Audits on the rise?

Companies that shift profits out of the jurisdiction of their operational activity to lower tax countries are facing increased scrutiny. This phenomenon, dubbed Base Erosion and Profit Shifting or BEPS by the OECD, is attracting the attention of the Finnish Tax Administration.

Three common ways for companies to shift profits abroad include special purpose entities, transfer pricing and hybrid mismatches. The Finnish Tax Administration is now using its audit power to stop what it sees as illicit profit shifting.

Of particular interest in Finland is transfer pricing. The Tax Administration is also reviewing cross-border related investments and corporate structures.

If your company gets audited, there are certain steps to consider. The earlier appropriate action is taken, the likelihood is increased for a more favourable (or at least less painful) outcome.

OECD and EU Commission set the groundwork

The Finnish tax regime is affected by the OECD's Base Erosion and Profit Shifting (BEPS) report, which was finalised on 5 October 2015. It provides guidelines on how member countries can close the gaps in existing international rules allowing companies to artificially shift profits out of the jurisdiction of operational activity. 

Further, the Communication from the Commission to the European Parliament and the Council addressing a Fair and Efficient Corporate Tax System in the European Union ("Communication"), released on 17 June 2015, suggests a new approach to corporate taxation to meet the goal of fairer and more efficient taxation and to effectively tackle corporate tax avoidance in the European Union. 

Both the BEPS report and the Communication are essentially politically driven and have evidently put significant pressure on the tax administrations of OECD member countries – accordingly, also in Finland. 

Increased tax audits in Finland

As a consequence, the Finnish Tax Administration has initiated a great number of tax audits focused, in particular, on transfer pricing of multinational enterprises. 

Interestingly, the issues under scrutiny in tax audits are based essentially on civil law originated arrangements. They typically involve a number of specific constructions of law, such as intellectual property rights of significant value. 

The issues involved tend to be complex and often involve multiple parties in various jurisdictions, as well as tax administrations in different countries. 

Furthermore, since taxation is based on transactions emanating from civil law, for example, licensing of a trade mark or patent portfolio, the complexity is significantly enhanced, as these transactions need to be correctly identified both in accordance with their civil law form as well as with respect to the applicable tax rules.

What to do if you are audited?

Once a tax audit is initiated by the Finnish Tax Administration, a company should first realise that this is typically the beginning of relatively lengthy legal proceedings. Accordingly, the better the case is built right from the beginning, the better the eventual outcome will be. 

Taxation is essentially about information on facts and circumstances laying the foundation for the tax assessment. In other words, a tax assessment is about finding out the underlying truth realised in any given tax year under scrutiny. 

Furthermore, the ultimate truth can never be found, unless the descriptions of the facts and circumstances relevant to the assessment are understood in a way reflecting the factual context. 

The ultimate purpose of a tax audit carried out by the Finnish Tax Administration should be to find out whether the information provided by a taxpayer is correct and adequate in order to have its taxation assessed in accordance with law. 

Accordingly, when facts are under scrutiny in a legal proceeding, there is always the issue of burden of proof and, in particular, the question of who is the party upon which such burden can be laid. This is definitively the case also with tax audits. 

Focus areas in tax litigation

There are two principal areas of focus in building up a tax case: the first is the factual context and how it is addressed between the taxpayer and the Finnish Tax Administration. The second focus area is the preparing of the documents of correspondence between the parties involved. 

Both of the focus areas need to be structured as if one would be preparing for the later stages of appellate proceedings. The facts and circumstances need to be clear and correctly in place and the documents drafted need to be explaining the case convincingly and in an understandable language. Also, the legal framework has to be implemented properly. 

Checklist for existing tax arrangements

Companies may wish to examine their existing or contemplated tax arrangements to assess their potential risk for an audit. 

  • Examine existing corporate structures to ensure the appropriate alignment of the allocation of profits with the economic activity, both in light of transfer pricing as well as with respect to possible permanent establishments in relevant jurisdictions.
  • Examine existing hybrid mismatch arrangements, for example, payments giving rise to a deduction in one jurisdiction with no taxable inclusion in another jurisdiction arising from a hybrid financial instrument mismatch.
  • Review your IP ownership structures as well the group internal allocation of IP and risks in connection with the value creation.
  • In case of contemplating a change of business model, carry out a full scale analysis and identification of tangible and intangible property, including related agreements from a tax, legal and economical perspective, well before the execution.

By taking a proactive role, companies are better prepared if an audit is initiated and can mitigate any detrimental effects to operational activity.