With the second deadline for filing your country by country report (CbCR) just behind us, the question arises whether tax authorities will use the CbCRs as roadmap for tax audits. How can multinational enterprises (MNEs) lower the probability of being subject to a tax audit?
To lower the probability of an audit, a thorough analysis of tables 1 and 2 of the CbCR is required. Various ratio analyses should be performed to identify red flags and potential vulnerabilities, which can then be addressed either as part of the preparation of the CbCR or through other documentation.
In our experience tax authorities want to have the full picture before asking questions and auditing MNEs following the submission of the CbCR. Anticipating possible questions which may arise following an analysis of the CbCR in the Master File and Local File, together with consistency in the MNE’s external communications, may reduce the likelihood that your MNE will be chosen as next taxpayer to audit.
To address red flags, the CbC Reporting strategy could be reconsidered, by making use of the freedom given by the OECD CbCR guidance regarding the interpretation of certain definitions, like for instance the profit definition. In various reporting countries, as the Netherlands, MNEs can exclude dividends and capital gains derived from constituent entities from profit before tax. Since such income is generally exempt pursuant to a participation exemption, the outcome of the ratio analysis (income tax accrued/profit) will show a closer resemblance to the actual tax position of the country reported, thus reducing red flags. Furthermore, red flags could be explained in table 3 of the CbCR, for instance if in a country taxes are levied on a consolidated basis, whereas the CbCR is compiled on an aggregate basis. This may explain an otherwise strikingly low effective tax rate.
Beyond the CbCR, red flags and vulnerabilities can be addressed proactively in the MNE’s Master File or Local File. By explaining how the required (risk control) functionality takes place, that this is in line with the contractual arrangements and that the pricing of the transactions is in line with the OECD Transfer Pricing (TP) Guidelines, red flags can be addressed in a neutral manner. Choices made should be substantiated in the TP documentation, not only positive ones, but also negative ones. Furthermore, MNEs should be aware of the fact that linking CbCR data (like table 2 data) to other databases the tax authorities have access to (like business information databases) gives tax authorities around the globe a wide source of information to explore. And to ensure consistency among the sources that the tax authorities consult, TP documentation should be aligned with external communications like the corporate website and LinkedIn profiles of employees.
When red flags cannot satisfactorily be explained in the Master File or Local File, the MNE may have to reconsider its business model or specific transactions in place. This will not eliminate the red flags for the year under review, but would result in a better picture to be shown in future years.