• Service: Tax
  • Type: Business and industry issue
  • Date: 6/3/2014

Tax Disputes and Controversy Update – Focus on Top Audit Issues – Selected Countries Part 1 

Levels of tax audits and disputes continue to rise in countries worldwide. In some cases, taxpayers face similar audit issues, such as those arising for global companies as the international movement to address base erosion and profit shifting (BEPS) continues to gather steam. In other cases, domestic issues and priorities are creating audit issues that are unique to the jurisdiction.

This article presents a high level round-up of some of the top audit issues being experienced by clients of KPMG International member firms in Canada, China, India, the United States and the United Kingdom. As the summary table below shows, clients in these countries face many of the same audit issues, although the country-specific comments that follow reveal some significant domestic differences.

In Part 2 of this article –coming soon – we will profile the top audit issues in the emerging MINT countries – Mexico, Indonesia, Nigeria and Turkey.

Top Audit Issues Canada China India United States
Cross-border structures and transactions
Transfer pricing
Changing tax audit processes and focus
Payroll/employment tax issues    
Emphasis on tax governance      
Indirect tax issues      
State and local tax issues      
R&D tax incentives      
Inefficient tax appeal process      
Legislative uncertainty      

Canada – Top Five Audit Issues

Paul Lynch
National Leader, Tax Dispute Resolution & Controversy Services,
KPMG in Canada

1 Cross-border structures and transactions As a G8 member, Canada is actively participating in the Organisation for Economic Co-operation and Development’s base erosion and profit shifting (BEPS) project. Canada is also laying the foundations for a homegrown plan to align with the OECD’s work. Canada’s government recently announced broad consultations on BEPs solutions and narrower consultations on possible anti-treaty shopping measures.

The government is putting priority on the gathering and exchange of taxpayer information, for example, by pursuing new tax information exchange agreements and tax treaties, adopting new foreign reporting rules and introducing a whistleblower program. The Canada Revenue Agency’s (CRA) current international audit focus is on withholding taxes on payments to non-residents, dispositions of taxable Canadian property, the existence of permanent establishments in Canada, passive foreign income taxable in Canada and treaty shopping.
2 Transfer pricing Ongoing transfer pricing enforcement continues to be a priority for the CRA, particularly in regard to financial transactions, including guarantee fees, insurance (reinsurance and captive insurance), and hedging. The CRA is taking a close look at intragroup fees charged between closely held groups for rent, interest, management and administrative services.
3 Changing tax audit processes and focus Taxpayers in Canada are seeing a number of changes as the CRA adopts new measures to do more with less – managing its audit workload more efficiently amid tightening cost and resource constraints. Cost cutting is resulting in less training and less experienced staff, which means taxpayers are seeing discretion applied less frequently, more onerous information requests and more by-the-book applications of assessments and penalties.

The CRA has also proposed a registration program for tax preparers, seeking to leverage their expertise to improve CRA’s operations.
4 Emphasis on tax governance A new CRA audit program for large corporations aims to base audit coverage on the taxpayer’s potential non-compliance risk in order to improve tax audit efficiency. Risk assessments are based on the taxpayer’s tax filing history, industry considerations, and, above all, the quality of the taxpayer’s tax oversight, controls and involvement in aggressive tax planning or unusual or complex transactions.

In theory, audit coverage is adjusted according to the assessed risk level, with quick reviews for low-risk taxpayers and full audits for high risk ones. Although some changes are underway, the pace of change is slow as this new cooperative compliance approach is at odds with the traditional audit approach.
5 Payroll/employment tax issues The CRA is taking a focused approach to payroll tax audits – known as “employer compliance audits” – to verify that employers are making their source withholdings in the right amounts and on time. Common issues on audit relate to employee versus independent contractor status and the taxability of benefits for employee use of automobiles and aircraft, employer-paid parking and relocation payments. Cross-border travelers are also frequently identified as being non-compliant with Canada’s rules.

Source: KPMG in Canada, 2014

back to country list | top

China – Top Five Audit Issues

David Ling
Partner-in-Charge of Tax, KPMG China
Tax Dispute Resolution and Controversy practice leader in China

1 Transfer pricing Since revised transfer pricing regulations (Circular 2) were issued in 2009, Chinese tax authorities have become increasingly active in enforcing transfer pricing rules. The State Administration of Taxation (SAT) runs a strict transfer pricing audit program, supplemented with a maturing advance pricing agreement program.

Recently, the SAT has been reviewing the day-to-day administration and advance management of taxpayers’ transfer pricing issues. This focus has led to more informal, pre-audit assessments by tax authorities. In these cases, the taxpayer can elect to make adjustments to its taxable income, although the adjustments may not be eligible for double tax relief.
2 Cross-border structures and transactions – equity transfers In China, cross-border equity transfer transactions continue to be under scrutiny as the SAT seeks to apply the offshore indirect transfer rules under Circular 698. In cases where an indirect transfer is perceived as lacking a reasonable business purpose, these rules allow the Chinese tax authorities to re-characterize the transaction as a direct transfer and tax it accordingly. This increased enforcement has led to a number of reported investigation cases.
3 Changing tax audit processes and focus The SAT has strengthened its Large Enterprise Division (LED), which directly manages tax compliance and enforcement for selected large enterprises. Large companies in China sometimes face dual scrutiny of both the LED and the Investigations Bureau. The SAT is working to reduce audit duplication and multiple site visits by these investigators by delegating more of this work to lower-level tax authorities.

The tax authorities’ audit focus has shifted toward BEPS, and they have made some significant tax adjustments as a result. The LED has issued for special examination notices to three large companies. These examinations will cover three priority areas: related-party transactions (transfer pricing), equity transfers and cross-border transactions.

Tax investigation activity is also targeting specific industries, such as the automotive and pharmaceuticals sectors.
4 Indirect tax issues China’s value added tax (VAT) is expected to replace the Business Tax by the end of 2015, when VAT will remain as the only indirect tax in China. One of the biggest issues facing taxpayers as the VAT is implemented involves invoices. In order to be eligible for input credit, VAT special invoices must be verified within 180 days. If the verification date is missed for any reason, taxpayers must undergo a lengthy approval process to be reinstated. If an invoice is not reinstated, the taxpayer’s VAT paid cannot be recovered.
5 R&D tax incentives In the past, Chinese audits of claims for research and development (R&D) tax incentives were somewhat informal. Now, in order to curtail perceived abuses of the program, the tax authorities are strictly enforcing eligibility rules and restrictions, for example, regarding the proportion of employees engaged in R&D and the company’s investment in R&D relative to its income. Many companies are being denied R&D benefits as a result.

Source: KPMG China, 2014

back to country list | top

India – Top Five Audit Issues

1 Transfer pricing As of April 2013, the Finance Act, 2012, expanded India’s transfer pricing reporting requirements to cover certain international transactions such as guarantees, purchases and sales of marketable securities, and business reorganizations. Reporting of ‘specified domestic transactions’ is also required.

Following these amendments, India’s tax authorities have been reviewing transactions involving issuance of shares and making steep transfer pricing adjustments on shortfalls in share premiums, even where the premium itself is not taxable as a capital receipt.

Information technology (IT) companies in India, including software developers and captive IT service providers of international companies, have always been on the radar of the Indian tax authorities. For the related-party transactions of these companies, India’s tax authorities expect a minimum margin of 25 percent in most cases.

Advertising, marketing and promotional expenses incurred by Indian entities on brands owned by their foreign parent companies are also being scrutinized, and transfer pricing adjustments are being made using a bright-line test.
2 Cross-border structures and transactions In India, major audit issues can arise for these cross-border structures and transactions:

  1. Direct and indirect transfers of shares of Indian companies where it is claimed that income arising on transfer of shares is not taxable in India. The tax authorities view these transactions with suspicion and apply a substance test, especially when the funds are routed through low-tax countries and there is double non-taxation on the transfer of shares.
  2. Creation of permanent establishments (PE) by foreign companies with a taxable presence in India, such as subsidiaries, employee secondments, or regular employee visits to clients’ premises. Where a PE in India is considered to exist, issues also arise regarding the attribution of income of the PE.
  3. Income from the provision of services treated as royalties and fees for technical services, and thus taxable on gross basis. Disputes are arising over the treatment of such income as royalty or business income regarding the sale of software and use of equipment. At issue is whether fees for provision of services can be treated as fees for technical services, especially when the services are rendered from certain tax treaty jurisdictions.
3 Legislative uncertainty Major legislative uncertainty in India accounts for the following features of the Indian tax system:

  1. Contrary decisions taken by various courts of different jurisdictions.
  2. Reversal of court decisions, including some Apex Court of India decisions, through tax law amendments. These amendments often have retrospective effect, creating hardship for taxpayers. However, where such amendments impose a significant burden on a taxpayer, KPMG in India has observed that courts take a more liberal view.
  3. Introduction of the Direct Taxes Code (DTC). The DTC, first announced in 2009, would replace Indian Income Tax Act, 1961. Among the DTC’s provision are a general anti-avoidance rule (GAAR) and controlled foreign company provisions.

However, India’s political parties have not arrived at a consensus on the DTC, and so it is yet to be implemented. The uncertainty for taxpayers is compounded by India’s 2014 elections. Whether India’s newly elected government will proceed with outstanding proposals or the GAAR’s implementation remains to be seen.
4 Changing tax audit processes and focus India’s swelling number of tax disputes is fuelled in part by changing legislation that lacks clarity, and India’s current approach to tax collection is aggravating the situation. Tax inspectors are allocated demanding budgets for tax collection, which is pressuring them to raise more assessments in higher amounts in order to meet their collection targets. Taxpayers face increasingly aggressive assessments as a result.
5 Inefficient tax appeals process As the number of tax disputes increases, India’s multi-layered tax court system is making the appeals process even more protracted. Tax authorities can appeal decisions through one lower court, which makes determinations based on facts and law, and two higher courts, which deal with legal issues only. As a result, it can take a significant amount of time to get far enough along in the appeals process to achieve any sort of resolution.

Source: KPMG in India, 2014

back to country list | top

United States – Top Five Audit Issues

Sharon Katz-Pearlman
Head of Global Tax Dispute Resolution & Controversy,
KPMG in the US

1 Transfer pricing Transfer pricing issues continue to be a top priority for the Internal Revenue Service (IRS). As part of its current strategic approach to transfer pricing audits, the IRS has introduced an internal road map for transfer pricing auditors setting out a new process for examinations and adjustments.

Although IRS auditors do not have a strong record of success in the area of transfer pricing assessments, taxpayers should expect to see more activity and more successful IRS adjustments as auditors adopt the new process in the field.
2 Cross-border structures and transactions The IRS is focusing on BEPS-related transactions as it seeks to raise the profile of tax avoidance cases (double non-taxation) involving arbitrage and stateless income.

In particular, the IRS is devoting more resources and has developed specialized capabilities to heighten the scrutiny of hybrid financial products, including issues involving the characterization of intragroup cross-border borrowings as debt or equity.
3 Changing tax audit processes and focus The IRS has set strict new guidelines for responding to its information document requests (IDR), including tighter timeframes and more serious consequences for failure to respond. These new mandatory procedures for enforcing IDRs and issuing summonses allow examiners almost no discretion in varying from the procedures, even at the manager level. Concerns have been raised over the process’s lack of flexibility.
4 Payroll/employment tax issues Employment tax issues related to employees who travel across borders are growing as the IRS heightens its scrutiny over the U.S. residency status and tax filing obligations of foreign employees working in the U.S. and U.S. employees working in other countries, along with the employer’s associated tax withholding and reporting obligations.
5 State and local tax issues State tax controversy is increasing and states such as California, Illinois, New Jersey and New York are becoming more active in their audit efforts in order to enhance state tax revenue. In particular, some states are taking aggressive positions on what constitutes nexus for state tax purposes. Some states are challenging allocations of income to the state and transfer prices that have been formally agreed between the taxpayer and the IRS through advance pricing agreements.

Source: KPMG in the US, 2014

back to country list | top

United Kingdom – Top Six Audit Issues

Paul Harrison
Partner, Tax and Head of Settlements & Investigations,
KPMG in the UK

1 Cross-border structures and transactions In a climate of rising public intolerance toward international tax avoidance, all cross-border transactions are coming under intense scrutiny by HM Revenue and Customs (HMRC), especially where profits are shifted to low-tax countries. HMRC is devoting more resources to target international financing structures and transfer pricing schemes (see below), and auditors are improving their ability to identify and target specific non-compliant structures and taxpayer profiles. Transactions involving the introduction of large amounts of debt into the UK are seen by HMRC as high-risk, with current audit challenges based on an anti-avoidance ‘unallowable purpose’.
2 Transfer pricing HMRC is changing its approach to transfer pricing audits, focusing less on arm’s length prices and taking a more substance-over-form approach that looks to functions, risks and rewards. Taxpayers should be prepared for the HMRC to inspect all of their intragroup, cross-border payments using this new approach.
3 Changing tax audit processes and focus Among the new UK tax legislation that is creating audit issues, perhaps the most draconian proposals would compel taxpayers to make accelerated payment of tax that is in dispute or subject to enquiry.

The proposals aims to prevent the use of delaying tactics to avoid settling open cases, and it specifically applies to tax avoidance schemes subject to disclosure rules and cases where HRMC has decided to pursue the application of GAAR on the basis of an opinion for the UK’s independent Advisory Panel for GAAR.

The proposals would also require taxpayers to settle disputed tax on receipt of a “follower notice” that their case is on substantially the same grounds as a case that has already failed. The follower notice requires taxpayers to amend their tax returns or settle their tax disputes in line with the tribunal or court decision, and tax payment would be due within 90 days of notification.
4 Focus on tax governance HMRC has developed a standardized process to formally assess business tax risk and established a High Risk Corporates Program in order to direct more resources to businesses with the greatest risk of non-compliance. The risk assessment process focuses on the quality of taxpayer’s governance of tax, its tax filing record, tax accounting arrangements, and its approach to tax planning.

While the intention was that HMRC would re-direct its resources away from low-risk taxpayers, the actual result appears to be a shift toward detailed tax governance audits of all large taxpayers. Additionally, a Large Business Risk Task Force has been established to identify and audit significant risk in areas such as transfer pricing and profit shifting.
5 Payroll/employment tax issues Payroll taxes are high on HRMC’s agenda of audit programs, especially where highly mobile, senior executives are involved. Managing the complex tax compliance obligations of these individuals is notoriously difficult. New attitudes toward tax morality and fairness are encouraging HRMC to take a closer look at cross-border business activity, compensation structures, bonus plans and source withholdings of senior executives.
6 Indirect tax issues Indirect taxes are another high priority, with HMRC devoting particular attention to the governance of indirect tax through processes and controls. HMRC is also emphasizing compliance with customs and excise rules, for example, by challenging sector-specific exemptions and recalculating customs liabilities despite unclear interpretations as to how the rules apply. Companies with high volumes of cross-border trade are suffering significant customs adjustments and penalties as a result.

Source: KPMG in the UK, 2014

back to country list | top


Share this

Share this

Dispute Resolution and Controversy Services

Information and insights on KPMG’ Dispute Resolution and Controversy Services.