Transfer Pricing Tax Audits and the Significance of R&D in Comparable Data
In tax audit practices, assessing the significance of the Research and Development (R&D) function is a crucial issue. This is because differing views on the importance of R&D functions often spark debates between taxpayers and tax authorities.
While this issue may seem simple, in practice, it involves significant complexity, especially during the process of selecting comparable companies for transfer pricing purposes.
Quite often, the assessment of the R&D function's significance in a potential comparable is based on a single indicator: the presence or absence of R&D expenses listed in the financial statements within commercial databases.
This approach frequently leads to the automatic elimination of comparable companies that record R&D expenses, without further analysis regarding the actual level of significance of those activities.
To illustrate, some companies record no R&D expenses at all, others record only small and sporadic amounts, while some consistently record large R&D expenditures every year.
In audit practice, companies that record R&D expenses, whether small or large, are often treated the same; they are eliminated as comparable data.
International Guidelines
This practice is based on the simple assumption that any company incurring R&D expenses is deemed to perform a significant R&D function and, therefore, is not comparable to the tested taxpayer. However, this approach is not fully aligned with international guidelines.
Paragraph 3.43 of the OECD Transfer Pricing Guidelines explicitly emphasizes that the selection of comparable data should not rely solely on the existence of R&D expenses, but rather on the level of significance of the function. One of the recommended indicators is the ratio of R&D expenses to sales, rather than merely the nominal amount of costs reported in the financial statements.
This means that the presence of R&D expenses should serve as a starting point for analysis, not as an immediate ground for elimination. Unfortunately, in practice, this ratio-based approach has not yet become a consistent standard.
The issue becomes even more complex because, to date, there is no clear threshold for the significance ratio of R&D expenses, either in the OECD Transfer Pricing Guidelines or in Indonesian tax regulations. This gap leaves broad room for interpretation and has the potential to give rise to differing views between taxpayers and the tax authority.
Under such circumstances, analyzing the impact of R&D expenses on company performance becomes relevant. In theory, a substantial R&D function does not merely end as an operating expense.
Significant R&D expenditures generally lead to the creation of intangible assets, such as patents, technology, or know-how, which ultimately contribute to improved corporate profitability.
The Significance of R&D to Profitability
This logic is consistent with the OECD approach, which links the R&D function to the ownership of intangible assets. The more significant the R&D function, the greater the potential value of the intangible assets owned by a company, and consequently, the greater the impact on the profits generated.
These findings are also supported by various empirical studies. A study by Pratama, Wibowo, and Inayah (2019) shows that R&D expenditure plays a significant role in improving a company’s financial performance. R&D drives innovation, process efficiency, and sustainable competitive advantage, which are ultimately reflected in higher levels of profitability.
Accordingly, if a comparable data candidate truly has a significant R&D function, this condition should be proportionally reflected in its level of profitability. Conversely, the recording of R&D expenses in limited or incidental amounts does not necessarily indicate the existence of a substantial R&D function.
Therefore, using the mere presence of nominal R&D expense figures as the sole basis for eliminating comparable data has the potential to result in an analysis that is not comparable and does not adequately reflect the actual conditions.
The Urgency of Legal Certainty
On the other hand, it must be acknowledged that the absence of clear quantitative parameters regarding the significance of R&D expenses remains a challenge. Without a well-defined ratio standard, room for differing interpretations will always exist, both in the audit process and in the preparation of transfer pricing documentation.
Going forward, strengthening regulations through the establishment of measurable and standardized parameters for R&D expense ratios is essential, not only to improve audit consistency but also to provide legal certainty for taxpayers.
With clearer regulatory support, harmonization between domestic provisions and international guidelines such as the OECD Transfer Pricing Guidelines can be further enhanced. Ultimately, this will encourage the application of the arm’s length principle in a manner that is more transparent and balanced. (ASP/KEN)
Disclaimer! This article is a personal opinion and does not reflect the policies of the institution where the author works.
