Should we only deal with transfer pricing when the tax office comes knocking at the door? By then it’s usually too late. A lack of documentation regarding the transfer prices at which companies within a group charge each other for goods or services can result not only in additional tax assessments running into millions, but also in weeks of work for management and unnecessary crisis management. So, how do you go about transfer pricing, step by step?
Transfer pricing is no longer just a tax issue. It is an area that has a direct impact on finance, risk management, internal processes, and relations within the group.
At first glance, transfer pricing documentation may seem like a pure formality for filing. In fact, it consists of a set of economic, accounting, tax and legal documents which must form a single coherent whole. It is only when the tax office carries out an audit that many companies realise that, whilst the individual parts may exist, they do not hold up when taken together.
Although transfer pricing documentation is not yet generally mandatory, in practice businesses often find they cannot do without it during tax audits. Furthermore, the government has sent a clear signal to multinational groups – in its policy statement, it indicated that companies will have to have the documentation for determining the arm’s length price ready in advance.
For senior management, this means one thing: transfer pricing should no longer be viewed as purely a tax issue that you only start addressing within the company when a tax inspection takes place. It is an area that has a direct impact on finance, risk management, internal processes, and relations within the group.
Risks and consequences
The lack of prepared documentation is not merely an administrative complication. In the event of an audit, you may face administrative fines, but above all additional tax assessments, interest on arrears and, as a rule, penalties. In the case of larger transactions, the sums involved can quickly run into tens or hundreds of millions of crowns. Tax audits also place a burden on internal teams, take up management’s time and often raise issues that you should have addressed within the company long ago.
When the tax office starts taking an interest in transfer pricing, they will not usually give your company several months to start mapping out intra-group transactions, track down contracts, explain pricing, or retrace who actually decided on a particular model for intra-group transactions. In addition to individual transactions, it is therefore important to examine the overall internal transfer pricing arrangements in detail. Join us as we walk you through how to do it. Can you answer these questions?
Transfer pricing step by step
1. Do you know exactly what intra-group transactions you have?
The first step is to regularly identify and update intra-group transactions. Map out the terrain in detail.
2. Do you have appropriate contracts in place for all intra-group transactions? And do the contracts reflect the reality?
The second step is to review the contractual documentation so that you have an overview of all the necessary contracts and to ensure that they reflect the actual way the business operates.
3. Can you prove how the price was determined?
The third step is the pricing method and its economic justification; ideally, prices should be underpinned by a comparative analysis where appropriate. It is often difficult to interpret the results correctly here. You can also turn to experts who will help you with a comparative analysis.
4. Do you have any documentation regarding the services received and their benefits? Are the allocation keys logical and documented?
The fourth step is the ongoing collection of evidence regarding the delivery and benefits of the services procured.
5. Do the company’s results reflect its role within the group? And have you got everything ready so that you can respond quickly if the tax office makes an enquiry?
The fifth step is to check the results, i.e. to verify whether the actual financial results correspond to the model that has been set up. It is precisely this point that is often underestimated. Although the company has drawn up documentation on transfer pricing and how it is set, the actual margins or results deviate significantly from this, and no one is addressing the issue in a timely manner.
From a management perspective, it is best to start simply. First of all, get a clear picture within the company of the intra-group transactions that are actually taking place. In practice, it is not just a matter of buying and selling goods. These often include management services, IT support, marketing, shared administrative functions, licences, cash pooling, intra-group loans, guarantees, cost re-invoicing, etc. The first step should be to draw up a map of these transactions: who provides what to whom, in what quantity, under what contract, according to what pricing model, and why.
Be wary of management services
It is precisely the economic rationale that tends to be crucial. It is not enough simply to prove that an invoice was issued. You must be able to explain why the transaction was structured in a particular way, what benefits it brought, and whether it would have taken place under similar conditions with other third parties. This is a particularly sensitive issue when it comes to services, especially management services. In recent years, these have been the subject of tax audits, and in practice it is often very difficult for companies to provide satisfactory evidence in the taxpayer’s favour.
The tax authorities typically do not merely enquire whether a service has been invoiced, but whether it was actually provided, whether it conferred an economic benefit on the recipient, whether it was not a duplicate service, and whether its price complies with the arm’s length principle. If you are unable to provide evidence of the content, scope and recipients of the service, how the price was calculated, and the specific deliverables, you will find yourself in a weak position.
Evidence comes in handy
When it comes to services, it is therefore worth having not only contracts and invoices ready, but also practical evidence of performance. These typically include reports, presentations, email correspondence, timesheets, project descriptions, internal deliverables, or activity reports that show what has actually been delivered. It is also important to distinguish between services that bring a real benefit to the Czech company and activities that the group carries out primarily for its own sake, for example in its capacity as a shareholder or owner. It is precisely in the case of shareholder activities that the risk of tax non-deductibility tends to be high.
Equally important is setting the right prices and profit margins for goods throughout the supply chain. In business models based on distribution or manufacturing, it is important to understand who within the group is responsible for which functions and what risks they bear. In other words: who decides on the strategy, who owns the key assets, who bears the inventory risk, exchange rate risk or sales risk, and who is to earn the corresponding margin.
Intra-group financing
Intra-group financing is a topic in its own right. Loans between companies within the group, cash pooling, guarantees and other financial transactions have come under increasing scrutiny in recent years. It is not enough simply to have agreed on an interest rate. You must be able to provide evidence of why the loan was granted, in what amount, for what period of time, on what terms, and whether an independent creditor would have accepted similar terms. The borrower’s credit profile, the purpose of the financing, the security provided and the overall economic rationale of the transaction also play a significant role. In practice, a common weakness is when a group applies a uniform financial policy that does not take into account the specific circumstances of individual countries or companies.
The tax office can usually audit transfer pricing for the last three years, but in the case of loss-making companies it may go back further.
The allocation key is crucial
Cost allocation is also a very common problem. The group procures certain services centrally or operates shared functions, and subsequently allocates the costs amongst the individual companies. That in itself is nothing out of the ordinary. A risk arises when it is unclear why and according to what criteria the costs were allocated, and whether the criteria correspond to the benefit actually received.
The allocation mechanism should therefore be clear, consistent and economically justifiable. If, for example, IT support costs are allocated according to the number of users, marketing costs according to turnover, and HR support costs according to the number of employees, it must be clear why these particular allocation keys make sense.
Three or more years back
The tax office can usually audit transfer pricing for the last three years, but in the case of loss-making companies it may go back further, as it may also do for companies claiming investment incentives in the form of tax relief. You should pay particular attention to transfer pricing even if changes to the business model, a reorganisation of the group, a transfer of functions or a change in financing took place in the past. This is because these changes tend to be sensitive from an audit perspective, as they may have a direct impact on the distribution of profits within the group.
It is also important not to underestimate group policies. The mere existence of a global transfer pricing policy does not in itself mean that a company is in the clear. Policy must also reflect the local reality in the country concerned. You need to incorporate it into your contracts, accounting data and day-to-day operations. Management in the Czech Republic should therefore not merely adopt the group’s policy, but actively scrutinise it – in order to determine whether it is applicable and justifiable in the Czech context. If this is not the case, it is necessary to liaise actively with the headquarters.
Key contacts
David Krch
Tax Partner
In the field of taxation, he has many years’ experience in representing both domestic corporations and foreign corporations operating in the Czech Republic. He provides a comprehensive service to clients, particularly in the areas of corporate income tax and VAT, in both domestic and international contexts. He is a founding partner of HAVEL & PARTNERS Tax.
Anna Křenková
Senior Tax Consultant
She specialises in transfer pricing issues. In this area, she has experience with a wide range of matters, including the preparation of transfer pricing documentation, comparative analyses, the submission of applications for binding rulings, the establishment of group transfer pricing models, and providing assistance during tax audits.
