arm's length principle matters, and how you can prepare for a successful audit. 

A transfer pricing audit is an evaluation to determine if you follow the arm's length principle when setting transfer prices for cross-border transactions with related entities overseas. The audit is conducted by the Indian Income Tax Department. It is mandated by Sections 92 to 92F of the Income Tax Act, 1961. 

So what is the arm's length principle? Based on it, the prices charged in your related party transactions must be the same as those you would charge an unrelated third party in similar conditions. 

Transfer pricing audits prevent Base Erosion and Profit Shifting (BEPS). BEPS is when businesses shift their profits from jurisdictions with higher income tax rates to those with lower rates by setting their transfer prices too high or too low. 

Transfer pricing audits are part of your regular income tax assessments. These audits can also be triggered if a tax assessing officer refers your case to a Transfer Price Officer (TPO). 

Multinational businesses that operate out of India with subsidiaries in other countries have an obligation to comply with both Indian and international tax regulations. Let's take a look at regulatory considerations to keep in mind: 

1. Indian law compliance

All businesses in India are subject to the Indian Tax Act, 1961. Sections 92 to 92F of this act deal with Indian transfer pricing laws and the arm's length principle. Beyond this, you are also subject to the Central Board of Direct Taxes (CBDT) audit requirements. This means you have to: 

• Maintain extensive documentation under Rule 10D on how you set transfer pricing. 
• File Form 3CEB that discloses all your cross-border transactions after getting it certified by a Chartered Accountant. 

2. Global law compliance

When dealing with related entities across borders, you also have international tax compliance requirements to meet. Apart from following the arm's length principle, you also need to take the OECD transfer pricing rules into account. 

According to OECD transfer pricing rules, the following methods for setting transfer pricing are accepted: 

• Comparable Uncontrolled Price (CUP) Method
• Resale Price Method (RPM)
• Cost Plus Method (CPM)
• Transactional Net Margin Method (TNMM)
• Profit Split Method (PSM)

Also, every transaction you make with related parties should be compared with transactions between comparable independent parties. 

Cross-border transactions must also comply with laws in the countries you are dealing with. For example, the Internal Revenue Code Section 482 in the US, the Taxation Act 2010 (TIOPA) in the UK and the EU Joint Transfer Pricing Forum (JTPF) in EU countries.

Transfer pricing audits apply to businesses that have a large volume of international transactions every year. The process usually involves document scrutiny, analysis, and information requests. Here's how the entire process works: 

1. Triggering the audit 

A transfer pricing audit can be triggered by an assessing officer during your regular tax assessment. Once it's triggered, your case gets referred to the Transfer Pricing Officer or TPO. Your transfer pricing audit applicability is determined by: 

• The volume of your international transactions. 
• The presence of any suspicious profit patterns. 
• Whether you operate in an industry with a high BEPS rate. 

2. Initial scrutiny 

If a transfer pricing audit has been triggered, the TPO will review your documents, including the Form 3CEB. They will also request you to submit your transfer pricing documentation, such as your TP study reports and intercompany agreements. You would also have to submit your documentation as per the BEPS Action Plan 13, which includes the Master File, Local file and CbCR. 

The scrutiny will also include checks to determine if you used the Most Appropriate Method(MAM) and the right comparables for setting your arm's length pricing. 

3. Functional and economic analysis

The analysis part of the audit includes a FAR (Functions, Assets, Risks) analysis. This means the authorities will analyse the following by each of your related entities: 

• Functions performed: What activity is each entity responsible for?
• Assets employed: What resources did each entity contribute to the transaction? 
• Risk assumed: Which of your entities is bearing the financial and operational risk of the transaction? 

When they put these aspects together, they will be able to determine if any of the entities is earning super-normal profits and if the profits are distributed fairly based on real value creation. 

4. Requests for clarification 

You may have to undergo several rounds of queries and clarify your: 

• Pricing rationale, including your pricing methods and benchmarking comparables 
• Agreements and evidence 
• Proof that services were actually rendered. 

5. Audit outcomes

Finally, the TPO will determine if the transfer pricing at your business was set fairly. Suppose they find that your transfer price does not reflect arm's length condition, a transfer pricing adjustment will be made. This adjustment hikes up your taxable income in the country. 

A transfer pricing adjustment can mean a higher tax liability. If the TPO flags severe price manipulations, you may also be forced to pay a penalty. 

6. Dispute resolution 

In case you disagree with the outcome of your transfer pricing audit, you have the right to appeal the decision. Here's how: 

• You can appeal to the Dispute Resolution Panel (DRP). 
• Approach the Income Tax Appellate Tribunal (ITAT).
• Or use APA (Advance Pricing Agreement) or MAP under double taxation treaties for resolution.

The lack of clear and comprehensive documentation is why several businesses fail the transfer pricing audit. It is generally a good practice to prepare and maintain documentation of your transfer pricing policies as you go to avoid scrambling for documents if an audit gets triggered. 

Here's a document checklist you can use: 

1. Form 3CEB: This is a mandatory form to file with your Income Tax Return. 

2. Transfer Pricing Study Report: This should include the nature and value of your transactions, profile of the multinational group and your Indian assets, your Functional, Assets and Risk (FAR) analysis and the explanation of the most appropriate method for transfer pricing chosen. 

3. Supporting Documents: You would need to share intercompany agreements, invoices and transaction records, price-setting policies, and evidence of actual services rendered. 

All of your transfer pricing documentation must be aligned with the OECD three-tiered documentation standard under the BEPS Action Plan 13. This means you have to maintain three documents: 

1. Master File 

This is a document that provides an overview of the entire multinational group. It shows your organizational structure, how entities are related, intercompany agreements and your consolidated financial statements. 

2. Local File 

The local file is a detailed country-specific document with information about your Indian entity's business operation, local FAR analysis and benchmarking with comparable independent transactions. 

3. Country-by-Country Report (CbCR)

This is a consolidated report of your revenue, profit/loss before tax, taxes paid, and number of employees in each jurisdiction. It also includes a list of your entities in each tax jurisdiction and details of their business activities. 

While it is true that transfer price audits require heavy documentation and can sometimes result in outcomes like a higher tax liability or penalties, there are also benefits that these audits can bring to your business. The benefits include: 

1. International tax compliance

A successful transfer pricing audit demonstrates that you are compliant with Indian, OECD, and other international regulations. This protects you from scrutiny from multiple tax agencies. 

2. Reduces the risk of double taxation

Double taxation is when you are forced to pay taxes for the same income in multiple countries. This happens when both countries feel entitled to tax that income. A transfer pricing audit proves that you have not artificially moved income from one country to another using unfair pricing methods. So, you pay tax only where the income was actually generated. 

3. Early detection of high-risk transactions 

Royalties, intercompany loans and service fees are some areas that tax authorities are often sceptical about, as they can be used to shift profits across borders. 

When you prepare for an audit, you can check that your pricing, terms and documentation are all in line with local and international regulations. You can then identify issues and fix your documentation early before they are noticed by tax authorities and attract penalties.

An inbound transaction is when your Indian entity is the buyer and has to pay the foreign subsidiary. The transfer pricing audit for an inbound transaction would determine if you are paying too high a price for goods and services and shifting profits out of India. 

On the other hand, an outbound transaction is when the Indian entity is the seller and is receiving payments from the foreign entity. In this case, the audit would determine if you are charging too low a price for the goods and services received and effectively under-reporting your profits in India. 

A transfer pricing audit focuses on identifying if you've followed the arm's length principle in your transactions with related entities. A statutory audit is entirely different from a transfer pricing audit. A statutory audit checks if your financial statements comply with accounting and legal standards. It is governed by the Companies Act, 2013 and follows the standards set by the Institute of Chartered Accountants of India (ICAI).

Here's how a pricing audit and a statutory audit differ from each other:

Here are some challenges that can come up with transfer pricing audits: 

1. Weak documentation and data gaps 

Not having documentation like transfer pricing studies or FAR analysis is a common reason businesses fail their audits. Weak documentation also means that a lot of your data related to agreements, transactions, and pricing is missing. To tax authorities, this looks like your transfer price is arbitrary and leads to income adjustments.

2. Choice of transfer pricing method 

There can be a disagreement between your business and the tax authorities regarding the Most Appropriate Method (MAM) for transfer pricing. A mismatch in method selection can translate to huge differences in the authorities' profit calculation and your actual profit. This results in upward profit adjustments. 

3. Selection of comparables 

Your transfer pricing relies heavily on the independent comparable companies you choose to benchmark your prices against. Authorities very often may reject your comparables due to differences in business size, models or geography. 

When tax authorities choose different comparables, it changes the transfer pricing calculations and can inflate your profit margins, leading to a higher taxable income. 

Transfer pricing audits can be quite time-consuming as they are detailed and data-heavy. Preparing for these audits in advance will put you in a better position to defend your pricing policies and complete the process successfully. 

Here are a few best practices to follow: 

1. Maintain detailed documentation throughout the year. Keep updating your transfer pricing reports, benchmark studies and FAR analysis regularly to avoid last-minute hurried changes that usually lead to errors. 

2. Align all your documents with OECD BEPS standards and maintain that consistency across all jurisdictions. 

3. Prepare yourself with internal transfer pricing audits. This helps you test your own transactions and identify issues before the tax authorities do. 

4. Use the most recent and defensible industry data to pick reliable comparables. Also, keep records of why you chose specific comparables over others. 

5. Maintain evidence for all your intra-group services like emails, invoices and reports. 

6. Wherever feasible, negotiate Advance Pricing Agreements (APAs) with tax authorities in advance to avoid disputes with them in the future. 

Transfer pricing audits require you to present detailed records of all your cross-border transactions. Preparing these documents manually can be time-consuming. A good way to simplify these audit preparation tasks is to automate them using accounting and compliance tools. 

These tools can help you: 

• Capture all of your intercompany transactions on a single system. They give you a clear transaction trail that can be presented during audits.

• Automate all your documentation and align reports with Indian and international transfer pricing laws and standards. 

• Match data in local and global reports to avoid cross-border inconsistencies. 

• Access comparables databases and benchmarking features to test your pricing margins before audits. 

• Flag high-risk transactions and inaccurate pricing to maintain consistent compliance.

As your business grows and expands to new tax jurisdictions, adhering to all tax regulations and transfer pricing laws can be quite challenging. The good news is that developments in AI, machine learning and automation technologies promise easier audit preparation and transfer pricing process.

Here's how transfer pricing audits will get simpler in the future: 

1. AI-powered benchmarking and audit intelligence 

AI will start helping with reviewing comparables, verifying that they meet standards, and helping companies choose the right comparable for their transfer pricing process. AI can be used to auto-check the accuracy of your filings like CbCR and APA. 

2. Digital documentation 

Maintaining detailed documentation for audits will get a lot simpler with automated filing and report creation. You will also be able to specify formats and standards that need to be followed with each document and get it done without any manual intervention.  

3. Cross-Jurisdiction coordination 

AI-driven data sharing between your entities across geographies can help you create a consolidated global compliance dashboard. Consistent reporting across countries reduces your risk of double taxation and excessive audits.

The primary requirements of maintaining cross-border tax law compliance are being able to produce accurate documentation that aligns with Indian and OECD transfer pricing rules. For this, you need payment solutions that fully comply with local and global taxation and help generate reports and documents automatically. 

Xflow is a cross-border payment solution that helps your business receive payments from international businesses with complete transparency. Xflow’s transaction records meet Indian transfer pricing laws and OECD documentation standards. Every transaction is tracked with the right tax disclosures, which makes your audit preparation easier. 

Xflow also offers: 

• Virtual bank accounts and local collections in INR
• Multicurrency support 
• Automated digital FIRA and eFIRA generation 
• No invoice limits and flexible FX rates 
• Enterprise-grade security and in-built compliance tools 

Xflow can dramatically simplify your audit readiness for both Indian and OECD transfer pricing standards. Schedule a demo and see how Xflow works for your business!