Is the logic of transfer pricing in place and is documentation updated?

Eve Lille
Eve Lille Grant Thornton Baltic

Why should transfer pricing be a top focus? 

Transfer pricing is often talked about solely in a tax accounting context but actually determining transfer price requires the existence of a strategically good budgetary and cost accounting system in managerial reporting.

If a company has designed a detailed, adequate cost accounting system, a key precondition for shaping transfer prices has been met, especially when it comes to transactions related to goods and services where a clear cost base is even more important than mark-up. Incorrectly determined transfer prices can have a significant influence on the financial results of parties to a transaction and thus financial reports can provide a misleading picture to information consumers, as well as owners for example, regarding the actual performance and financial position of a company.

Estonia has a requirement of preparing detailed and comprehensive transfer pricing documentation when consolidated revenue, balance sheet volume or number of employees thresholds are exceeded. Whereby it should be borne in mind that Estonia has many smaller companies that are part of large international groups and which are thus also bound by the detailed documentation obligation. 

Transfer pricing documentation must be submitted to the tax authority at the request of the latter within two months, but if transfer prices have not been continuously and proactively documented, practice shows that often it takes significantly more time to create the original documentation. This results in pointless time expenditure for the company’s management and accountant. If the pricing of transactions is not in line with the arm’s length principle, the worst case is that financial reporting must be corrected or a tax assessment must be obtained which in addition to the time expenditure also means money, since the tax authority can make retroactive adjustments going back up to three years.

Tax audits of transfer pricing seen more frequently

In the last few years, the tax authority has significantly increased the number of audits related to transfer pricing, especially where companies perform cross-border transactions with related parties. For the tax authority, annual reports are extremely efficient starting sources of information for identifying potential transactions between related parties, and involve a higher probability of facing a tax audit regarding transfer pricing.

If a subsidiary of an international group is operating in Estonia and making a loss and the note in the annual report on related parties indicates that a significant share of the sales or purchases was with related parties, that sets off alarm bells and can raise the suspicion that transfer pricing principles may not be aligned with the arm’s length principle. So it pays to be attentive and head off potential later transfer pricing disputes.

Business operators should be sure to note that if transactions between related parties are evident in the annual report but the transfer pricing transactions are not clear and precise, it would be a good idea to take time to map the major transactions and put in place transfer pricing principles.

How to prepare for an unexpected tax audit?

It is worth being prepared for unexpected audits – so think through the pricing of related-party transactions before you ever enter into the transactions. The more elaborate the transaction, the more attention and unravelling of details it needs to avoid later costly transfer pricing adjustments.

If you already have transfer pricing documentation, be sure to review whether it still meets the requirements of the regulation now in force. This pertains especially to companies whose documentation was last updated more than three years ago. Namely, a new wording of the regulation on transfer pricing came into force in early 2022, which provides much more detailed documentation requirements for such aspects as describing supply chain, proving the conformity of financing transaction agreements to the arm’s length principle, etc. In addition, updating documentation is critical if major changes have occurred in the company’s business activity and the logic for determining transfer prices as described in the documentation no longer matches the economic substance of the transactions. That, too, brings the risk of retroactive adjustments.

To avoid unnecessary tax risks, Grant Thornton Baltic’s specialists can provide support in transfer pricing planning, preparing transfer pricing documentation and updating documentation.