The Role of Transfer Pricing Questions in Audits
A tax audit in transfer pricing files does not begin with the objective of “correcting a price,” nor does it proceed according to a rigid checklist of questions. What actually happens is a gradual mental process that builds doubt, then conviction, then transforms that conviction into recharacterization, and finally into an assessment. The questions raised by the tax offices are neither innocent, nor random, nor merely formal. Every question is a testing tool, and every answer either closes a path or opens it wide.
These questions should be understood not as prompts to be “answered,” but as issues to be anticipated and managed to prevent any adverse impact. What follows is not a set of instructions; rather, it is an analytical reading of the questions that most frequently recur in actual audits—explaining what the audit is truly seeking behind each question, and how meaningful preparation should be undertaken before the question is even raised.
When the tax office asks about related parties, it is not merely looking for a list of names. It is testing whether the company tends toward broad disclosure or deliberate restriction. The implicit question is: Is the company trying to narrow the scope of transfer pricing, or does it acknowledge the economic reality of the relationships?
A good answer is not just a legal list, but a coherent narrative explaining why this party is considered related and why that one is not, based on economic logic rather than defensive reasoning. Excessive restriction is read as an early signal of concealment intent and opens the door to expanding the scope of the audit later.
The Question “What Is the Nature of the Transaction?” Is a Disguised Recharacterization Question
When the company is asked about the nature of the transaction, the audit is not satisfied with its accounting label. It is searching for its economic substance. Is it a real service or a cost recharge? Is it a genuine royalty or a distribution of profits? Is it a loan or disguised equity financing?
The more superficial and descriptive the answer, the greater the likelihood that the audit will recharacterize the transaction itself. Real preparation here is not linguistic, but lies in having a prior economic analysis that links the transaction’s nature to its function and impact.
The Question “Who Sets the Price?” Is the One That Brings Files Down
This question appears in different forms and is more dangerous than any benchmarking exercise. Whoever sets the price bears the risk, and whoever bears the risk deserves the profit. If the company is described as low-risk, but it turns out to be the decision-maker on pricing, the audit needs no other tool to recharacterize.
The answer here is not “we follow group policies,” but proof of how that policy is actually applied, who has the right to amend it, who approves it, and who bears the consequences of the decision.
The Risk Question Is Not Theoretical, It Is Accounting-Based
When the tax office asks about risks, it does not accept theoretical answers. It looks directly at the books. Who bears bad debts? Who bears foreign exchange differences? Who bears inventory losses? Who covers operating losses?
If the company claims it does not bear risks while its books prove otherwise, the audit considers the economic description to be inaccurate and rebuilds the role from scratch. Preparation here lies in aligning accounting treatment with the economic description, not in creating post hoc justifications.
The Benefit Question in Services Is the Gateway to Full Disallowance
In intra-group services, the benefit question is the point of no return. If the company cannot prove a traceable benefit, the audit may not even discuss pricing, but instead disallow the expense in full.
Benefit is not proven by a contract or an invoice, but by impact: a report, a system, training, a performance change, a strategic decision. The absence of impact turns the service into a serious defensive burden.
The Functional Duplication Question Reveals Unintentional Manipulation
The audit asks: Does the company locally perform the same functions it claims the group provides? If the answer is yes, the next question becomes: Why pay for a service that adds no value?
This question is not answered by denial, but by defining the boundaries of local functions versus central support. Any ambiguity here is used to reduce or disallow the cost.
The Contract Question Is a Test of Reality, Not Text
The tax office does not merely ask: Is there a contract? It asks: Is it implemented? Is it relied upon? Are its clauses activated in times of loss? Are compensation mechanisms applied?
A contract that does not appear in daily operations does not protect; it weakens the position by revealing a disconnect between text and reality.
The Method Question Is Really “Why This and Not Another?”
When asked about the pricing method, the tax office is not testing technical knowledge, but whether the method was chosen because it is the most appropriate or simply the easiest. The absence of an analysis excluding other methods gives the audit justification to change the method entirely.
And changing the method is the most dangerous outcome, because it allows the result to be rebuilt from scratch.
The Comparable Question Is a Question of Selectivity
The audit asks: Why these companies? Why this market? Why these years? Are there loss-making companies? Why were they excluded? Is the Egyptian market even comparable?
Every comparable can be used against the company if its selection is not economically justified. Real preparation lies in understanding that comparable are not a defense, but a double-edged weapon.
The Consistency Question Between the File and the Books Is a Question of Trust
Any inconsistency between the transfer pricing file and the financial statements is read as a structural flaw. The audit is not debating a number, but the credibility of the entire file.
This is why the strongest files are not the most complex, but the most consistent.
The Accounting Segregation Question Reveals Inflation of Impact
The tax office asks: Is this low profitability caused by related-party transactions or by an independent loss-making activity? If the company cannot clearly segregate, the audit may discard the defense entirely and reassess the activity as a single high-risk unit.
The Question “What Happens in a Loss?” Remains the Question No One Prepares For
The audit loves this question, because it reveals the truth. Is the loss pushed back to the group? Is the royalty reduced? Is the local entity compensated? Or does the company bear the loss alone?
The practical answer to this question reveals who actually bears the risk, regardless of everything written in the file.
The History and Change Question Reveals Defensive Pricing
Why did the margin change? Why did the method change? Why did the company’s description change? If the change is linked only to an audit year, the audit reads it as defensive pricing, not a governance system.
The Timing Question Is a Question of Intent
When was the file prepared? Before implementation or after? Before year-end or after? A file prepared after results appear is read as justification, not compliance.
The Governance Question Is the Unspoken Question
Ultimately, all the previous questions converge into one question that is never asked explicitly: Is this company managed with independent and consistent logic, or with a logic of adjusting numbers when needed?
The existence of internal policies, approvals, minutes, and decision pathways is what prevents this question from turning into a negative conviction.
Conclusion
The list of audit questions in transfer pricing is not an administrative checklist, but a mental map for rebuilding the tax base. Each question either closes a path or opens it. Real preparation is not memorizing answers, but building an operational reality that makes the question itself harmless.
Companies that understand this logic do not wait for the audit to defend themselves; they manage transfer pricing as a daily operating system. Those that treat it as a file written upon request find themselves answering questions after it is too late.
Frequently Asked Questions
How do tax auditors use transfer pricing questions?
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Auditors do not treat transfer pricing questions as a neutral checklist. Each question is a deliberate tool in a mental process that starts with doubt, moves to conviction, then to recharacterization and finally to assessment. Questions are used to test disclosure behavior, economic substance, risk allocation, and consistency between the transfer pricing file and the financial statements. Every answer either closes an investigative path or opens a new one, giving the auditor a structured way to rebuild the tax base rather than simply “correct a price.”
Why is the related parties question a test of intent?
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The related parties question goes beyond a legal list of entities. It is used to assess whether the company tends toward broad, economically coherent disclosure or defensive restriction. A narrow, overly technical list signals potential concealment and an attempt to limit the scope of transfer pricing. A strong answer explains why specific parties are included or excluded based on economic relationships and actual dealings. Excessive restriction is read as an early sign of intent to hide exposure and often leads the audit to expand its scope later.
Why is who sets the price so critical in audits?
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The question “Who sets the price?” is crucial because pricing authority is directly linked to risk and entitlement to profit. The party that actually decides or can change the price is seen as bearing key commercial risks and therefore deserving the corresponding margin. If the file describes the local entity as low risk, but in practice it sets or approves prices, the auditor gains a powerful basis to recharacterize its role and profitability. General statements such as “we follow group policy” are insufficient; auditors look for evidence of who designs the policy, who can amend it, who approves it, and who absorbs the consequences of pricing decisions.
How do risk and accounting shape transfer pricing outcomes?
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In transfer pricing audits, risk is tested through the accounts rather than through theoretical descriptions. Auditors examine who bears bad debts, foreign exchange differences, inventory losses, and operating losses. If the file claims the entity is low risk but the books show it consistently absorbs these items, the economic description is considered inaccurate. The auditor will then rebuild the functional and risk profile from scratch. Proper preparation requires aligning accounting treatment and actual risk-bearing with the narrative in the transfer pricing documentation, instead of relying on post hoc justifications when discrepancies are discovered.
Why is the benefit test in intra group services decisive?
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For intra-group services, the benefit test is often the decisive point in an audit. If the company cannot demonstrate a concrete and traceable benefit, the auditor may disallow the expense entirely without even moving to price analysis. Benefit is proven by impact rather than paperwork: reports issued, systems implemented, training delivered, performance improvements, or strategic decisions supported. Where there is no visible impact, or where local functions duplicate the claimed group services, the charge is seen as adding no value and becomes a serious vulnerability that can lead to full disallowance.
What does the question about losses reveal in practice?
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The question “What happens in a loss?” reveals the true allocation of risk in practice. Auditors look at whether losses lead to reductions in royalties or service fees, adjustments to pricing, or compensation from the group, or whether the local entity bears the loss entirely. Whatever actually happens in a loss year overrides the theoretical risk descriptions in the file. This question, which most companies do not prepare for, exposes who really bears business risk and can undermine an entire transfer pricing position if day-to-day behavior contradicts the documented model.
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