Transfer Pricing and Corporate Income Tax (CIT) - Risks and Disputes with the Tax Authorities

Why transfer pricing can increase your CIT liability

Transfer pricing is not a separate tax, but in practice it can lead to a significant increase in corporate income tax (CIT) liability. This happens when the authorities of the National Revenue Administration (KAS) conclude that the terms of a transaction between related entities differ from those that independent entities would have agreed - in other words, that they breach the so-called arm’s length principle.

During an audit, the authority does not limit itself to a formal review of the transfer pricing documentation. It analyses the economic substance of the transaction, including the functions performed, the risks borne and the way the remuneration was calculated. If the settlement model adopted does not reflect market realities, the tax authority may interfere directly with the taxpayer’s taxable result.

The mechanism is relatively simple. Where a price, margin or level of costs does not correspond to market conditions, the tax authority may adjust income upwards in the case of sales at an understated price, limit or exclude tax-deductible costs in the case of inflated remuneration, or adjust the level of profitability to a market level. Each of these adjustments leads directly to a higher tax base and higher CIT.

Importantly, audits concern past events, often going back several years. An upward adjustment of income means not only tax arrears but also late payment interest, which can dramatically increase the company’s overall tax burden.

Intangible services - the most common area of disputes with the tax authorities

Intangible services are one of the most “sensitive” areas of transfer pricing audits. These include management, advisory, marketing, IT or HR services - services that have no physical output and whose value rests on intra-group calculations. From the tax authorities’ perspective, it is relatively easy to show that a cost was incurred, but much harder to prove its actual economic value.

The tax authorities verify in particular:

• The cost base - whether the costs forming the basis of the calculation are genuine and reasonable;
• The method of cost allocation - whether the allocation key adopted (revenue, headcount, working time) reflects the actual use of the services;
• The level of mark-up - whether it is justified by market conditions;
• The benefit test - whether the service brings a real and measurable benefit to the recipient.

It is the benefit test that is of key importance. If the authority concludes that the services were not actually provided or do not bring an economic benefit, it may exclude the entire cost from tax-deductible costs. In practice, this can mean several million zlotys added to the tax base.

Non-market prices of goods and misaligned profitability

Price adjustments in trade in goods

Transactions in goods between related entities are easier to verify than intangible services. The tax authorities have tools to compare prices with the market and quickly identify the two most common irregularities: inflated purchase prices (artificially increasing costs) and understated sales prices (understating revenue).

On the basis of a comparability analysis, the authority examines the level of prices and margins applied to independent entities, the commercial terms and the role of individual entities in the supply chain. Where prices depart from the market level, the tax authority makes an adjustment - it increases revenue or reduces costs, which leads to higher CIT.

Functional profile and profitability

Another important element of an audit is the analysis of functions, assets and risks (FAR analysis). Entities with a simple, routine business profile - such as limited-risk distributors, contract manufacturers or shared service centres - should, as a rule, achieve stable, positive profitability. Losses or very low margins in such entities are a signal of heightened risk for the authorities.

The taxpayer should be able to justify deviations from the market level, for example by a particular market situation, an investment phase or temporary disruptions. Otherwise, the authority will raise profitability to the lower end of the market range, which will directly increase the tax liability.

Debt financing and transfer pricing adjustments

The debt capacity concept

With intra-group financing, the authorities analyse not only the level of interest but the taxpayer’s overall financing structure. The debt capacity concept, that is, an entity’s ability to borrow on market terms, is becoming increasingly important. The tax authority examines whether the taxpayer could obtain financing from an independent lender, whether the level of debt is economically justified and whether part of the financing should instead be classified as equity.

A finding of irregularities may result in a reduction of the market interest rate, the exclusion of part of the interest from tax-deductible costs, or the reclassification of part of the debt as equity. Each of these scenarios leads to an increase in the tax base.

Challenges to year-end adjustments

A transfer pricing adjustment under Article 11e of the CIT Act is subject to strictly defined conditions. The original transaction must have been set on market terms, the change in result must stem from circumstances revealed after the end of the year, and the taxpayer must hold appropriate documentation and confirmations from the other party.

In practice, the authorities very often challenge so-called downward adjustments - adjustments that reduce income - arguing that they are an attempt to “repair” a non-market price originally set, rather than a genuine transfer pricing adjustment. Where an adjustment is not accepted, the cost cannot be recognised, which may increase the tax base by as much as several million zlotys.

How to protect your company from risk - a practical checklist

Preparing for a possible transfer pricing audit requires a systematic approach. The checklist below highlights the key areas that deserve your attention today:

• Intangible services - gather reports, correspondence and evidence of performance confirming a real benefit (benefit test);
• Price calculation - prepare an up-to-date comparability analysis (benchmark) and a justification for the choice of method;
• Profitability - draw up a reliable analysis of functions, assets and risks (FAR) tailored to the company’s profile;
• Transactions in goods - document your pricing policy and compare the terms with market terms;
• Intra-group financing - carry out a debt capacity analysis and prepare an interest rate benchmark;
• Transfer pricing adjustments - make sure the conditions of Article 11e of the CIT Act are met, including the economic justification and confirmations from the counterparty.

A proactive approach to documentation and transfer pricing policy not only helps you avoid costly disputes with the tax authorities, but above all provides tax certainty for years to come.

Don’t wait for an audit - protect your company now

Transfer pricing can become one of the most serious sources of tax risk in your company. An upward adjustment of income, the exclusion of costs or the challenging of adjustments - each of these scenarios means a real and often very significant increase in CIT liability, further increased by late payment interest.

Contact our firm to review your transfer pricing documentation, identify risk areas and implement solutions that will effectively protect your company from the negative consequences of a tax audit. The sooner you act, the better your chances of getting through a possible audit calmly.