burden of proof in transfer pricing

It is a common practice that the tax authorities require a transfer pricing study to be conducted where there are inter company related transactions. The transfer pricing study is used to support the profit margin that the company ought to have earned.

Just because there is inter related party transaction does not mean that the profit margin is inaccurate. Attention should focus on whether the profit margin can be justified. And that requires analysing the cost of goods sold. And in analysing the cost of goods sold, the inter company payments could also be analysed to determined if any of the inter company payments ought to be allocated to those goods sold. Those payments can then be added to the cost of goods.

Any remaining inter company payments should then be separately analysed. All expenses paid by the company under the general rules are typically deductible any way. The mere fact that the payments are to a related entity does not make the payments non-deductible. Should it not be the tax authorities that has the onus of challenging the deductibility of the inter company payments and it is then up to the company to justify the functions, assets and risk analysis of why the expense should be deductible.

The difference in this approach is that the expenses out to be prima facie deductible. And it is the tax authorities that has the burden of discharging the onus that it is not deductible and it is the tax authorities that has the burden of producing the local comparables in order to do so.

Although it may seem practical to adopt a simplistic approach in conducting a benchmarking study to justify the profit margins of the company, there should not be an over reliance on empirical data. Entity characterisation ought not to be taken to the extreme such that companies need to fit within each pigeonhole. There is no justification for the tax authorities to require companies to operate in a particular manner. Oftentimes, it is the uniqueness of the business operations that make a company profitable. Furthermore, in carrying out its duties to collect taxes, the tax authorities should not overly burden the taxpayer.

In short, the tax authorities should operate within the audited financial statements of the company. After all, those figures are audited and are relied upon by shareholders and stakeholders using the financial statements. And those financial statements do verify that the gross profit and the operating profit figures are true and fair.

The company should be able to rely on those same financial statements to support that the inter company related payments are also true and fair and fully disclosed. Again from the standpoint of the financial statements, the onus is on the tax authorities to prove that the financial statements are in fact not true and fair.

To shift the onus to the taxpayer would be to require the taxpayer to conduct an exercise principally for tax purposes which does not derive any value to the company. And that would go against the objective of the company to keep its eye on achieving profitability.