Transfer prices targeted by auditors
January is traditionally a month in which KPMG’s tax department becomes involved in the examination of the financial statements of its audit clients, as transfer pricing may be associated with significant tax risks. Our audit teams assess these risks and communicate them to companies’ management bodies, focusing in particular on their systemic nature.
A typical issue to consider is a drop in operating profit or profit before tax. In our experience, a cautious approach is called for: a manufacturing company reporting a significant fall in profit or continuous losses, and simultaneously trading considerably with related parties always draws the tax authority’s attention. In such cases, the tax administrator tends to claim that Czech manufacturing companies are in the position of contract manufacturers and losses should therefore be attributed to their foreign parents.
The tax authorities’ simplistic approach is nothing new; but in 2019, we came across new and rather unclear situations relating to manufacturers that are part of corporate groups: the manufacturing capacity and the cost of labour of such manufacturers were on the verge of economic viability, and they were sometimes unable to deliver the contracted volumes. The question then arises what party to a transaction, the contractor or the manufacturer, should actually bear any related extra costs.
Another trend to consider is that the outcomes of transfer pricing inspections carried out at foreign related parties are systemically mirrored at their Czech counterparties, i.e. the accounting implications of such changes are reflected in the financial statements of Czech companies being audited. These changes may involve adjustments to pricing agreements and business cooperation models, e.g., the introduction of royalties or payments for functions performed abroad that have so far not been remunerated. The Czech tax administration is aware of this tendency and repeatedly made itself clear that it will not automatically tolerate any decreases in the Czech income tax base as a result of foreign inspection outcomes.
We also often encounter the issue of pricing adjustments and their recording in the period to which they relate in terms of substance and timing. We also assess the quality of transfer pricing and inter-company services documentation, bearing in mind that transfer pricing continues to be an area of concern of tax administrators both in the CR and worldwide.
Auditors as external experts are the first line of defence to deal with these issues and initiate communication of transfer pricing risks. Their role is crucial, as they identify the risks and initiate intra-company discussion of relevant remedial measures.