New transfer pricing regulation – focus on profitability calculation
Transfer pricing remains a priority audit area for the tax authority. For tax years beginning on or after 1 January 2018, taxpayers are required to prepare their transfer pricing documentation according to the provisions of the Ministry for National Economy decree no. 32/2017. (X.18.) (hereinafter: “NGM decree”), where one of the most significant changes is the requirement pertaining to the specifically detailed presentation of the taxpayers’ financial data.
September 2019, Budapest
Based on the NGM decree, it must be demonstrated – as part of the transfer pricing documentation – that the transfer prices applied in the given transaction were calculated based on the arm’s length prices defined by the selected transfer pricing method. In this respect, the NGM decree requires a summary of the financial information used and the presentation of how this financial data may be linked to the data in the taxpayer’s financial statements. The effective regulation fails to provide further information as to the method or level of details required. However, in the guidance published for the practical application of the NGM decree, it has been added that the arm’s length price shall be reviewed per transaction or per consolidated transaction irrespective of the selected method. Furthermore, the tax authority emphasizes that the method used for assessing the data needed to determine the profit level indicators should be included in the local file as well, e.g. by specifying the individual segment, profit centre or specifying the relevant cost centre, G/L accounts (income, expenses) or engagement codes.
Increased burden of documentation
Collecting financial data in the required detail may pose a challenge to taxpayers. This primarily depends on the transfer pricing method used for the given transaction in the local file, and the level of detail of the internal records available to the taxpayers
– Hedvig Tóth, Deloitte’s transfer pricing team leader emphasized.
In Deloitte’s experience, the most widely used transfer pricing method – except for financial transactions – remains the transactional net margin method (TNMM), which is based on the review of the profitability of the tested party on the tested transaction. The financial data required for defining the profit level indicator for the purposes of the TNMM method (e.g. operating profit on operating costs or related revenue) – in line with the guidance issued by the tax authority – should be disclosed as part of the transaction specific analysis of the Local file for all tested transactions.
IThe above means that rather than companies disclosing the relevant financial data on a company level, they should do this in a segmented manner, in relation to solely the tested transaction(s).
In Deloitte’s practice, companies struggle most with defining costs only indirectly associated with a given transaction. This would require reports from their ERP systems that are not directly available, as well as the creation and use of related allocation mechanisms.
We note that while there is no detailed regulation on such segmented calculations, taxpayers should endeavour to comply with their prime cost calculation principles and other national and international principles (e.g. the OECD Transfer Pricing Guidelines). The tax authority emphasized in its guidance that the preparation of reliable (consolidated) transaction level data in an overseeable menner is essential
– Balázs Prágay-Szabó, manager of Deloitte’s transfer pricing team explained.
For the purposes of defining the profitability data, taxpayers should duly include or, if needed, adjust potential one-off items (out of the ordinary course of business) related to the transaction.
Intensified authority focus on loss making entities
The tax authority has always inspected loss making entities with extra attention, however, with the requirement of transactional profitability data, this tendency seems to further increase. Therefore, it is essential that the determination of the transactional profitability is consistent for all transactions/transaction types and for all tested periods. The tax authority is only able to determine the source of potential losses based on such calculations during an audit. The primary targets of these audits are typically transfer prices, i.e. assessment of whether the prices applied were defined in line with the arm’s length principle.
Please note that as of 1 January 2019, Act CLI of 2017 includes the provision that in the case of taxpayers reaching net sales of HUF 60 billion in two consecutive tax years while realizing zero or negative after-tax profits, tax audit is obligatory. Based on the reasoning of this provision, such taxpayers may deliberately avoid compliance with their tax obligations. These audits are expected to include a detailed transfer pricing audit as an inevitable element.
What is the importance of transfer pricing?
Transfer price is the price applied between related parties. Therefore, if a transaction takes place between parties, which are not independent of each other, i.e. they are related parties, the determination of the prices applied is significant. In the case of cross-border transactions, transfer prices are important because the tax burden may differ between jurisdictions; the general significance is due to the fact that the related parties involved in the transaction have the opportunity to influence their tax bases through the prices applied in their intercompany transactions. Such tax optimization may result in a loss of tax income for the given country; therefore, tax authorities pay special attention to this. Pricing not in line with the arm’s length principle may result in tax assessments during tax audits; the tax authority may challenge the prices applied leading to potential tax base adjustments and tax shortages, with all their consequences (tax penalty, late payment surcharge, default penalty).