Transfer Pricing – Where Is It?
Galina Belikova, Director
Audit and Tax Department, Alinga Consulting Group
It is likely that few, if any, companies are simply indifferent to the bill on funds transfer pricing that has been in the development phase for a few years already.
In the beginning of 2010, when the bill had already passed the first reading, there was a small hope that it would become law by the end of the year. However, that was at first glance. By the time of its second reading in June, the bill had undergone significant amendments, but still passed the second reading. What next? It’s promised that the bill will become law by the end of the year, but should this process be rushed?
We will take a moment to look at the bill’s principle provisions and problems.
As is already known, the bill on funds transfer pricing excludes Article 20, “Interdependent Entities,” and Article 40, “Principles for Determining Prices on Goods, Work, and Services for Tax Purposes,” from Russia’s Tax Code. Instead of these articles, it has been suggested to introduce a separate division devoted to accounts between interdependent entities.
What kinds of changes does the bill hold?
It significantly expands the limits of interdependence. Following are recognized as interdependent entities:
- Organizations – when one organization (together with its interdependent entities) directly and/or indirectly takes part in a different organization and their share is over 20%;
- An individual (together with their interdependent entities) and an organization – if the individual directly and/or indirectly takes part in such an organization and has more than a 20% share;
- Organizations – if one or the other individual (together with their interdependent entities) directly and/or indirectly takes part in these organizations and the share in each organization is more than 20%;
- A parent company (partnership) and its affiliates;
- An organization and a member of its board of directors (supervisory council) or another collective management body, a member of its collective executive body, or another individual exercising authority of the organization’s single-member executive body;
- Organizations in which the authority of the single-member executive body lies with one and the same entity;
- An organization and/or individual – if each preceding entity’s share of direct ownership in each preceding organization is more than 50%;
- Individuals – if one individual is subordinate to another individual in terms of official status;
- Individuals who are married, related by blood or adoption, or legal guardians (caretakers) and those under their care;
- A trustor (of a trust or trust fund created in accordance with the government), trustee and beneficiary, or a trustee and organizations that the trustee manages;
- Entities – if one entity and the representative of another entity are interdependent entities, either the representatives of these two entities are interdependent or their interdependence influences the conditions and/or results of transactions conducted between them and/or influences the economic results of their activities.
Furthermore, the list of entities recognized as interdependent by law is expanding. Entities can be recognized as interdependent on the grounds of any basis in legal practice. There is also a declarative method – entities have the right to independently declare themselves interdependent.
Tax authorities have the opportunity to control organizations through a “chain of influence” (i.e., joint mergers via a third party).
The objects under control are also changing. Now the tax authorities will have the ability to control transactions:
- On sales of goods, work, or services;
- On sales of property rights;
- On sales of intellectual property, means of individualization, etc.
Exactly which transactions are controlled:
- Any transactions with interdependent entities or with the participation of such entities by way of a third party, under the condition that:
- the transaction was executed between Russian entities and the income and expenses from the transaction exceed 1,000,000,000 rubles;
- the transactions were foreign trade deals;
- the object of the transaction is subject to the natural resources production tax imposed at an ad valorem rate;
- the business partner is on the Single Agricultural Tax or the Unified Tax on Imputed Income.
- Transactions performed in the field of international trade, with global exchange trade goods (oil, ferrous and non-ferrous metals, etc.) (according to a list determined by the Russian government; at the present time, this list has not been established);
- Transactions with business partners from locations with lower tax rates, including places where beneficiaries are located.
The bill introduces the concept of a “consolidated group of taxpayers,” and the transactions between them will not be subject to such controls.
Instead of a 20% difference from the market price, a price range will be instituted. Utilizing it will free the taxpayer from audits and auditors from having to assess the applied prices.
It is important to note that if the price is regulated in accordance with legislation, for tax purposes, the price which the parties to the transaction used is applied if it corresponds to the regulated price (and is within the fixed price limits with regard to the specified price raises or reductions).
The list of information sources is also increasing. These are the sources that may be used for determining whether transaction prices correspond to market prices and regulated prices.
When determining whether prices applied in transactions correspond to market and regulated prices for tax purposes, the following are used:
- Information on prices and price quotations in global markets for goods that are traded worldwide;
- Foreign trade customs statistics in Russia;
- Information on prices (price fluctuation limits) and market quotations contained in official information sources from authorized authorities;
- Information received from companies’ accounting and statistical reports;
- Information on the market value of property being appraised;
- Any other information.
The bill outlines six methods of determining price correspondence between prices applied in transactions and market prices for taxation purposes; two of these methods were added to the bill by the time of its passage in the first reading.
The main method is the use of commensurate market prices. This method is used when there are at least four transactions in the corresponding goods market (work, services) and the object of the transactions are identical goods (or at least similar goods) (work, services). The transactions should be performed in similar economic (commercial) conditions between the entities that are not interdependent and only when sufficient information on such transactions is present.
Another feature of the bill is the establishment of a list of documents and information justifying the prices applied by the taxpayer to transactions which should have been reported to the tax authorities. A provision is also made for the taxpayer to produce documents, prepared in any form, which contain information:
- About the activities of the taxpayer and entity (or entities) involved in the controlled transaction, connected with the transaction, or on the controlled transaction itself;
- About the methods used to determine the price correspondence between the prices applied to the controlled transaction and market prices:
- Description of methods, sources of information, and other data used when determining price correspondence;
- Justification of the choice of method;
- Calculation of the market price interval (profitability margin) on the controlled transaction with a description of the approach used for choosing the comparable transactions;
- The amount of income (profit) received and/or the amount of expenses (losses) incurred as a result of the controlled transaction and the profitability received;
- Other factors that influence the price applied in the controlled transaction, including information on the market strategy of the entity performing the controlled transaction (under the appropriate circumstances).
Controlling authorities may ask for the given information no earlier than April 1 of next year.
The controlling authorities may request the above-mentioned information if the amount of income and expenses from all controlled transactions performed in the calendar year with one entity (a few of the same entities that were parties to the controlled transactions) exceeds 10,000,000 rubles. If the legislation provides for the establishment of regulated prices, presenting the above-mentioned information to the tax authorities is not required.
Additionally, taxpayers are obligated to submit a notification (using the prescribed form) to the tax authorities in the form of information about controlled transactions they performed in the calendar year if the amount of income and expenses from all these transactions performed this year by the taxpayer with one entity (a few of the same entities that were parties to the controlled transactions) exceeds 100,000,000 rubles (this amount will gradually be reduced to 20,000,000 rubles by 2015). These notifications should be sent to the tax authorities no later than May 20 of the year following the calendar year in which the controlled transactions took place.
The tax authorities will send the notification to the Federal Tax Service 10 days after receiving it.
On the basis of the notices and information received on the controlled transactions, the Federal Tax Service carries out an audit of the correspondence of the prices applied in the transactions with market and regulated prices. The audit is performed after the corresponding decision has been made, in a period not to exceed six months from the date the decision is made to the date an authorization is created for performing such an audit. In exceptional circumstances, the time period may be extended to 12 months.
An audit may be performed no more than three years prior to the date that the decision was handed down.
According to the results of the audit, within two months from the date the authorizatio was written up, a certificate of audit is compiled. After this is received, the entity under inspection may submit an objection accompanied by additional documentation within 15 business days.
The bill’s innovations are conditions on symmetrical adjustment of the tax base on income tax and VAT from the parties to the controlled transaction (when a decision is handed down on additional taxation) as well as on the taxpayer’s right to conclude preliminary agreements on pricing with the tax authorities for taxation purposes. The agreement is not about the price, but rather about the principles and methods the taxpayer will use for determining the price. The opportunity to conclude such agreements is only available to major taxpayers. The agreement on pricing can be concluded on one transaction or on several transactions involving the same item, in a period not to exceed three years.
The fine for a taxpayer who violates the conditions of the pricing agreement is 1,500,000 rubles.
In addition, sanctions are introduced for not paying taxes as a result of the taxpayer applying “incorrect” prices and not submitting the full packet of documents requested by the tax authorities.
If taxes are not fully paid on a controlled transaction, a sanction of 40% of the unpaid amount of tax will be applied. For a second offense, the sanction will be up to 80% of the unpaid amount.
There is a 5,000 ruble fine for not submitting notifications on controlled transactions or for submitting notifications with inaccurate information.
We will briefly review the basic problems of transfer pricing that the bill does not resolve.
- The bill presupposes regulation from guidelines from the Ministry of Finance. Since there are no guidelines on this particular issue, this may lead to the law being put into force while guidelines may only just be beginning to be developed.
Also, the status of the guidelines is ambiguous. Due to the fact that the guidelines are not a regulatory legal act in the field of taxation, many of the guidelines were abolished (including the guidelines on profit tax and VAT) which, incidentally, uncovered a lot of issues that were not included in the legislation.
- Lawmakers have left the list of controlled transactions open. Only references to the corresponding chapters of Part 2 of the Tax Code are included in the bill. This may give the tax authorities the opportunity to control prices on a very wide spectrum of interactions.
- The list of sources of prices applied for determining market prices is open, therefore a priority of sources has not been established. This gives rise to the following problems:
- There is no actual method for determining transaction costs;
- Any entity can create another entity that may give out information on prices;
- There will always be a conflict between the tax authorities and companies about which prices to apply since they will be taken from different sources.
- There will be a large volume of accounting reports on the preliminary disclosure of information. The amount of documentation for one declaration may consist of a few thousand pages. This will result in the taxpayer having to hire a separate group to prepare accounting documents for the controlled transactions. At the same time, preparing such large amounts of information can be somewhat futile, since it is unlikely that the tax authorities will actually review all of the documents. Additionally, the bill does not specify a method of safekeeping for such information, so it may lead to violation of companies’ business secrets.
- One of the bill’s biggest flaws is the vagueness with regards to price determination. Although, unlike previous versions of the bill, this one at least describes how to determine prices, the descriptions are still not clear.
- Another point worth mentioning is the opportunity to make “corrections in hindsight” when additional taxation is required. Essentially, if a seller receives additional taxation because of an increase in sales prices, the purchaser can add an additional amount to their expenses (by increasing the cost of the acquired goods, work, or services). The purchaser then must justify the size of the adjustment. The bill does not contain procedures for how to verify the accuracy of the price.
- The bill also brings up some issues on the ability to draw up agreements on pricing.
Firstly, the given provision of the bill has a discriminatory character inasmuch as it is only accessible to major taxpayers. .
Secondly, the one-year time period for the tax authorities to review such agreements is astonishing. During one year, business conditions may change significantly along with the economic situation in the country, etc. so that after one year, the agreement may no longer be relevant.
Thirdly, the agreement is somewhat different in the civil-legal sense, since the tax authorities do not have any type of counter-obligations.
Another of the bill’s disadvantages is the size of the sanctions for violating the legislation on transfer pricing. The size of the fine is 40% (80% for a second offense) of the amount of additional taxation. The tax authorities will obviously try by any means to apply “their” prices to transactions in order to collect additional taxes, fines, and penalty fees.
The current draft of the bill allows the tax authorities to place the burden of justifying transaction prices on the taxpayer, which contradicts existing legislation.
Finally, it should be noted that the bill provides for the most extensive judicial discretion of disputes on prices used in transactions. Since there is no applicable case law, the taxpayer going to court to defend his rights will never be able to foresee the outcome of even (in his mind) a surefire matter.
To summarize, one can conclude that the bill presents more questions than it does answers.
Incidentally, the bill on consolidated groups of taxpayers that is closely associated with the law on transfer pricing is in the works, but is not expected to be passed into law in 2010.
The question is, should the law be rushed into passage before the end of the year? Taxpayers have waited many years for a law on transfer pricing and will likely agree to wait a bit longer rather than receive a law that would lead to unnecessary wastes of time, energy, and resources.
Alinga Consulting Group provides the following services related to transfer pricing:
- Preparing companies for impending changes in the field of transfer pricing;
- Developing transfer pricing strategies;
- Analyzing operations on transaction items whose prices are subject to control;
- Preparing notifications and supporting documents on applied prices for the tax authorities;
- Analyzing the consistency of the applied prices with market prices;
- Working out agreements on pricing;
- Developing internal control systems for companies with respect to transfer pricing;
- Defending clients’ rights in the event that problems arise with the tax authorities regarding the prices being applied.
Tel: +7 (494) 988-21-91 ext. 142
Cell: +7 (926) 230-90-31
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