Impact of transfer pricing on the financial statements

Profit shifting is believed to be a common practice used by multinational companies to spread profits and reduce taxes. However, in our experience, transfer pricing problems usually arise in cases where the taxpayer has disagreements with the Latvian Tax Authority due to differences in experience, knowledge, etc., rather than because of any underlying bad faith.

The impact of transfer pricing on financial statements can be significant and can affect a company’s financial performance, tax liabilities and compliance with accounting standards.

Revenue and expenditure recording

Transfer pricing can affect a company’s revenues and expenses because it affects the prices at which goods and services are sold between related companies. This may result in differences in the recognition of revenue and expenses.

This is the primary way in which transfer pricing affects the annual reports. There are two extremes with regard to annual reports, i.e. audit opinions. First, the annual reports most often state that transactions were carried out at market (arm’s length) prices, a conclusion that is not supported by any evidence. The other extreme is that the auditor states in the audit opinion on the annual report that the transfer prices are not reasonable and are subject to material misstatement. In either case, the taxpayer must cooperate with the auditor by providing the necessary calculations and other information to satisfy the auditor that the transfer pricing has been applied appropriately. However, this also means that the auditor has to consider all relevant factors and not, for example, just the fact that the taxpayer has not prepared transfer pricing documentation.

What are the typical situations that pose risks?

Where goods/services are sold to related parties, the net profit/cost method is generally used, applying a mark-up to the cost base (assuming the cost base is uncontrolled). The most common problem with revenue is that the entire cost base is not taken into account when selling goods or, in particular, services to related parties. For example, a service provider achieving management services pays and employee a bonus in January 2023 which is expensed in 2022 because it relates to the period during which the employee has successfully performed the duties. However, this cost is not included in the 2022 transfer pricing calculations because the company has invoiced at the end of each month based on a full cost-plus approach. This will result in a loss in the 2022 income statement. If revenues are below market value or expenses are above market value, the best way to solve this problem is to issue a transfer pricing adjustment invoice in the last month of the year or immediately after the year end and included in the previous year.

The main problem for distributors is often the incorrect purchase price from a related company. When selling to unrelated customers, prices are dictated by the market, so for example a customer may demand a substantial discount which will reduce gross margins. Such a reduction may result in the gross profit not covering the administrative costs and, consequently, a loss. Therefore, in commodity purchase transactions, it is essential to provide in the controlled transactions agreement a mechanism for adjusting the purchase price in line with changes in the market. Of course, it is possible that the distributor may bear all the risks and incur losses as a result, but such situations are difficult to justify and can only work in the short term.

Corporate income tax risk

As a consequence of the tax risks described it the previous paragraph, transfer pricing can affect a company’s tax liability because it can affect the allocation of profits between different jurisdictions through a reduction in revenue or an increase in costs. Tax authorities may challenge transfer pricing arrangements if they consider that they do not comply with arm’s length conditions, resulting in additional tax liabilities and penalties and interest.

Existence of transfer pricing documentation

The existence of transfer pricing documentation is important to substantiate transactions between related companies, but in certain cases it is mandatory. As a reminder, documentation becomes mandatory when the total amount of transactions between related companies reaches EUR 250 000 per year. In case the total amount of controlled transactions reaches EUR 5 million, then it is important not only to prepare, but also submit the documentation to the Latvian Tax Authority on time.

In Latvia, there is a significant problem, namely that the tax liability resulting from transfer pricing adjustments has to be disclosed in the last (December) return of the year, i.e. by 20 January of the following year. The annual report has to be submitted within 4 months after the end of the accounting year, while the transfer pricing documentation has to be prepared by 31 December of the following year.

This creates a rather absurd situation where the taxpayer has to understand at the end of the year whether transactions are carried out in accordance with the transfer pricing principles. This requires regular monitoring of pricing and the issue of adjustment invoices at the very end of the year.

To avoid such problems, it is advisable to set up a transfer pricing system and follow it independently – by preparing a budget and monitoring its implementation. To fully eliminate the risks, it is advisable to prepare the documentation in time for the annual report. This will prevent transfer pricing risks from being reflected in the annual report and will also reduce the risk if late payment penalties if it turns out that transfer pricing adjustments have to be made to the CIT return.

Compliance with accounting standards

Controlled transaction contracts must comply with accounting standards such as International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP). Failure to comply with these standards may result in misstatement of the financial position of the company the problem is that transactions with related companies are often limited in terms of functions and risks, as only certain functions are delegated to the company.

For example, where a group consists of a service provider and an intermediary whose sole function is to control the paperwork and payment, then it is formally the intermediary who invoices the customer for full amount. But by applying accounting principles such as “Revenue”, it becomes clear that it is not reasonable to recognize the full amount of money received as revenue, i.e. it is correct to recognize only the revenue of the intermediary that arises from the actual risks and functions undertaken.

Financial performance

As a result of the above, transfer pricing can affect a company’s financial performance, such as return on assets, return on equity and profit margin. If the transfer pricing arrangement results in lower profits in certain jurisdictions, this may affect these ratios, which in turn may affect how investors and creditors assess the financial performance of the company and, for example, reduce the ability of the related company to obtain bank credit or limit the company’s competitiveness in the market.

What to do?

The first important thing is to understand the principle of controlled company pricing – what method is used and what are the data transactions to be compared.

The next step is to draw up a budget for the year, or at least price estimates, and monitor the budget as the year progresses.

At or near the end of the year, assess possible anomalies and make proposals to resolve them (corrective invoice, explanations, etc.).

This year-end assessment will provide a good and sufficiently accurate basis for making adjustments to the tax return (if possible), as a basis for submission to auditors, and as a for transfer pricing documentation. I would that this is a recommendation and not a mandatory requirement, as the preparation of transfer pricing documentation is not compulsory until the annual reports are submitted.

The final step is the development of a comprehensive transfer pricing documentation, which can be done within a year of the end of the reporting year, but the development of such documentation is not an end in itself, but a description and justification for the exiting transfer pricing system.