Estimating Income-Adjustment Risk in Transfer Pricing

Abstract

Transfer Pricing policies are the focus of many investigations on corporate income around the world, yet corporations rarely use models and metrics to estimate their exposure to tax risk. In this paper I propose a framework for multinational enterprises to deal with transfer pricing risk, i.e. the risk of incurring income adjustments and penalties as intercompany prices fall out of the arm’s length range. We’ll approach the issue from an a-priori perspective, by developing a risk model for mapping risk over transactions and for estimating the risk to undergo a tax audit, and from an a-posteriori perspective, where we look at risk as a function of the actual-price location in the benchmark range to estimate the risk that actual prices fall out of the arm’s length range. Those are scenario probabilities from which we can derive also tax risk expressed in monetary units. This framework can be used to design transfer pricing policies, to test pricing methods, to forecast the behaviour of the tax administration prior to or during an audit, and to quantify the monetary value of tax risk.