Year-end adjustments, specifically “true-up” and “true-down”, are common practices in transfer pricing (TP) and financial reporting. These adjustments are corrections made at year-end to align related-party transactions with arm’s-length standards or budgeted/targeted financial metrics. Generally, true-up adjustments involve correcting financial or operational data to align with actual performance or arm’s-length standards. This accounting process identifies the exact amount of expenses, revenue, or costs before closing the books for the accounting period. It represents an upward adjustment that increases a company’s revenue or profitability to meet regulatory or contractual requirements, such as those imposed by transfer pricing rules. 

Conversely, true-down adjustments involve revising projections downward to reflect actual performance or revised expectations. This process is similar to true-up adjustments but involves making downward corrections. When actual expenses, costs, or revenues are lower than budgeted or estimated, true-down adjustments are made.

The process of making true-up and true-down adjustments can be broken down into four distinct steps. First, there is the review of financial records: at year-end, the actual financial records of related party transactions are compared against transfer pricing policies, pre-agreed profitability thresholds, or budgeted metrics, such as budgeted profit margins.

Next is the comparison with Arm’s Length Standard: companies assess whether their transfer pricing arrangements – covering prices for goods, services, royalties, or financing – fall within an arm’s length range, as outlined by OECD guidelines or local transfer pricing regulations, like those in the UAE or other OECD member countries.

Then comes the calculation of adjustments: If actual results differ from expected or targeted outcomes, adjustments are calculated. A true-up adjustment increases the value of financial transactions to meet the target, while a true-down adjustment decreases the value to correct for overbooked transactions.

Finally, there is the Recording of Adjustment: These adjustments are documented in the financial records before the finalization of the financial statements, thereby impacting taxable income.

The following tables illustrate the case scenarios for true-up and true-down TP adjustments.

True-Up TP Adjustments

True-Down TP Adjustments

Accurate execution of TP adjustments, whether through a true-up or a true-down, is crucial to avoid double taxation. This becomes particularly vital when related entities operate across multiple tax jurisdictions, as inconsistencies in intercompany transaction pricing may lead tax authorities in different countries to make unilateral profit adjustments.

Such adjustments can result in the same income being taxed multiple times, posing significant financial and compliance challenges for the group. Beyond the risk of double taxation, incorrect TP can lead to underreporting of taxable income and, consequently, underpayment of taxes. In such cases, tax authorities may impose penalties or sanctions for tax avoidance or non-compliance with local transfer pricing regulations, especially if appropriate year-end adjustments have not been properly implemented.

TP adjustments can also affect withholding tax obligations. If an adjustment alters the amount or nature of intercompany payments, it may create new or increased withholding tax obligations that must be addressed before the financial year ends. For instance, a true-up adjustment that increases taxable income may require the immediate withholding of tax on the revised amount.

To ensure full compliance, it is essential to issue updated intercompany invoices reflecting the adjusted values, so the correct withholding tax can be applied at the time of payment.