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Why related party disclosures matter for tax

Not many people find financial statements interesting. Even finance people don’t take more than casual looks at published financial statements of listed companies. Even fewer people care to look at disclosure notes of the financial statements because it is tedious work. Transfer pricing documentations are even more tedious because they demand that a company not only disclose the actual transactions, but the economic drivers of such transaction. Tanzanian transfer pricing documentation requirements also demand an analysis of industry factors that shape such related party transactions.

A good transfer pricing documentation should be able to provide the reader with a comprehensive view of what related party transactions an entity had, the prices of such transactions and economic basis for why they should be acceptable as ‘arm’s length.’ Moreover, a great transfer pricing documentation speaks to the financial statements, as well as tax return, in perfect harmony.

Every documentation should be crafted with the reader in mind. For transfer pricing purposes, the intended reader is primarily the tax authority. Chapter five of the OECD Guidelines, which deals with documentation, highlights three key purposes of a transfer pricing documentation.

1.      To ensure that taxpayers give appropriate consideration to transfer pricing requirements in establishing prices and other conditions for transactions between associated enterprises and in reporting the income derived from such transactions in their tax returns;

 

2.      To provide tax administrations with the information necessary to conduct an informed transfer pricing risk assessment; and

 

3.      To provide tax administrations with useful information to employ in conducting an appropriately thorough audit of the transfer pricing practices of entities subject to tax in their jurisdiction, although it may be necessary to supplement the documentation with additional information as the audit progresses.

The exercise of documenting indicates the thoroughness of thought that was put in place by those who are documenting. From the revenue authority’s perspective, a transfer pricing documentation is a risk assessment tool. This means that the quality of the disclosure, and the thoroughness of the supporting information will have a bearing on how smooth the transfer pricing audit will be. The important thing to remember is to always triangulate what is documented in the financial statements so that it speaks to the transfer pricing documentation.

What usually transpires is that the preparers of the financial statements, as well as the auditors, are not the same people who look at the transfer pricing documentation. This is because these things are not typically done concurrently. Indeed, even the timing of the preparation of the documents are not the same. Typically, financial statements are prepared and finalized during the audits while the transfer pricing documentations are prepared and finalized at the time of filing the returns. In many cases, these preparers can have different source documents.

As a risk assessment tool, a typical revenue authority official will start with the disclosures in the financial statements to assess the quantum and nature of the related party transactions. Many times, the related party note may not be as detailed as they need to be, which would necessitate further questions or even suspicion. It is therefore important for those reporting the related party transactions to have a clear basis for those transactions (including a clear description of whether those amounts are balances from previous years, or current year related party charges). Indeed, International Accounting Standard 24 (IAS 24) requires the disclosure of four elements among many, these are the amount of the transactions, the amount of outstanding balances, including terms and conditions and guarantees, provisions for doubtful debts related to the amount of outstanding balances, and expenses recognised during the period in respect of bad or doubtful debts due from related parties.

One clear requirement of Tanzanian transfer pricing documentation is the detailed workings and computational analysis supporting the related party transactions. My experience is that if this information is only sought during the time of preparing the transfer pricing documentation, it is often too late. The reporting teams need to have this information, including the volumes, basis for cost allocation, supporting back-end information by the time they are reporting in the financial statements.

The burden of proof for the related party transactions often lies with the taxpayer. The consequences for failing to meet such burden is a potential disallowance of the related party expense or sale, with punitive tax consequences. Taxpayers would therefore be prudent to pay adequate attention to it.

 

Samwel Ndandala is Tax Partner with Deloitte Consulting Limited. The views presented are his own and not necessarily those of Deloitte. He can be reached at sndandala@deloitte.co.tz