How to avoid risks of recharacterization or disregard of intercompany transactions?

In the day-to-day operations of a multinational group, it is common for related parties within the group to engage in various types of transactions. Purchases, sales, licensing, services, and financing are part of daily operations. But what happens when these transactions are incorrectly characterized by the taxpayer?

In this scenario, tax authorities may not recognize the intercompany transaction or may seek to recharacterize it. This could occur under any of the following circumstances: 

1) the transaction differs significantly from agreements that would have been reached between independent third parties in comparable circumstances, 

2) the transaction lacks economic substance for the contracting parties (meaning there were better alternatives available at the time of the transaction), and 

3) there is an erosion of the taxable base as a result of the transaction between related parties.

Taxpayers in this situation face potentially costly adjustments, the imposition of fines and surcharges, impacting withholding or sales tax, or in the worst case, they may become involved in a situation where tax authorities may seek to typify certain behaviors as simulation, alleging tax fraud.

Consider the following scenarios: 

First a taxpayer consistently incurs losses or is undercapitalized, yet engages in a financing transaction. Should this transaction be considered as financing or a capital contribution? 

Second a company pays royalties for the use of a brand, but the intangibles it uses are more aligned with its production processes. Should it be paying for a brand, a patent, know-how, technology, or some other type of intangible more closely aligned with its circumstances?

The incorrect characterization of intercompany transactions represents a substantial tax risk to multinational groups. A proactive review of your intercompany operations can prevent unnecessary risks. Consult with our expert advisors for a free evaluation to implement efficient tax policies and ensure compliance with your transfer pricing obligations.