International TP Handbook 2011

International
Transfer Pricing
2011
www.pwc.com/internationaltp
www.pwc.com/transferpricing
Growing
scrutiny
The scrutiny of transfer pricing by tax
authorities worldwide has intensifed. Our
network of transfer pricing specialists has
extensive experience in dealing with revenue
authorities around the world. Using their
expertise in economics, dispute resolution and
industry, they can help you prepare for the
challenges this scrutiny willpresent.
As a network of specialists, we help companies
develop sustainable, tax-effcient structures,
and help make them more compliant with legal
requirements. We help them respond quickly to
an audit and resolve transfer pricing disputes.
We also assist them so theyre less exposed to
transfer pricing risks inthe future.
Weve built a network of 1,800 transfer pricing
specialists in over 70 countries. Heres how our
transfer pricing network can help you manage
risks and improve your tax effciency:
We advise
We develop coordinated, centralised
global documentation and
defence processes, building in the
requirements of each jurisdiction.
We draft economic and
industrystudies.
We negotiate Advance Pricing
Agreements (APAs).
We benchmark licensing fees for
intangible assets and royalties.
We assess potential benefts and
risks of transfer pricing in your
existing global operations.
We support
We assist businesses with
experienced testimony and
litigationsupport.
We help resolve global disputes and
Competent Authority negotiations.
We help multinational organisations
centrally control and manage sales
to third parties, including managing
all accompanying opportunities
andrisks.
We perform due diligence.
To fnd out more, please contact:
Garry Stone
Global Leader, Transfer Pricing
+1 312 298 2464
[email protected]
Visit www.pwc.com/
transferpricing for more information.
International
transfer pricing
2011
All information in this book, unless otherwise stated, is up to date as of 1 March 2010.
This publication has been prepared for general guidance on matters of interest only, and does not constitute professional
advice. You should not act upon the information contained in this publication without obtaining specifc professional advice. No
representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this
publication and, to the extent permitted by law, PwC does not accept or assume any liability, responsibility or duty of care for any
consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for
any decision based on it.
2010 PwC. All rights reserved. Not for further distribution without the permission of PwC. PwC refers to the network of mem-
ber frms of PricewaterhouseCoopers International Limited (PwCIL), or, as the context requires, individual member frms of the
PwC network. Each member frm is a separate legal entity and does not act as agent of PwCIL or any other member frm. PwCIL
does not provide any services to clients. PwCIL is not responsible or liable for the acts or omissions of any of its member frms nor
can it control the exercise of their professional judgement or bind them in any way. No member frm is responsible or liable for the
acts or omissions of any other member frm nor can it control the exercise of another member frms professional judgement or
bind another member frm or PwCIL in any way.
Design Services 25679 (11/10).
Preface
It is my pleasure to present the 2011
edition of our International Transfer
Pricing book. There have continued to
be major changes in transfer pricing
since our last edition, with several new
countries implementing either formal or
informal transfer pricing documentation
requirements. There have also been
important regulation changes in many
countries over the past twelve months.
Part I of the book gives a general overview
of the global approach to transfer pricing
issues, and Part II is a summary survey of
specifc requirements of the key countries
with transfer pricing rules.
We expect that 2011 will be an exciting
year for transfer pricing as several
major territories adopt new or revised
requirements for transfer pricing, and as
the impact of the OECDs new guidelines
are evaluated. We also expect an increase
in disputes globally as more and more tax
authorities try to enforce their transfer
pricing rules aggressively. It is PwCs
view that strategic dispute management
(such as through dispute avoidance or
alternative resolution techniques) on
a global basis will become increasingly
crucial in companies efforts to sustain
their global transfer pricing strategies.
We look forward to working with you in
2011 and beyond.
Best regards,
Garry Stone, PhD
Global transfer pricing leader
PwC US
International Transfer Pricing 2011 1 Introduction
In this book we have provided general
guidance on a range of transfer pricing
issues. We update technical material
for each new edition and this book is
correct as of 1 March 2010. In hard
copy form, this 2011 version is the latest
development of a piece of work that we
began two decades ago, and is now in its
twelfth edition.
If you would also like real-time access to
current information and news alerts on
current transfer pricing developments
by email, you can register for this free
service by sending an email request
entitled Pricing Knowledge Network
Registration to [email protected].
Multinational companies are facing
the growing problem of preparing
documentation to show that they
comply with transfer pricing rules across
multiple territories. Many countries
have established documentation rules
that require companies to state clearly
and with supporting evidence why their
transfer pricing policies comply with the
arms-length standard. Territories have
also implemented strict penalty regimes
to encourage taxpayers compliance
with these new procedures. However,
some of the biggest challenges facing
taxpayers in their efforts to abide by these
requirements are the subtle differences in
transfer pricing documentation expected
across the various tax territories. These
conficting pressures need to be reviewed
and managed very carefully, both to meet
the burden of compliance and to avoid
costly penalties.
Introduction
Nick Raby
PwC US
2 www.pwc.com/internationaltp Introduction
Most of the world's major tax jurisdictions
now impose formal and informal
documentation requirements to support
taxpayers inter-company pricing
policies, and have established aggressive
audit teams to review compliance.
Non-compliance now comes with a
signifcant risk of being assessed material
adjustments and penalties. For many
years, companies accepted nominal
adjustments as a small price to be paid to
get rid of the tax auditor. In the current
environment, however, adjustments
have now become potentially so material
that companies cannot simply write off
assessed adjustments without recourse.
These developments are refected in
the increasing use of mutual agreement
procedures under bilateral double
taxation agreements, or the Arbitration
Convention within the European Union,
in order to seek relief from double
taxation and unsustainable proposed
adjustments. This, in turn, necessitates a
more controlled and organised approach
by companies to handling the audits as
they take place, to ensure the process
is conducted effciently and that any
areas where the transfer pricing system
is defcient are corrected rapidly. Today,
a properly coordinated defence strategy
is a basic necessity rather than an
expensiveluxury.
In this book we show that transfer pricing
is an important matter for multinational
companies. Its vital for every company to
have a coherent and defensible transfer
pricing policy that is up to date and
current. A sound transfer pricing policy
must be developed within a reasonable
timescale and be invested in by both
company management and professional
advisers. This needs to be re-examined
regularly due to changes in the business,
perhaps as the result of acquisitions or
divestments of part of the group. We have
tried to provide practical advice wherever
possible on a subject where the right
amount of effort can produce signifcant
dividends in the form of a low and stable
tax burden, coupled with the ability to
defend a company against tax auditor
examination. Of course, nothing in this
format can replace a specialists detailed
professional advice on the specifc facts
relevant to a particular transfer pricing
issue. However, our hope is that, with the
help of this book, you can approach inter-
company pricing considerations with
greater confdence andknowledge.
Nick Raby
PwC US
Nick Raby is the Global Operations leader for the PwC
Tax Controversy and Dispute Resolution network, and
has extensive experience in advising on transfer pricing
and tax planning for multinational companies. His
international experience includes six years in London,
and three in Brussels and Amsterdam. Many members of
the PricewaterhouseCoopers international network of
transfer pricing specialists have contributed to this book
over the years. In particular, thanks are due this year to
the following individuals who have edited their country/
territory materials in this edition.
Africa
David Lermer
Corneli Espost
Mark Badenhorst
Jeanne Havinga
Argentina
Violeta Maresca
Juan Carlos Ferreiro
Australia
Nick Houseman
Scott Warnock
Austria
Herbert Greinecker
Doris Bramo-Hackel
Melinda Perneki
Azerbaijan
Movlan Pashayev
Mushfg Aliyev
Belgium
Patrick Boone
Xavier Van Vlem
Gaspar Ndabi
Brazil
Cristina Medeiros
Leandro Scalquette
Bulgaria
Ginka Iskrova
Ekaterina Dimitrova
Canada
Charles Thriault
Andrew McCrodan
Chile
Roberto Carlos Rivas
Carolina Cspedes
China
Spencer Chong
Qisheng Yu
Cecilia Lee
Colombia
Carlos Mario Lafaurie
Rafael Parra
Croatia
Janos Kelemen
Ivo Bijelic
Matija Vukuic
Czech Republic
David Borkovec
Natalia Pryhoda
Denmark
Erik Todbjerg
Klaus Okholm
Anne Mette Nyborg
Dominican Republic
Ramn Ortega
Amparo Mercader
Ecuador
Pablo Aguirre
Csar Ortiz
Alex Espinosa Moya
Egypt
Sherif Mansour
Abdallah ElAdly
Khaled Youssef
Nouran Mohamed
Estonia
Villi Tntson
Hannes Lentsius
Finland
Merja Raunio
Jarno Mket
France
Pierre Escaut
Marie-Laure Hublot
Georgia
Paul Cooper
Sergi Kobakhidze
Anastasia Kipiani
Germany
Lorenz Bernhardt
Greece
Antonis Desipris
Hong Kong
Spencer Chong
Rhett Liu
Cecilia Lee
Hungary
Zaid Sethi
Iceland
sta Kristjnsdttir
Frigeir Sigursson
Jn I. Ingibergsson
Valdimar Gunason
India
Rahul K. Mitra
Rakesh Mishra
Indonesia
Ay-Tjhing Phan
Sarah M. Stevens
Ireland
Gavan Ryle
Barbara Dooley
Noel Maher
Israel
Gerry Seligman
Vered Kirshner
Adi Bengal-Dotan
Italy
Gianni Colucci
Marco Meulepas
Japan
Akio Miyamoto
Ryann Thomas
Toshiyuki Kurauchi
Kazakhstan
Carmen Cancela
Almas Nakipov
Khayrulla Akramkhodjaev
Korea
Henry An
Heui-Tae Lee
Wonyeob Chon
Joon-Kyoo Yang
Latvia
Ilze Berga
Vita Sakne
Janina Landisa
Lithuania
Nerijus Nedzinskas
Martynas Novikovas
Arnas Laurynas
Luxembourg
David Roach
Geetha Hanumantha Rao
Malaysia
SM Thanneermalai
Jagdev Singh
Fung Mei Lin
Anushia Joan Soosaipillai
Mexico
Fred J. Barrett
Mauricio Hurtado
Adolfo Calatayud
Jaime Heredia
Moldova
Mihaela Mitroi
Andrian Candu
Svetlana Ceban
Maxim Banaga
Netherlands
Arnout van der Rest
Jeroen Peerbooms
Frans Blok
New Zealand
Cameron Smith
Agnes Kurniawan
Norway
Morten Beck
Ola Nicolai Borge
ystein Andal
Peru
Rudolf Rder
Miguel Puga
Fernando Becerra
Frida Llanos
Philippines
Alexander B. Cabrera
Carlos T. Carado II
Roselle K. Yu
Poland
Mike Ahern
Piotr Wiewirka
Sebastian Lebda
Joanna Kubinska
Portugal
Leendert Verschoor
Jaime Esteves
Jorge Figueiredo
Clara Madalena Dithmer
Romania
Ionut Simion
Blanca Kovari
Livia Carloban
Russia
Svetlana Stroykova
Ilarion Lemetyuynen
Singapore
Nicole Fung
Matthew Andrew
Slovakia
Christiana Serugov
Alexandra Jaicov
Michaela Firick
Mria Malovcov
Slovenia
Clare Moger
Tina Klemenc
Spain
Javier Gonzlez Carcedo
Michael Walter
Valeri Viladrich
Santallusia
Raul Martin
Sweden
Jrme Monsenego
Maria Plannthin
Maria Blom
Switzerland
Nicolas Bonvin
Benjamin Koch
Norbert A. Raschle
Taiwan
Steven Go
Wendy Chiu
Dave Barberi
Thailand
Peerapat Poshyanonda
Janaiporn Khantasomboon
Turkey
Zeki Gunduz
zlem G Aliolu
UK
Diane Hay
Kevin Norton
US
Nick Raby
Vu P. Tran
Matias Pedevilla
Uruguay
Maria Jose Santos
Sergio Franco
Uzbekistan
Abdulkhamid Muminov
Akmal Rustamov
Natasha Tsoy
Venezuela
Luis Fernando Miranda
Jos Gregorio Garcia
Jos Rafael Monsalve
Mara Carolina Sanchez
Vietnam
Thanneermalai
Somasundaram
Jagdev Singh
Anushia Joan Soosaipillai
Desmond Goh Keng Hong
This work also builds on the efforts of many individuals,
not listed here, who contributed ideas and words to
earliereditions.
The author would also like to express his gratitude to
the editorial team for this edition, which consisted of Vu
Tran, Matias Pedevilla, Henry An, Arnout van der Rest,
Maria Plannthin and Dana Hart.
International Transfer Pricing 2011 7 Contents
1. Introduction...................................14
2. Categories of inter-company
transfer ..........................................19
3. The work of the OECD ...................34
4. Establishing a transfer pricing policy
practical considerations ..............51
5. Specifc issues in transfer pricing ....76
6. Managing changes to a transfer
pricing policy ..............................107
7. Dealing with an audit of transfer
pricing by a tax authority .............122
8. Financial Services .......................128
9. Transfer pricing and
indirect taxes ............................... 141
10. Procedures for achieving an offsetting
adjustment ..................................158
11. Africa Regional ............................170
12. Argentina ....................................200
13. Austalia .......................................213
14. Austria .........................................232
15. Azerbaijan ...................................243
16. Belgium .......................................248
17. Brazil ...........................................262
18. Bulgaria .......................................276
19. Canada ........................................282
20. Chile ........................................... 304
21. China ...........................................307
22. Colombia ....................................322
23. Croatia .........................................331
24. The Czech Republic .....................335
25. Denmark ......................................340
26. Dominican Republic .....................355
27. Ecuador .......................................357
28. Egypt ...........................................363
29. Estonia.........................................367
Contents
8 www.pwc.com/internationaltp Contents
30. Finland ........................................375
31. France ........................................ 384
32. Georgia ....................................... 404
33. Germany ......................................408
34. Greece .........................................424
35. Hong Kong ...................................434
36. Hungary ..................................... 440
37. Iceland .........................................447
38. India ............................................451
39. Indonesia .....................................478
40. Ireland ....................................... 484
41. Israel ...........................................497
42. Italy ............................................501
43. Japan ...........................................513
44. Kazakhstan ..................................525
45. Korea ...........................................531
46. Latvia...........................................540
47. Lithuania .....................................547
48. Luxembourg ................................551
49. Malaysia ......................................555
50. Mexico .........................................566
51. Moldova ......................................586
52. The Netherlands ..........................591
53. New Zealand ...............................605
54. Norway ........................................ 619
55. Peru .............................................632
56. Philippines ...................................639
57. Poland ........................................ 645
58. Portugal .......................................653
59. Romania ......................................663
60. Russia ..........................................669
61. Singapore ....................................680
62. Slovakia ......................................689
63. Slovenia .......................................694
64. Spain ...........................................701
65. Sweden ........................................712
66. Switzerland .................................719
67. Taiwan .........................................725
68. Thailand ......................................732
69. Turkey .........................................740
70. United Kingdom ..........................752
71. United States ...............................777
72. Uruguay .......................................809
73. Uzbekistan ...................................822
74. Venezuela ....................................825
75. Vietnam .......................................834
Appendix 1
Functional analysis questions ............ 848
Appendix 2
Examples of databases for use in
identifying comparative information .855
Appendix 3
US Proposed service regulations .....856
Global Transfer Pricing Contacts ........859
Index ..................................................863
International Transfer Pricing 2011 9 Glossary
Advance pricing agreements
(APA): Binding advance agreements
between the tax authorities and the
taxpayer, which set out the method
for determining transfer pricing for
inter-companytransactions.
Arms-length principle: The arms-
length principle requires that transfer
prices charged between related parties
are equivalent to those that would have
been charged between independent
parties in the same circumstances.
Berry ratio: A ratio sometimes used in
transfer pricing analyses, equal to gross
margin divided by operating expenses.
Comparable profts method (CPM):
A transfer pricing method based on
the comparison of the operating proft
derived from related party transactions
with the operating proft earned by
third parties undertaking similar
businessactivities.
Comparable uncontrolled
price (CUP) method: A method of
pricing based on the price charged
between unrelated entities in respect
of a comparable transaction in
comparablecircumstances.
Competent authority procedure:
A procedure under which different
tax authorities may consult each other
to reach a mutual agreement on a
taxpayersposition.
Cost-plus method: A method of
pricing based on the costs incurred plus a
percentage of those costs.
Double taxation treaty: A treaty made
between two countries agreeing on the
tax treatment of residents of one country
under the other countrys tax system.
Functional analysis: The analysis of
a business by reference to the location of
functions, risks and intangible assets.
GATT: General Agreement on Trade
andTariffs.
Inland Revenue: The UK tax authority.
Intangible property: Property that
is not tangible, e.g. patents, know-
how, trademarks, brands, goodwill,
customerlists.
Glossary
10 www.pwc.com/internationaltp Glossary
Internal Revenue Service (IRS):
The US tax authority.
OECD: The Organisation for Economic
Co-operation and Development.
OECD Guidelines: Report by the OECD
on transfer pricing entitled Transfer
Pricing Guidelines for Multinational
Enterprises and Tax Administrations,
published in July 1995, with additional
chapters subsequently issued.
Patent: Legal protection of a product
or process invented or developed by the
holder of the patent.
Permanent establishment (PE): A
taxable business unit. Exact defnitions
vary in different countries and according
to different double taxation treaties.
Proft split method: A method of
pricing where the proft or loss of a
multinational enterprise is divided
in a way that would be expected of
independent enterprises in a joint-
venture relationship.
Resale price method: A method of
pricing based on the price at which a
product is resold less a percentage of the
resale price.
Royalty: A payment (often periodic) in
respect of property (often intangible),
e.g. a sum paid for the use of
patentedtechnology.
Tangible property: Physical property,
e.g. inventory, plant, machinery
andfactories.
Thin capitalisation: A situation in
which a company has a high level of
borrowing relative to its equity base.
The term is usually used when the
high levels of debt are derived from
relatedcompanies.
Trademark: A name or logo associated
with a particular product.
Trade name: A name or logo associated
with a particular company or group
ofcompanies.
Transactional net margin method
(TNMM): A transfer pricing method
based on an analysis of the operating
proft derived by a business from a
particular related party transaction or
group of transactions.
Value added tax: A tax on products or
services charged at the point of sale.
WTO: World Trade Organisation.
Part 1: Developing
defensible transfer
pricing policies
Introduction
1.
101. At the eye of the perfect storm
Globalisation and the rapid growth of international trade has made inter-company
pricing an everyday necessity for the vast majority of businesses. However, the growth
of national treasury defcits and the frequent use of the phrase transfer pricing in the
same sentence as tax shelters and tax evasion on the business pages of newspapers
around the world have left multinational enterprises at the centre of a storm of
controversy. Tax authorities have made the regulation and enforcement of the arms-
length standard a top priority (see section 701 for commentary on the audit approach
to pricing matters in a number of countries). A key incentive for challenging taxpayers
on their transfer prices is that the authorities see transfer pricing as a soft target
with the potential to produce very large increases in tax revenues. Since there is no
absolute rule for determining the right transfer price for any kind of international
transaction with associated enterprises, whether it involves tangibles, intangibles,
services, fnancing or cost allocation/sharing arrangements, there is huge potential for
disagreement as to whether the correct amount of taxable income has been reported in
a particular jurisdiction. While the existence of tax treaties between most of the worlds
major trading nations might lead the casual observer to conclude that international
transfer pricing is a zero sum game where an adjustment in one jurisdiction will be
matched by the granting of corresponding relief at the other end of the transaction, the
reality is that transfer pricing controversies are expensive and time-consuming to deal
with, not to mention full of pitfalls for the unwary, which frequently result in double
taxation of income.
The impact of this focus by governments has been to create a very uncertain operating
environment for businesses, many of whom are already struggling with increased
global competition, escalating operating costs and the threat of recession. Add to
this, accounting rule changes, which often create tension between the economists
viewpoint that there are many different possible outcomes to any transfer pricing
analysis, a number of which may be acceptable and some of which may not, with the
accountants need for a single number to include in reported earnings and you have
what many commentators have termed the perfect storm, which threatens:
The risk of very large local tax reassessments;
The potential for double taxation because income has already been taxed elsewhere
and relief under tax treaties is not available;
Signifcant penalties and interest on overdue tax;
International Transfer Pricing 2011 Introduction 15
Introduction
The potential for carry forward of the impact of unfavourable Revenue
determinations, creating further liabilities in future periods;
Secondary tax consequences adding further cost for example the levy of
withholding taxes on adjusted amounts treated as constructive dividends;
Uncertainty as to the groups worldwide tax burden, leading to the risk of earnings
restatements and investor lawsuits;
Conficts with customs and indirect tax reporting requirements;
Conficts with regulatory authorities; and
Damage to reputation and diminution of brand value as a consequence of the
perception of being a bad corporate citizen.
102. The need for adequate planning and documentation of
transfer pricing policies and procedures
Typically the life cycle of a global transfer pricing policy involves an initial detailed
analysis of the underlying facts and economics, evaluation and development of the
proposed policy in relation to the groups global tax planning objectives, a detailed
implementation and monitoring plan, and the adoption of a defensive strategy, given
the virtual inevitability that someone, somewhere will want to challenge the result.
Probably the biggest challenge inherent in this whole process is the need to balance the
conficting goals of being able to achieve a very high standard of compliance with the
myriad of rules and regulations that have fourished in the many different jurisdictions
in which a multinational may operate, with the need to manage the level of taxes paid
on a global basis at a competitive level. In the current hostile environment there is no
play safe strategy taxpayers must assume that they will be subject to challenge, no
matter how conservative a philosophy they may initially adopt in their transfer pricing
policies and procedures.
Most of the worlds major trading nations now have detailed requirements for
the documentation of transfer pricing matters, but even those that have not yet
implemented specifc requirements will expect taxpayers to be able to explain and
produce support for the positions taken on local tax returns, and to show that they
conform to arms-length results. One important trend that is emerging is based on the
realisation that in such a volatile area, the only clear path to certainty lies in advance
discussions with the authorities. Tax rulings and advance pricing agreements (APAs),
once thought to be solely the realm of the biggest and most sophisticated taxpayers, are
increasingly being seen as an everyday defensive tool.
The planning process can also provide an excellent forum for gathering information
about the business and identifying tax and commercial opportunities that have
until now gone unnoticed. The development of a transfer pricing policy will involve
fnancial, tax and operational personnel and, therefore, provides a useful opportunity
for a varied group to communicate their respective positions and assess business
priorities. Implementation is also an area that will require cross-functional cooperation
within a multinational enterprise since success will ultimately be determined by an
ability to ensure that the policies and procedures adopted are fully aligned with the
underlying business activities and that the results are reliably reported on the books
and records of the entities undertaking the transactions.
Introduction 16 www.pwc.com/internationaltp
103. The importance of keeping policies and procedures up
todate
A pricing policy cannot be established, set in stone and then ignored. If it is to have any
value, the policy must be responsive to an increasingly dynamic and turbulent business
environment and must be reviewed on an ongoing basis, at a minimum whenever the
groups business is restructured or new types of transactions are contemplated. This
should not be an onerous task if it is performed by appropriate personnel who are
well-briefed on the aims of the analysis and any necessary amendments to the policy
are implemented quickly. An updating of the transfer pricing policy should form part of
the routine process of reviewing the overall business strategy. Regular and as-needed
policy updates can help to ensure that the policy continues to cover all inter-company
transactions undertaken by the company, as well as produce arms-length results and
prevent unwelcome surprises.
104. Theory and practice
The theory on which a perfect pricing policy is based has been much discussed
in recent years. This book, while recognising the need for theoretical guidelines,
focuses on how to establish a successful transfer pricing policy in practice. This is
achieved by explaining to the reader the broad principles to be applied in establishing
transfer pricing policies that would be acceptable under the generally recognised
Organisation for Economic Co-operation and Development (OECD) principles. The
book also indicates, through a number of country studies, the areas in which such
general practice might need to be amended slightly to meet the requirements of local
country law. The degree to which such local amendments will need to be made will
undoubtedly change over time and there can be no substitute for current advice from
local experts in looking at such matters. In many cases, however, the general principles
laid down in this text will satisfy the local law.
105. Transfer pricing is not just about taxation
In addition to evaluating the risks of tax controversies in advance, careful advance
planning for transfer pricing also allows a multinational enterprise to consider
implications beyond taxation. For instance, the effect on corporate restructuring,
supply chain, resource allocation, management compensation plans and management
of exposure to third-party legal liabilities must also be considered.
The implications of transfer pricing policies in the felds of management accounting
and organisational behaviour have been the subject of an increasing volume of
academic debate; for example, there may be a signifcant infuence on the actions of
managers who are remunerated by a bonus linked to local company operating profts.
A change in a group transfer pricing policy that fails to recognise the impact that may
be felt by individual employees may not bring about the behavioural improvements
management wish to achieve.
Legal matters that fall under the corporate general counsels offce should also be taken
into account. Matters such as intellectual property protection arising from cost sharing,
treasury management issues arising from centralised activities such as cash pooling
and areas of logistics and inventory management in coordination centre arrangements
all require careful consideration. In some cases there may be confict between the tax
International Transfer Pricing 2011 Introduction 17
Introduction
planners desire to locate certain functions, risks and assets in one jurisdiction and the
lawyers need to have recourse to the legal system of another.
Ultimately, transfer pricing policy should beneft a company from a risk management
as well as a business perspective. To this end, building a foundation of internal support
by the multinational is imperative in order to enable compliance with tax regulations as
well as effective management decision-making.
106. New legislation and regulations
The current framework for interpretation of the arms-length principle dates back
to the early 1990s when the US broke new ground with detailed regulations on
intangibles, tangibles and cost sharing. These regulations evoked widespread
reaction among the international community, with the regulations on the application
of the commensurate with income standard and the need for contemporaneous
documentation in order avoid specifc transfer pricing penalties proving especially
controversial. The OECD responded by publishing new guidelines that covered many of
the same issues. Subsequently, many countries around the world introduced their own
transfer pricing rules based on the principles set out in the OECD Guidelines, which in
some cases include requirements that go beyond the regulations in the US.
Based on over a decade of experience in enforcement of these rules and regulations,
the last few years have seen renewed legislative activity in a number of jurisdictions.
The US has revisited the regulations pertaining to services, intangibles and cost
sharing, and has developed new requirements such as the need to include the cost
of stock-based compensation in cost sharing charges and charges for inter-company
services as well as new transfer pricing methods to respond to perceived issues with the
existing regulations pertaining to intangible transfers. In 2010 the OECD issued fnal
revisions to the Guidelines, which included signifcant changes to the chapters dealing
with the Arms-length Principle, Transfer Pricing Methods and Comparability Analysis,
and also fnalised guidance on Transfer Pricing Aspects of Business Restructurings,
which was included as a new chapter.
107. The future
Around the world legislative change continues unabated. Transfer pricing rules have
recently been introduced or reformed in a number of countries, while many other
countries are in the process of reviewing the effectiveness of their existing transfer
pricing rules and practices. In parallel, Revenue authorities are stepping up the
pace of transfer pricing audits, presenting fresh challenges of policy implementation
and defence to the taxpayer. Issues that may trigger a transfer pricing investigation
mayinclude:
Corporate restructurings, particularly where there is downsizing of operations in a
particular jurisdiction;
Signifcant inter-company transactions with related parties located in tax havens,
low tax jurisdictions or entities that beneft from special tax regimes;
Deductions claimed for inter-company payments of royalties and/or service fees,
particularly if this results in losses being claimed on the local tax return;
Royalty rates that appear high in relative percentage terms, especially where
intellectual property that is not legally registered may be involved;
Introduction 18 www.pwc.com/internationaltp
Inconsistencies between inter-company contracts, transfer pricing policies and
detailed transaction documents such as inter-company invoices and/or customs
documentation;
Separation of business functions and related risks that are contractually assigned to
a different jurisdiction;
Frequent revisions to transfer pricing policies and procedures;
Recurring year-end pricing adjustments, particularly where they may create book/
tax differences;
Failure to adopt a clear defence strategy; and
Simply having a low effective tax rate in the published fnancial statements.
It must be presumed that the pace of change will be maintained, and that it may even
increase due to budgetary pressures on governments. A multinational enterprise must
maintain continual vigilance to ensure that its transfer pricing policies meet the most
up-to-date standards imposed by tax authorities around the world and also continue to
meet its own business objectives.
The immediate future presents great challenges to both taxpayers and tax authorities.
Taxpayers must cope with legislation that is growing by the day across jurisdictions,
and which is often not consistent. For instance, safe harbour rules in one jurisdiction
may represent a non-controversial alternative and yet could be countered in the
other contracting country. Similar diffculties are encountered while dealing with
the fundamental defnition of arms-length range, which continue to have differing
legislative meanings and judicial interpretations. The onus is on the taxpayer
to establish arms-length transfer pricing by way of extensive country-specifc
documentation. Failure to do so will inevitably result in the realisation of some or all of
the threats listed above. It is not enough for taxpayers to honestly believe they have the
right answer they will also need to be able to demonstrate that it is.
Tax authorities are to some extent in competition with their counterparts from other
transacting jurisdictions in order to secure what they perceive to be their fair share of
taxable profts of multinational enterprises. This frequently leads to double taxation
of the same profts by Revenue authorities of two or more transacting countries.
Consequently, there is also an increasing trend towards tax authorities favouring
the use of bilateral advance pricing agreements where they are available. Another
trend being witnessed is the rise in the number of disputes going to the competent
authorities for resolution under the mutual agreement procedures of bilateral tax
treaties. On the other hand, transfer pricing is also an anti-avoidance issue and to this
end, tax authorities have to work together to ensure that the increasing trade and
commerce by multinational enterprises and their ability to allocate profts to different
jurisdictions by controlling prices in intragroup transactions does not lead to tax
evasion, for example through the use of non-arms-length prices, the artifcial use of
tax havens and the use of other types of tax shelters. Inevitably there will have to be
trade-offs between these conficting considerations.
Categories of inter-company transfer
2.
International Transfer Pricing 2011 19 Categories of inter-company transfer
201. Introduction
Inter-company transactions take place through transfers of tangible and intangible
property, the provision of services, as well as inter-company fnancing, rental and
leasing arrangements, or even an exchange of, for example, property for services or
the issue of sweat equity. It is important to note that it is the substance of the situation
that always determines whether a transaction has taken place, rather than whether
an invoice has been rendered. For instance, management services may be delivered
through the medium of a telephone call between executives of a parent company and
its subsidiary. In this example, a service has been performed that the provider had to
fnance in the form of payroll costs, phone charges, overheads, etc and the service itself
is of value to the recipient in the form of the advice received. As a result, a transaction
has taken place for transfer pricing purposes even though, at this stage, no charge
has been made for the service. Transfer pricing rules typically require related entities
to compensate each other appropriately so as to be commensurate with the value of
property transferred or services provided whenever an inter-company transaction takes
place. The basis for determining proper compensation is, almost universally, the arms-
length principle.
202. The arms-length principle
Simply stated, the arms-length principle requires that compensation for any inter-
company transaction conform to the level that would have applied had the transaction
taken place between unrelated parties, all other factors remaining the same.
Although the principle can be simply stated, the actual determination of arms-length
compensation is notoriously diffcult. Important factors infuencing the determination
of arms-length compensation include the type of transaction under review as well as
the economic circumstances surrounding the transaction. In addition to infuencing the
amount of the compensation, these factors may also infuence the form of the payment.
For example, a given value might be structured as a lump-sum payment or a stream of
royalty payments made over a predetermined period.
This chapter summarises the various types of inter-company transfers and the
principles that may be applied to determine the proper arms-length compensation for
these transactions. The application of the arms-length principle is discussed in detail
in chapters 3 and 4.
Categories of inter-company transfer 20 www.pwc.com/internationaltp
203. Sales of tangible property defnition
Tangible property refers to all the physical assets of a business. Sales of raw materials,
work in progress and fnished goods represent a major portion of the transfers that take
place between related parties, typically referred to as sales of inventory (see section
205). However, it is important to bear in mind that sales of tangible property can
include all the machinery and equipment employed by businesses in their day-to-day
activities as well as the goods they produce.
204. Sales of machinery and equipment
Machinery and equipment is frequently provided to manufacturing affliates by the
parent company. For example, this may be a means of providing support to an existing
subsidiary or it may be in the form of the sale of complete manufacturing lines to a new
company in a greenfeld situation. The equipment may have been purchased from
an unrelated company, manufactured by the parent or might be older equipment that
the parent (or another manufacturing affliate) no longer needs. Tax rules generally
require that the transferor of this equipment (whether new or used, manufactured
or purchased) should receive an arms-length consideration for the equipment.
This is generally considered to be the fair market value of the equipment at the time
oftransfer.
While the tax treatment of plant and machinery transfers is generally as described
above, there can be circumstances where an alternative approach might be adopted.
Such circumstances usually arise in connection with general business restructuring
or, perhaps, when a previously unincorporated business (or an overseas branch
of a company) is transferred into corporate form. A number of countries offer
arrangements in their domestic law or under their treaty network to defer the tax
charges that might otherwise arise as a result of an outright sale of assets at their fair
market value. Another possibility to consider is whether there are any tax implications
arising from the transfer of business as a whole, which is to say, the bundling of assets,
related liabilities and goodwill or intangibles, as against the transfer of assets such as
plant and machinery on a piecemeal basis.
205. Sales of inventory
Sales of inventory generally fall into three categories: sales of raw materials, sales of
work in progress and sales of fnished goods. Goods in each of these categories may be
manufactured by the seller or purchased from third parties.
Tax rules typically require that arms-length prices be used for sales of inventory
between affliates. Ideally, arms-length compensation is determined by direct reference
to the prices of comparable products. Comparable products are very similar, if not
identical, products that are sold between unrelated parties under substantially similar
economic circumstances (i.e. when the market conditions affecting the transactions are
similar and when the functions performed, risks borne and intangible assets developed
by the respective unrelated trading parties coincide with those of the related parties).
Example
Assume that Widgets Inc. (WI), a US company, manufactures and sells in Europe
through a UK subsidiary, Widgets Ltd. (WL). WL manufactures one product, Snerfos,
International Transfer Pricing 2011 Categories of inter-company transfer 21
using semiconductor chips that are produced by WI, transistors purchased by WI
through a worldwide contract and packaging material that WL purchases locally from
a third party. In addition, a testing machine, which is proprietary to WI, is supplied
byWI.
In this situation, there are three inter-company sales of tangible property by WI to WL:
Sale of the testing machine;
Sale of semiconductor chips; and
Sale of transistors purchased from unrelated parties.
In each case, an arms-length price must be determined, invoices for the sales must be
produced and payment on those invoices must be made by WL.
An important consideration in the context of determining comparability in the context
of transfer of inventory is the level of investment in working capital between the related
enterprises and the independent enterprises, which is driven by payment terms and
inventory lead times. At arms length, an uncontrolled entity expects to earn a market
rate of return on that required capital. Accordingly, the effects on profts from investing
in different levels of working capital warrant an adjustment to the transfer prices.
206. Transfers of intangible property defnition
When the profts of a corporation exceed the level that would otherwise be expected
to arise, taking into account market conditions over a long period, the cause is the
presence of what economists refer to as a barrier to entry.
Barriers to entry are those factors that prevent or hinder successful entry into a market
or, in other words, perpetuate some sort of monopoly control over the marketplace.
Sometimes these barriers to entry create an absolute monopoly for the owner or
creator of the barrier. For example, Aluminum Company of America (ALCOA) owned
the worlds source of bauxite (vital in the production of aluminium) and, until the US
courts forced ALCOA to divest itself of some of the supply, had an absolute monopoly
in the production of aluminium. In another example, the pharmaceutical company Eli
Lilly owned the patent on a drug sold as Darvon. This patent was so effective that
no competitor was able to develop a drug that could compete with Darvon until the
patentexpired.
Barriers to entry are recognised as intangible assets in an inter-company pricing
context. Examples of intangible assets include goodwill, patents, brands and
trademarks, intellectual property, licences, publishing rights, the ability to provide
services and many others. In general, intangible assets are non-physical in nature, are
capable of producing future economic benefts, can be separately identifed and could
be protected by a legal right.
Those intangibles that produce a monopoly or near-monopoly in their product areas
are sometimes referred to as super intangibles and are the subject of much current
interest in the transfer pricing arena. Ever since the Tax Reform Act of 1986 and the
subsequent white paper, the question of the appropriate inter-company royalty rates
for super intangibles had remained a controversial issue in the US. (See chapter
71 for a detailed discussion of the current US regulations.) An intangible asset that
does not produce a monopoly (i.e. situations where the product to that the intangible
relates is sold in very competitive markets) is sometimes referred to as an ordinary or
routineintangible.
207. Types of intangibles
In the transfer pricing world, intangible assets are commonly divided into two general
categories. The frst category consists of manufacturing intangibles, which are created
by the manufacturing activities or the research and development (R&D) effort of the
producer. Marketing intangibles the second category are created by marketing,
distribution and after-sales service efforts.
208. Modes of transfer of intangibles
Intangibles can be transferred between related entities in four ways:
1. Outright sale for consideration;
2. Outright transfer for no remuneration (i.e. by way of gift);
3. Licence in exchange for a royalty (lump sum or periodic payment based on a
percentage of sales, sum per unit, etc.); and
4. Royalty-free licence.
As a general rule, transfers without remuneration are not accepted by the tax
authorities of any country, except occasionally in the limited context of property
owned and exploited from tax havens or business reorganisations that attract special
tax reliefs. These exceptions are not considered further in this book. Transfers of
intangibles through licences are very common and are the primary method of transfer
discussed in this book.
Sales of intangibles are generally treated in the same way as sales of tangible property
(i.e. the arms-length standard requires that the selling price be the fair market value
of the property at the time of sale). Some countries tax authorities, notably the US,
require that an assessment of whether a transaction is arms length meet certain
requirements. For the transfer of an intangible asset, US tax law requires that the
consideration paid be commensurate with the income generated or expected to be
generated by the intangible asset. This may require additional support, beyond an
assessment of fair market value that by itself does not consider the income potential of
the transferred intangible.
209. Manufacturing intangibles
Patents and non-patented technical know-how are the primary types of manufacturing
intangibles. A patent is a government grant of a right that guarantees the inventor that
his/her invention will be protected from use by others for a period of time. This period
varies from one country to another and, to a lesser extent, according to the product.
Patents can be either very effective barriers to entry or quite ineffective barriers. Very
effective barriers create an absolute monopoly for the owner for the life of the patent
and are exemplifed by product patents. Ineffective barriers are created by patents
that can easily be designed around or cover only minor aspects of a product, such as
process patents.
When transferring patents to affliates, it is vital to understand the degree of monopoly
power conveyed by the patent. This is critical to the determination of the arms-length
compensation due to the transferor because patents that provide more protection to
the owner are more valuable than patents that provide less protection.
Technical know-how is the accumulated specifc knowledge that gives a manufacturer
the ability to produce a product. In some industries, technical know-how is worth
very little, so that when it is transferred between unrelated parties the royalty rate is
extremely low. In other industries, technical know-how is highly valuable.
Example
Consolidated Wafers Ltd. (CWL) designs and manufactures semiconductors. Its
research and development (R&D) department has designed a memory chip that
is signifcantly faster and uses less power than any other chip on the market. CWL
has an absolute monopoly on the production of this chip until a competitor reverse
engineers the chip and markets a clone. At that time, CWLs ability to remain
successful in the market will be determined by its ability to produce high-quality
chips at lower cost (higher yield) than its competitors. Typically, in the semiconductor
industry, this process may take less than two years.
The manufacturing intangibles cited in this example are of different value at different
points during the life of the product. At the outset, the design of the chip explained
its success in the marketplace. The design was proprietary but not patented. After
the competition began marketing its own version of the chip, the manufacturing
intangible of greatest value to CWL was its ability to improve the quality of the product
and reduce the cost of manufacturing the product, both critically important factors in
thisindustry.
In determining the value of the intangibles in this example, it is important to note the
length of time during which the original design created an absolute monopoly for CWL.
Intangibles that sustain monopoly positions over long periods are far more valuable
than intangibles that create monopoly positions for much shorter periods. The longer
the monopoly continues, the more time the owner of the intangible has to exploit the
monopoly position and to develop value in the form of technical know-how or selling
intangibles such as trademarks, which will protect an imperfectly competitive market
position after the expiration of the patent.
Furthermore, in this example, the ability to produce a high-quality and low-cost
product is extremely valuable in the long run, because without this ability, CWL would
not be able to compete in the marketplace. There are countless examples of these types
of intangibles in the modern world.
210. Marketing intangibles
Marketing intangibles include, but are not limited to, trademarks and trade names,
corporate reputation, the existence of a developed sales force and the ability to provide
services and training to customers.
A trademark is a distinctive identifcation of a manufactured product in the form of a
name, logo, etc. A trade name is the name under which an organisation conducts its
business. Trademarks and trade names are frequently treated as identical, although
one (trademark) is a product-specifc intangible, while the other (trade name) is
a company-specifc intangible. A product-specifc intangible applies to a particular
product and has zero value at the time the product is marketed for the frst time
under that name. Its value is developed by the marketing/sales organisation over the
life of the product. This is important for inter-company pricing because trademarks
typically have little or no value when a product is frst introduced into a new market
(even though it may have high value in the markets into which the product is already
beingsold).
A company-specifc intangible is one that applies to all products marketed by a
company. For example, Xerox applies to photocopiers manufactured and sold by
the Xerox Corporation. In fact, the very word xerox has become a synonym for
photocopy in many markets. However, the power of the brand name means that this
type of intangible includes new, as well as existing, products and has value in most
markets at the time the products are introduced into these markets.
Corporate reputation represents the accumulated goodwill of a corporation and is
sometimes used as a synonym for trade name. A company with a strong corporate
reputation will have a developed sales force. This means that a trained sales force is
in place and is familiar with the company, its customers and its products, and can sell
products effectively. This in turn involves pre-sales and post-sales activities. Pre-sales
services entail generating interest in prospective customers, establishing proof of
concept, making effective product demonstrations and thereby leading to closing a
sale, which can be critical in industries such as healthcare, insurance and software.
Service to customers after a sale and training of customers in the use of a product
are extremely important in some other industries. In fact, in some industries, this
intangible is the one that keeps the company in business.
Example
Deutsche Soap, AG (DSAG) is in the business of manufacturing and selling a line of
soap products to industrial users. Its products are not patented and the manufacturing
process is long-established and well-known. It sells to industrial customers that rely
on DSAG for technical assistance and advice regarding diffcult cleaning problems.
DSAGs sales force is on 24-hour call to assist customers within 30 minutes of a request.
DSAG has developed training programmes and a service manual that it provides to its
salesforce.
DSAG has decided to establish a wholly owned subsidiary in France. The subsidiary will
purchase products manufactured by DSAG (in Germany) and will be responsible for
sales and services in the French market. DSAG intends to train the French subsidiarys
sales force and to provide a copy of the service manual for each member of its French
sales force.
From an inter-company pricing standpoint, the intangible of value is the ability to
provide service to the customer. The transfer of this intangible to the French subsidiary
should be accompanied by an arms-length payment to the German parent.
211. Hybrid intangibles
In the modern world, it is diffcult to classify every intangible neatly as either a
manufacturing or a marketing intangible. Some intangibles can be both. For example,
corporate reputation may result from the fact that a company has historically produced
high-quality products which were at the leading edge in its industry. The reputation
that results from this is clearly a manufacturing intangible.
In another example, suppose that corporate reputation of a particular company results
from its advertising genius, so that customers and potential customers think of the
corporation as, for example, The Golden Arches (McDonalds) or the company that
taught the world to sing (Coca-Cola). In this case, corporate reputation is a very
powerful marketing intangible. In such cases, a signifcant portion of the value of the
corporation is attributed to the trade name itself, such as BMW.
Further complexity arises when software is the product in question. It is not clear
whether software is a product to be sold or an intangible to be licensed (and there
may well be withholding tax and sourcing of income implications to be considered, in
addition to pricing considerations). The transfer of software to customers has elements
of both a sale and a licence in most instances.
If software is determined to be an intangible, the question is then whether it is a
manufacturing or a marketing intangible. Whatever the answer, the important question
for inter-company pricing purposes is: Which legal entity developed the value of the
intangible? The developer must receive an arms-length remuneration for the use of its
property from any user of the intangible.
There can be differences of opinion on this issue, stemming from whether a particular
product succeeds in a specifc, new market because of the technology, giving rise to
manufacturing intangibles or the sales efforts, resulting in the creation of marketing
intangibles. The recently settled GlaxoSmithKline dispute regarding the drug Zantac is
a case in point.
212. The provision of services defnition
Services that are provided to related parties range from the relatively commonplace,
such as accounting, legal or tax, to complex technical assistance associated with
transfers of intangibles. The proper handling of service fees is a diffcult inter-company
pricing issue (considered more fully in chapter 5). In general, each country requires
that arms-length charges be made for any service rendered to an overseas affliate.
In many countries, arms length is defned as the cost of providing the service, often
with the addition of a small margin of proft. Furthermore, only arms-length charges
for services that are directly benefcial to the affliate can be deducted by an affliate in
its tax return. (The diffculty in determining whether a service is directly benefcial can
be a major issue.)
213. Examples of types of service
Five types of service may be provided to related parties:
1. The service can be a routine service, such as accounting or legal services, where
no intangible is transferred. In situations such as this, the price charged in arms-
length relationships is invariably based on a cost-plus formula where the plus
element varies greatly with the value added of the service and the extent of
competition within the market. In the inter-company context, many countries allow
reimbursement on a cost-plus basis, though with a relatively small and steady uplift
for services that are regarded as being low risk and routine. However, a minority do
not allow the inclusion of a proft or have restrictive rules.
2. The service can be technical assistance in connection with the transfer of an
intangible, either manufacturing or marketing, but usually a manufacturing
intangible. Typically, in arms-length relationships, a certain amount of technical
assistance is provided in connection with a licence agreement (at no extra charge).
If services in excess of this level are needed, arms-length agreements usually allow
for this at an extra charge, typically a per diem amount (itself determined on a cost-
plus basis) plus out-of-pocket expenses.
3. The service can be technical in nature (pertaining to manufacturing, quality control
or technical marketing), but not offered in connection with an inter-company
transfer of the related intangibles. In this situation, only the services provided are
paid for on an arms-length basis.
4. When key employees are sent from their home base to manage a new facility,
some tax authorities have tried to assert that there is a transfer of intangibles.
For example, when a new manufacturing plant is established outside the home
country, it is not unusual for a parent company to place a key manufacturing
employee in that plant as plant manager to get it established and to train a local
employee to take his/her place. Such a relationship may exist for three to fve years.
The tax authority may take the position that the knowledge and experience in
the head of that employee is an intangible, owned by the parent company, which
should therefore be compensated by the subsidiary for the use of the intangible
asset. However, in arms-length relationships between unrelated parties, such
a new manufacturing plant could easily recruit a plant manager from existing
companies in the industry. In such a case, the plant manager would be paid a
market-determined wage and no royalty would be payable to any party. Therefore,
it would appear that no royalty is appropriate in the context of the multinational
group, although a service charge might be needed to cover the cost of the assignee.
5. A combination of (1) to (4) above could exist where the offshore affliate
requires the expertise of the parent in order to manage its own affairs, including
determining its strategy. In this situation, the substance of the relationship is that
the parent company is managing the offshore affliate with little or no local input.
The substance of the relationship is such that the parent company tax authority
can easily show that the amount of proft allowed to the offshore affliate should
be minimal in that it is performing a service for the parent (e.g. through a contract
manufacturer arrangement or a manufacturers representative arrangement).
214. The problem of shareholder services
From a transfer pricing point of view, activities conducted by a parent company (or
perhaps a company that provides coordination of services within a group) are not
always such that a charge should be made to the other companies involved. This is
because they might be performed for the beneft of the parent company in its role as
shareholder, rather than to provide value to the subsidiaries. This category of services
has been defned in chapter VII of the OECD Guidelines as shareholder services (a
narrower defnition than the stewardship discussed in the earlier OECD reports).
Chapter VII was added to the guidelines in 1996. In reviewing a transfer pricing policy
for services, it is very important to examine this issue thoroughly to see whether the
services rendered by a parent company can directly beneft one or more recipients,
can duplicate services performed by the subsidiaries, or can represent shareholder
activities and, if so, whether the subsidiary will succeed in obtaining a tax deduction
for the expense if a charge is made.
Directly benefcial services are those that provide a beneft to the recipient. For
example, if a parent prepares the original books and records for a related company, this
accounting service is directly benefcial to the recipient because it allows the recipient
to produce its fnancial statements. Whether an intragroup service has been rendered
so as to warrant the payment of a inter-company charge depends on whether the
activity provides the related entity with economic or commercial value to enhance its
commercial position. This can be determined by considering whether an independent
enterprise in similar circumstances would have been willing to pay for the activity if it
was performed by a third party or would have performed the activity in-house. In the
absence of any of these conditions being met, the activity would not be regarded as an
intragroup service.
Duplicate services are those that are initially performed by a company and duplicated
by an affliated entity, often the parent company. An example would be a marketing
survey of the local market, which is completed by the subsidiary but redone by the
parent (because it did not trust the subsidiarys work, for example). In cases of this
type, the parent cannot bill its costs to the subsidiary for this service. However, if it can
be shown that the subsidiary requested the service to ensure that its marketing survey
was correct (i.e. that the parents input added value to the subsidiary), the position
would be different.
Shareholder services are those that are incurred to protect the shareholders interests
in its investment and relate to activities concerning the legal structure of the
parent company, reporting requirements of the parent company or costs of capital
mobilisation. These services can be distinguished from stewardship services, which is
a more broad term, referring to a range of intergroup activities performed, for which
a careful evaluation is required to determine if an arms-length payment is normally
expected. This determination will depend upon whether, under comparable facts and
circumstances, an unrelated entity would have been willing to pay for a third party to
provide those services or to perform them on their own account.
For instance, a service provider may be required to act according to the quality control
specifcations imposed by its related party customer in an outsourcing contract. To
this end, the parent company may depute its employees as stewards to the related
subsidiary. Stewardship activities in this case would involve briefng of the service
provider personnel to ensure that the output meets requirements of the parent
company and monitoring of outsourcing operations. The object is to protect the
interests of the service recipient (i.e. the parent company). In such a case, it is evident
that the parent company is protecting its own interests rather than rendering services
to the related entity. Consequently, a service charge is not required to be paid to the
parent company that is in receipt of outsourcing services.
Examples of these various types of expenses are included in Table 2.1.
Table 2.1 Costs often incurred by a parent company
Typical stewardship expenses Typical benecial expenses
The cost of duplicate reviews or performance
of activities already undertaken by the
subsidiary
The cost of preparing the operating plans of a
subsidiary, if it is not a duplicate function
Table 2.1 Costs often incurred by a parent company
Typical stewardship expenses Typical benecial expenses
The cost of periodic visitations to the
subsidiary and general review of the
subsidiarys performance carried out to
manage the investment
The cost of reviewing/advising on personnel
management plans and practices of a
subsidiary, if it is not a duplicate function
The cost of meeting reporting requirements
or the legal requirements of the parent-
shareholder, which the subsidiary would not
incur but for being part of the afliated group
The cost of supervising a subsidiarys
compliance with local tax and legal
requirements, if it is not a duplicate function
The cost of nancing or renancing the
parents ownership of the subsidiary
The cost of conducting an internal audit of a
subsidiary if the audit is required by the local
laws of the subsidiarys country and it is not a
duplicate review
Example
Beautiful Unique Bathtubs SA (Bubble) is a French company that manufactures
bathtubs in France for resale to related companies throughout Europe. Bubble
developed the manufacturing intangibles associated with the production of the
bathtubs and completes the entire manufacturing process in its plants in France and
Sweden. The technology involved is unique in that the bathtub produces its own
bubbles when the surface is wet. This process has been licensed to an unrelated
Canadian company in exchange for a royalty of 5% of sales. Ten workdays of technical
assistance are provided to the Canadian company free of charge.
A licence agreement to manufacture bathtubs in Sweden has been entered into
between the French and Swedish affliates, wherein the French parent agreed to
provide its technology and 10 workdays of consulting regarding the implementation of
the technology in return for a royalty of 5% of sales. During the current year, Bubbles
technicians have spent 15 workdays assisting the Swedish subsidiarys manufacturing
employees.
In addition, Bubble has developed a unique marketing approach that it allows related
parties in the UK, Sweden, Ireland and Italy to use in their selling efforts. This
marketing strategy was developed in France and is modifed by each sales subsidiary
for the local cultural peculiarities existing in each country. Finally, Bubbles president
visits each subsidiary quarterly to review performance.
In this example, three types of service are provided by the French company:
1. Technical assistance to the Swedish subsidiary in connection with the utilisation of
the manufacturing technology;
2. Marketing assistance to all selling subsidiaries; and
3. The presidents quarterly review.
The fve days of technical assistance over the amount normally provided to third
parties should be charged to the Swedish subsidiary, probably on a cost-plus basis. The
cost of rendering the marketing assistance must be charged to the selling affliates on a
cost-plus basis. However, before concluding that this is the current approach, it would
be necessary to consider whether the marketing strategy developed in France is in fact
critically important to the subsidiaries and is therefore an intangible being licensed (for
local modifcation) to each country. This would be more akin to a franchise, in which
case it is the value of the licence to the subsidiary which needs to be established and a
royalty charged, and the cost of maintaining the strategy in France becomes irrelevant.
The presidents quarterly review is not of direct beneft to the subsidiaries and should
therefore not be billed to them, because it represents shareholder expenses.
215. Financing transactions
The arms-length principle generally applies to fnancing arrangements between
affliated parties as for other related party transactions. To ensure arms-length terms
are in place, it is necessary to analyse the various forms of fnance that are being
provided by one related party (often the parent company) to another.
A number of factors are relevant in the context of related party debt:
The rate of interest on the loan (including whether it is fxed or foating);
The capital amount of the loan;
The currency; and
The credit worthiness of this borrower (including whether any guarantees have
been provided in connection with the loan).
Tax authorities may review whether a third party would charge the rate of interest set
between the related parties or whether that rate is too high or low (see section 542).
Furthermore, the tax authority in the borrowers country may question whether a third
party would have been willing to lend the funds at all. In assessing the answer to the
latter question, the local Revenue authority will have reference to the debt-to-equity
ratio of the borrower.
If it is considered that the interest rate is too low, the tax authorities in the lenders
country may deem additional interest income to arise and tax this notional
incomeaccordingly.
If it is considered that too much interest is being paid by the borrower (because the
rate is too high and/or because the amount of the debt is too great) the following
consequences may ensue:
Tax deductions for interest accrued or paid may be denied, increasing the local
taxburden; and
Interest paid may be recharacterised as dividends, which may result in additional
withholding taxes being due.
If it is considered that an entity has related party debt in excess of the amount that a
third party would lend, the borrower is said to be thinly capitalised. Many countries,
particularly the developed nations, have special thin capitalisation rules or practices.
A detailed analysis of these rules, as they apply in each jurisdiction, is beyond the
scope of this book (although a number of examples are included in the country
commentaries). However, it is crucial to review any specifc rules and practices
(including any safe harbour debt-to-equity ratios) applicable in the relevant countries
before international fnancing structures are established.
216. Financing short-term capital needs
A companys short-term capital needs are typically greatest when it is frst formed or
undergoing rapid expansion. A parent company that has established a new subsidiary
needing to fnance its short-term working capital may use:
Inter-company payables and receivables;
Advances of capital from a related party;
Extended credit for inventory purchase or sales; and
Related party guaranteed loans.
The long-term, strategic funding of R&D costs is often a very important issue to be
considered as groups expand. A possible way of spreading the expenditure to be
directly fnanced by profts earned overseas is cost-sharing.
Even where no specifc thin capitalisation rules apply, a revenue authority may attempt
to challenge interest deductions on related party debt where a very high debt-to-
equity ratio exists under other general anti-avoidance provisions. There may also
be regulatory end-use restrictions preventing the usage of long-term borrowings to
fnance working capital requirements.
Example
TLC Inc. (TLC) is an American company that has recently established a new subsidiary
in the UK (TLUK). TLC manufactures a special line of pillows that lull small children
to sleep within 10 minutes of lying down. The pillows are successful in the US market
but have just been introduced in the UK market and are not currently selling very well
(little English children never have problems sleeping!). The parent company sells
the pillows to TLUK, which is responsible for marketing and distribution. The overhead
expenses of the subsidiary are greater than the current sales revenue, and serious cash-
fow problems exist in the UK. These problems can be addressed as follows:
1. Inter-company payables and receivables
The parent company may invoice TLUK for the pillows but not collect the receivable
until the subsidiary can afford to make the payment. If the period of time involved
is short (no longer than the payment terms ordinarily granted to distributors in this
industry), this is an acceptable way of fnancing the receivable. However, in many
countries (the US in particular), an inter-company receivable outstanding for a longer
period of time than is commercially appropriate is reclassifed as a loan and deemed
interest accrues on it.
2. Advance of capital
TLC may loan the funds required to fnance the short-term needs of the subsidiary and
collect interest on that loan. This method is acceptable unless the amount of debt owed
by TLUK is suffciently greater than the equity of the subsidiary, such that the local
tax authority can argue that the subsidiary is thinly capitalised. In these situations,
the tax authority may recharacterise all or part of the loans as if they were equity. In
this case the parent is taxed at the subsidiary level as if it did not receive interest for
use of those funds, but rather inter-company dividends in respect of equity capital.
This recharacterisation means that no tax relief is obtained by TLUK on the interest.
Furthermore, the tax treatment of interest is often different from dividends with
respect to withholding taxes/imputation tax credits, etc.
3. Parent guaranteed bank loans
TLC may guarantee a loan that is granted to the subsidiary by a third party (e.g, a
bank). A loan guarantee fee may be required to be paid by the subsidiary to the parent
for having provided the guarantee. The loan itself is primarily the responsibility of
the subsidiary and must be repaid by the subsidiary. This may potentially cause a
thin capitalisation problem for the subsidiary if it could not have obtained the loan
without the parents guarantee, although in practice the risk of tax authority attack is
generally much less than where the loan is made directly from the parent company to
the subsidiary.
217. Market penetration payments
An alternative to the fnancing schemes discussed in sections 215 to 216 is to use
a market penetration or market maintenance mechanism. In this situation, the
manufacturing company treats the related selling companys market as its own in the
sense that the manufacturer wishes to expand its sales into a new market. Because its
products have not previously been sold in the new market, it must penetrate the market
through marketing (e.g. advertising or through a reduction in price to customers
below the price that is expected to be charged after achieving the desired level of
sales). These costs are the costs of the manufacturer rather than the distributor.
Market penetration payments can be made in one of two ways. A lump-sum payment
(or a series of periodic subvention payments) can be made to cover the market
penetration costs or, alternatively, transfer prices can be reduced for the market
penetration period. Effectively, the payment for market penetration or subvention
payments converts the selling company into a routine distributor, assuming less-than-
normal business risk and leaving it with a normal proft margin. Documentation is a
key issue in defending this approach, and great care must be taken to ensure that any
lump-sum payment will attract a tax deduction for the payer. A reduction of transfer
prices must be viewed as a temporary reduction of prices only; it cannot be allowed
to become permanent, because the profts of the subsidiary would eventually become
excessive and cause transfer pricing problems in the future.
Market maintenance occurs when a company is threatened by competition and must
respond, either through reducing prices to customers or by signifcantly increasing
marketing activity, if it is to maintain its market share. The cost of this activity can be
funded in the same way as market penetration, that is, either through a lump-sum
payment or through a reduction of the transfer price.
218. Cost-sharing
Cost-sharing has frequently been used by companies that need to fnance a major
R&D effort but cannot fund it in the company that must perform the activity. For
example, in a group where the parent company houses the R&D department, funding
R&D locally may become a problem if domestic profts fall. However, if the group has
proft in other locations, it may decide to institute a cost-sharing agreement with its
subsidiaries to allow proftable subsidiaries to fund the R&D activity of the group. The
establishment of cost-sharing arrangements has a major long-term impact on a groups
proftability and tax strategy, country by country, in that the companies contributing
to the research will obtain an interest in the knowledge created and thereby be entitled
to a share in profts derived from it. Furthermore, a buy-in payment may be required
when companies come into the cost-sharing arrangement. Participating companies
wishing to exit from a pre-existing cost-sharing arrangement would correspondingly
have to receive a buyout payment representing the value of their share in the intangible
developed until date of opting out.
219. Financing long-term capital needs
Long-term capital needs can be fnanced through:
Mortgages;
Lease fnancing;
Capital stock;
Long-term debt (inter-company or third party); and
The issue of equity to shareholders and bonds or other fnancial instruments in the
marketplace (this activity with third parties is not covered further).
220. Mortgages
The purchase of land can be accomplished through a lump-sum payment or through
a mortgage. Use of a mortgage means that the total cash outlay for the land is spread
over a period of years. Usually, the interest rate on mortgages is lower than for
unsecured loans (whether short- or long-term), so that it is cheaper to raise funds
through this mechanism than through other types of debt fnancing.
In the event that the mortgage is obtained from a related party, the interest rate
and terms should normally be the same as would have been obtained from an
unrelatedparty.
221. Lease fnancing
A subsidiary may lease capital equipment from a related or unrelated party. This means
that the subsidiary does not make a lump-sum payment for the asset but spreads its
cost over a number of years and may not necessarily take all the risks of ownership.
If the lease is obtained from a related party, the interest rate and terms must be the
same as would have resulted had the lease been obtained from an unrelated party.
One consideration would be structuring the lease as an operating lease (where the
substantial risks and rewards relating to the asset remain with the lessor) or a fnance
lease (where the eventual ownership of the asset transfers to the lessee) and pricing
the lease rental accordingly.
222. Capital stock
The parent can provide capital to a subsidiary through purchase of capital stock in the
subsidiary. This is probably the most straightforward method of fnancing the long-
term needs of a subsidiary but is relatively diffcult to adjust quickly to meet changing
needs. In particular, many jurisdictions have rules making it diffcult for a company to
reduce its equity base.
The dividend policy between subsidiary and parent is usually the only area of inter-
company transactions that does not attract signifcant interest from tax authorities
(although they sometimes challenge inter-company payments to a parent company,
such as royalties and interest in circumstances where no dividends are paid on ordinary
capital or where they consider the company to be thinly capitalised).
From a planning perspective, it can sometimes be preferable to issue shares at a
premium rather than issue more shares at the same nominal value. This is because
many jurisdictions allow the repayment of share premium, while a reduction of share
capital often requires relatively complex and formal legal proceedings or may not be
possible at all. The fexibility gained will probably weaken the balance sheet somewhat
where such arrangements exist. It is also worthwhile exploring the possibility of issuing
redeemable preference shares or similar quasi-equity instruments, which would enable
early redemption or other simpler forms of capital reduction or equity repurchase.
Preference shares are broadly similar to equity shares in terms of the treatment of
dividend payout, but have priority in matters of proft and capital distribution.
223. Long-term inter-company loans
A parent company usually has the fexibility to lend funds to subsidiaries directly in
the form of loans, whether secured or unsecured. Most parent company jurisdictions
require that the parent charge an arms-length rate of interest on the loan based on
the term of the loan, the currency involved and the credit risk associated with the
subsidiary (see section 542).
At the subsidiary level, tax deductions are normally available for interest expense.
However, thin capitalisation is increasingly an area that is scrutinised by tax
authorities, so particular attention must be given to the gearing levels acceptable in
the borrowing country. Careful attention must also be given to any double taxation
agreement in force between the countries involved.
224. Other fnancing techniques
The methods of determining an appropriate price for the fnancial transactions
discussed in sections 215 to 223 apply equally to the more sophisticated fnancing
techniques, such as deep discounted loans, hybrid fnancing arrangements (where the
instrument is taxed on an equity basis in one country and as debt in the other), swaps,
etc. In all these situations, the correct remuneration for the parties involved can be
determined only by a careful analysis of the various obligations and risks of the parties
to the transaction and how these would be compensated in an arms-length situation.
This analysis is essentially the same as that which a bank does in setting the terms
of special arrangements with its customers or the market processes that eventually
determine how a quoted fnancial instrument is valued on a stock exchange.
225. Flexibility in managing capital needs
It is important to bear in mind that cash is easily moved from one place to another. A
multinational will have opportunities to raise external capital from shareholders or
from institutional backers and banks, probably in a number of different countries,
and will similarly be generating profts across a wide spread of territories. While the
remarks in sections 215 to 224 generally refer to the fnancing of subsidiaries by the
parent, there may well be opportunities to arrange fnance between subsidiaries across
the group, perhaps through a special entity taxed on a low basis, such as a Belgian
Coordination Centre. Similar principles apply in these circumstances.
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3.
34 www.pwc.com/internationaltp The work of the OECD
301. Introduction
The formation of the OECD
According to its Convention, the Organisation for Economic Co-operation and
Development (OECD) was established in 1961 in order to establish policies within its
member countries that would:
Achieve the highest maintainable economic growth and employment and a
sustained rising standard of living in member countries;
Result in sound economic expansion; and
Contribute to the expansion of world trade through a multilateral, non-
discriminatory basis.
A list of the OECD member countries is set out at the end of this chapter.
The OECD report and Guidelines on transfer pricing
The tax authorities in the US and a handful of other countries started to pay
considerable attention to transfer pricing in the 1960s and 1970s. As part of their
general remit, the OECD member countries recognised that it would be helpful to
provide some general guidance on transfer pricing in order to avoid the damaging
effects that double taxation would have on international trade. The result was the
OECD report and Guidelines on transfer pricing which were frst issued in 1979 and
were subsequently revised and updated in 1995 and again in 2010.
To summarise the main points, the 2010 OECD Guidelines:
Reaffrm the position of OECD member states that the arms-length principle is the
fairest and most reliable basis for determining where profts fall to be taxed and
reject alternatives such as global formulary apportionment;
Remove the hierarchy of methods contained in earlier versions of the OECD
Guidelines, which had expressed preference for the use of traditional transaction-
based methods in favour of a new most appropriate method rule;
Elevate the standing of the transactional net margin method (TNMM) to be on an
equal footing with other transfer pricing methods and provide detailed guidance
on the use of proft level indicators (PLIs) including return on sales, return on cost,
return on capital or assets and the Berry ratio (i.e. markup on operating expenses);
Place additional emphasis on the use of the proft split method, which is suggested
to be likely to be the most appropriate method where inter-company transactions
involve the use of valuable, unique intangibles;
International Transfer Pricing 2011 The work of the OECD 35
In addition to the fve comparability factors that were added in 1995 (see section
302), place more emphasis on data analysis and the use of adjustments and
statistical methods to draw conclusions, including for the frst time endorsement of
the use of an interquartile range; and
Introduce a nine-step process for the establishment of transfer pricing policies
andprocedures.
New OECD initiatives
Refecting a much higher level of activity by the OECD, a number of new initiatives
have resulted in pronouncements that potentially have signifcant impact on
transfer pricing matters. In December 2006 fnal versions of Parts I, II and III of the
Report on Attribution of Profts to Permanent Establishments dealing with general
considerations in relation to the taxation of permanent establishments and application
of these principles to banks and in the context of global trading were issued. This
was followed on 22 August 2007 by a revised Part IV dealing with insurance. The
changes to the report on permanent establishments were refected in a revised text of
Article 7 and associated commentary included in the 2010 update to the Model Tax
Convention. Finally, on 4 August 2010 the OECD published revised chapters IIII of the
OECD Guidelines covering the arms-length principle, transfer pricing methods and
comparability analysis. At the same time, fnal guidance on the Transfer Pricing Aspects
of Business Restructurings was issued, which is now incorporated into the OECD
Guidelines as a new chapter IX.
302. The arms-length principle
Under the arms-length principle, related taxpayers must set transfer prices for any
inter-company transaction as if they were unrelated entities but all other aspects
of the relationship were unchanged. That is, the transfer price should equal a price
determined by reference to the interaction of unrelated frms in the marketplace.
This concept is set out defnitively in art. 9 of the OECD Model Tax Convention, which
forms the basis of many bilateral tax treaties. The OECD Guidelines acknowledge that
it is often diffcult to obtain suffcient information to verify application of the arms-
length principle in practice, but state that it is the best theory available to replicate
the conditions of the open market. The OECD Guidelines then focus on best practice
in determining the equivalent of a market price for inter-company transactions within
multinational groups.
Guidance for applying the arms-length principle
The arms-length principle is usually applied by comparing the conditions (e.g.
price or margin) of a controlled transaction with those of independent transactions.
The OECD Guidelines allow the use of inexact comparables that are similar to the
controlled transaction but not the use of unadjusted industry average returns. The
factors that should be considered when assessing the comparability of a transaction
include:
The specifc characteristics of the property or services;
The functions that each enterprise performs, including the assets used and, most
importantly, the risks undertaken;
The contractual terms;
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The economic circumstances of different markets, for example differences in
geographic markets, or differences in the level of the market such as wholesale vs.
retail; and
Business strategies, for example market penetration schemes when a price is
temporarily lowered.
For instance, if a subsidiary corporation manufactures a sports shirt and then sells
that shirt to its foreign parent for distribution, it must establish an inter-company price
for the shirt. Under the arms-length standard, this inter-company price should be
determined by analysing what comparable sports shirt manufacturers receive when
they sell shirts to unrelated distributors. Although there are several acceptable methods
for determining arms-length price, each is based on a comparabletransaction.
Analysis of transactions
The OECD Guidelines set out how transactions should be analysed when determining
or reviewing transfer pricing.
The tax authorities should review the actual transaction as structured
by the related parties (however, see paragraph 313 below in relation to
businessrestructuring).
Although the OECD Guidelines prefer a review of transfer pricing on a transaction-
by-transaction basis, they acknowledge that this is not often practical, and so a
combination of transactions may be examined.
It is not always possible to use a single fgure, for example, as a price or margin;
instead, a range of prices may be more appropriate.
The OECD Guidelines suggest examining data from both the year in question and
previous years.
Transfer pricing methods
The OECD Guidelines comment on various pricing methodologies, with examples of
their application, under a number of headings. Prior to the 2010 revision the OECD
Guidelines expressed a preference for the use of traditional transaction methods as
being the most direct price comparisons as compared to more indirect proft-based
methods. However, under the OECD Guidelines, it has always been the case that a
taxpayer must select the method that provides the best estimation of an arms-length
price. To do this, the tax authorities or taxpayer only need to analyse one method
indepth.
303. Comparable uncontrolled price method
The comparable uncontrolled price (CUP) method offers the most direct way of
determining an arms-length price. It compares the price charged for goods or services
transferred in a controlled transaction to the price charged for property or services
transferred in a comparable uncontrolled transaction. The OECD report states that, if
it can be used, the CUP method is preferable over all other methods. In practice, this
method is often very diffcult to apply as it is unusual for multinationals to have access
to suffcient details of appropriately comparable third-partytransactions. In response
to this, the OECD report suggests that multinationals and tax authorities should take
a more adaptable approach to the use of this method, possibly working with data
prepared for CUP purposes supplemented by other appropriate methods. The extent
of the OECDs support for the CUP method can be seen from the comment that every
effort should be made to adjust the data so that it may be used appropriately in a
CUPmethod.
Using the CUP method for sales to affliates, potentially comparable sales include
sales made by a member of the controlled group to an unrelated party, sales made
to a member of the controlled group by an unrelated party, and sales made between
parties that are not related to each other. Any of these potential CUPs may provide an
arms-length price for use in the sale between related parties if the physical property
and circumstances involved in the unrelated party sales are identical to the physical
property and circumstances involved in the sales between the related companies.
Transfer pricing regulations in most countries allow CUPs to be adjusted if differences
between the CUP and the related party transaction can be valued and have a
reasonably small effect on the price. Examples of adjustments that are commonly
allowed include differences in:
The terms of the transaction (for example, credit terms);
The volume of sales; and
The timing of the transaction.
Differences in respect of which adjustments are diffcult or impossible to make
includethe:
Quality of the products;
Geographic markets;
Level of the market; and
Amount and type of intangible property involved in the sale.
Example
Far East Steel Ltd (FES), a Japanese company, manufactures steel ingots in the Far East
and ships them to related and unrelated foundry businesses in the UK. The ingots that
FES ships to its unrelated and related party customers are identical in every respect.
Moreover, the terms and conditions of the sales are also identical, except that the
related party customers are given payment terms of 90 days as opposed to only 45 days
for unrelated party customers. Based on this information, it is determined that the
unrelated party ingot sales represent a CUP for the inter-company transfer price. The
difference in payment terms must be taken into account, however, before the actual
arms-length inter-company price can be determined.
Based on prevailing interest rates, it is determined that the difference in payment terms
is worth 0.5% of the ingot price. Adjusting the unrelated party price for this difference,
it is established that the inter-company price should refect the unrelated party price
plus 0.5%.
Example
Gluttony Unlimited, a UK company (GUK), manufactures a type of cheese that is
calorie- and cholesterol-free when eaten while drinking fne French wine. The cheese is
sold to related companies in Germany and the US and to an unrelated company, Guilt
Free Parties (GFP), in France. A transfer price is needed for GUKs sales to its affliates.
GFP is a sponsor of cheese and wine parties in France. Individuals ask GFP to organise
and conduct these parties and to provide the cheese, wine and other food and utensils
needed to sponsor the event.
GUKs subsidiaries in Germany and the US are distributors of the cheese to
unrelated grocery stores and to wine and cheese party sponsors throughout their
respectivecountries.
The price charged to GFP by GUK does not qualify as a CUP in this instance because the
level of the market is different, i.e. the German and US affliates sell to a higher level
of the distribution chain than does GFP. Typically, these differences cannot be valued
and, as a consequence, no CUP exists.
304. Resale price method
An arms-length price is determined using the resale price method by deducting an
appropriate discount for the activities of the reseller from the actual resale price.
The appropriate discount is the gross margin, expressed as a percentage of net sales,
earned by a reseller on the sale of property that is both purchased and resold in an
uncontrolled transaction in the relevant market. Whenever possible, the discount
should be derived from unrelated party purchases and sales for the reseller involved
in the inter-company transaction. When no such transaction exists, an appropriate
discount may be derived from sales by other resellers in the same or a similar market.
The OECD Guidelines recognise that there are problems in obtaining comparable data,
for example where there is a considerable period of time between the comparable
transaction and the one under review within the group, where movements within the
economy (i.e. foreign exchange rate, interest rate, recession or boom) generally would
cause possible distortion.
As with the CUP method, it is possible to adjust the discount earned by the reseller
for differences that exist between the related transaction and the comparable,
unrelatedtransaction.
Example
Shirts Unlimited (SU), an Italian company, manufactures and sells sports shirts.
Manufacturing takes place at the parent companys factory in Italy. Subsidiaries in
Germany, France and the UK serve as distributors in their respective markets. Through
a search of comparable distributors of sports shirts, it is determined that independent
distributors earn gross margins of 25%. There is one major difference between
the related party distributors and the independent distributors the independent
distributors also design the shirts, whereas the related party distributors do not. Upon
further investigation, it is learned from independent distributors that they typically
charge a 3% (on sales) royalty for designing shirts. Based on this information, the
comparable resale price margin is adjusted for the design function. Therefore, the gross
margin to be earned by the related party distributors is reduced from 25% to 22%, to
account for the absence of a design function.
305. Cost-plus method
The cost-plus method is one of the methods typically applied in analysing the activities
of a contract manufacturer (see 409), or when determining the arms-length charge
for services. It can also be applied to fully fedged manufacturers, although the
markup, as well as the cost base, may be different from that used in the case of a
contractmanufacturer.
The cost-plus method determines the arms-length price by adding an appropriate
markup to the cost of production. The appropriate markup is the percentage earned
by the manufacturer on unrelated party sales that are the same or very similar to the
inter-company transaction. The cost base for both the comparable company and the
one under review must be carefully analysed to ensure that the costs to be marked up
are consistently defned. So, as with the resale price method, which is also premised on
using gross margins as the basis for comparison, a careful comparative review of the
accounting policies is as important as the determination of the markup, particularly
with a view to identifying any potential mismatches of expense categorisation between
cost of goods sold and administrative expenses when comparing the fnancial results of
the taxpayer and the comparables.
When determining the markup to be applied in the contract manufacturing case, it is
important to note that the goods transferred under the comparable transaction need
not be physically similar to the goods transferred under the inter-company transaction.
For example, a contract manufacturer should be compensated for the manufacturing
service provided rather than for the particular product manufactured.
When determining arms-length markups for fully fedged manufacturers, i.e.
manufacturers that operate with a greater degree of independence and which carry
out more sophisticated activities, the nature of the product that is manufactured
will probably be of much greater signifcance to the analysis. Markups earned
by manufacturers could vary considerably from one product to another because
of manufacturing intangibles that may have been developed by the fully fedged
manufacturer. As a result, identifying a comparable for the fully fedged manufacturer
may be extremely diffcult unless the company manufactures and sells the products
in question to unrelated companies at the same level of the market as the affliates to
which the related party sales are made (i.e. an internal comparable exists).
Example
A UK company, Glass Shapes Ltd (GSL), is a specialist glass manufacturer. The
company conducts all of its research and development (R&D) and manufacturing
activities in the UK. After the glass has been produced, it is shipped to the
manufacturers Irish affliate where it is shaped, using a special technical process
developed by the UK company. The shaping process is not complex, nor does it require
highly skilled labour. When the unfnished glass arrives at the plant, the Irish personnel
examine the accompanying work order and immediately begin processing the glass.
The Irish affliate never takes title to the glass; rather, the unfnished glass is consigned
to it.
In this case, the Irish affliate is a contract manufacturer. It performs limited
manufacturing activities and engages in no production scheduling, materials
purchasing, or technical service. Moreover, it bears no raw material or market risk.
When the shaping process is complete, the Irish affliate ships the completed products
to the UK parent for sale in the UK market. In addition to this service provided to the
UK parent, the Irish affliate also provides similar services to unrelated companies.
Since the UK company uses no other contract manufacturer, a CUP does not exist from
the UK standpoint. However, as the Irish affliate is also performing manufacturing
services for unrelated companies, comparable information will be available from these
transactions. Specifcally, the markup the Irish affliate earns on services provided to
unrelated companies can potentially be used to apply a cost-plus method to the related
party transaction.
306. Cost-plus method capacity adjustments
Regardless of whether the manufacturer is a contractor or a fully fedged manufacturer,
several issues must be considered when evaluating a comparable transaction.
These issues include capacity, technology owned by the manufacturer, volume and
geographic market.
In many cases capacity issues are important in determining the appropriate cost
base. For example, if a contract manufacturing plant is operating at 50% capacity,
the question of whether all the overhead costs should be included in the cost base in
determining the fee received by the contract manufacturer is critically important. If
those costs are excluded, the contract manufacturer may report negative income; if
instead, all overhead costs are included, the fee paid to the contract manufacturer
may be so high that the cost base of the product exceeds the market price. The correct
answer is determined by the nature of the relationship between the parties. Typically,
in arms-length relationships between unrelated parties, a contract manufacturer
would not devote its entire productive capacity to a single customer, so that capacity
utilisation problems are not the responsibility of any single customer. However, if a
contractor agrees to maintain a certain productive capacity to be available to a given
customer at any moment, that customer should pay for the cost of maintaining that
capacity, whether it is used or not.
Example
As an example, if we take the facts of GSL from section 305 but change the assumption
such that the Irish affliate dedicates 100% capacity to GSL through a long-term
contract, then the fee for charges to GSL must take account of all the overhead accruing
on a long-term basis. As a result, GSL and its Irish affliate must budget to maintain the
subsidiary in an appropriately proftable position.
Where there are signifcant differences in the cost base due to geographic market
differences, it will be important to conduct a thorough review of the existence of
location savings and which parties to the transaction should be the benefciary of
suchsavings.
307. Proft-based methods
Situations sometimes arise where there is no satisfactory evidence of a CUP and where
it is not possible to apply the resale price or cost-plus methods. In these situations it
is necessary to apply an appropriate alternative method to determine arms-length
transfer prices. Such methods include the proft split method (PSM) (see section 308)
and transactional net margin method (see section 309). In turn, use of the TNMM
requires the selection of an appropriate PLI. The OECD Guidelines distinguish PLIs
where proft is weighted to assets such as the return on assets or capital (see section
310) and where proft is weighted to sales or costs such as the return on sales or Berry
ratio (see section 311).
Chapter III of the OECD Guidelines considers other methods that are referred to as
transactional proft methods. Transactional proft methods may be used to examine
the profts that arise from particular transactions among associated enterprises where
such methods are the most appropriate to the circumstances of the case. The extent
to which there is a signifcant difference in the results of the application of traditional
methods as compared to proft-based methods has led to extensive international
debate. A careful reading of the OECD Guidelines will reveal that the authors did not
believe that there would be a great divergence of outcomes from different methods of
analysis in practice. For example, in the defnition of the resale price method in Chapter
II of the OECD Guidelines it is noted that, in addition to covering the selling costs of the
distribution company concerned, the gross margin earned by the company is required
to cover other operating expenses and, in the light of the functions performed (taking
into account assets used and risks assumed), make an appropriateproft.
Each of these other methods compares some fnancial measure or PLI of the related
parties to the same measure for similar frms in the same industry. The need to base
the fnancial measure used to determine transfer prices on a measure for similar
unrelated frms underscores the fact that all transfer pricing methods have to refer to
external comparable data to be defensible. Standard operating practices in competitive
industrial situations indicate that third parties often determine market prices through
resale price or cost-plus methods. Rarely do third parties negotiate prices based on
any of the alternative methods. Therefore, when they are used to establish transfer
prices, there are few, if any, reasons to argue for the use of one method over another
as a matter of principle. However, the choice of a confrming method is more likely
to be determined by practical considerations such as the availability of third-party
comparable data in order to demonstrate that the result of the internal policy is arms
length in nature. This is why alternative transfer pricing methods, especially proft-
based methods, are commonly used to provide a test of the reasonableness of a transfer
pricing policy determined by using one of the frst three methods. For instance, if a
resale price margin is used to determine the appropriate transfer price between a
manufacturer and its related distributor, an analysis of the proft split between these
parties can give some indication of the reasonableness of that transfer price.
Example
The Loveable Bear Company (LBC), a Canadian company, manufactures and sells
teddy bears. The parent company develops and manufactures the bears and sells
completed products to subsidiaries in the US, Japan and France. After a complete
functional analysis (see section 402), it is determined that the subsidiaries function as
marketer distributors that operate with a fairly high degree of independence, and a
search is conducted for comparable distributors purchasing completed products from
unrelated manufacturers.
No comparable businesses are identifed that distribute only teddy bears. Several
comparables that distribute childrens toys are identifed and their gross margins are
used to derive an arms-length range expressed as a percentage of their sales. Thus
a resale price method is used to determine transfer prices such that the subsidiaries
gross margins, approximately 15% of their net sales, fall within the range established
by reference to the third-party transactions. Because these comparables are not
perfect, in that their product lines are broader than the subsidiaries product lines,
the results are tested to make certain that they are reasonable. The test that is selected
is a proft split.
The income statement for the manufacture and sale of teddy bears in the US market
is prepared. The Canadian parents revenues and costs with respect to sales to its US
subsidiary are computed, as also are the revenues and costs of the US subsidiary (using
consistent accounting policies). Using a residual proft split approach, arms-length
rates of proftability are established by reference to a group of external comparables
for the routine manufacturing activities of the Canadian parent and the routine
distribution activities of the US subsidiary, and the residual proft attributable to
intangible assets owned by each party are split, based on a appropriate formula
refecting the relative contributions made by each party. The result indicates that 60%
of the consolidated operating proft should be reported in the Canadian parent and
40% is reported in the US subsidiary. Notice that the operating proft used here is the
consolidated operating proft earned on products that are sold in the US market (any
other revenues, costs and profts of the Canadian parent are ignored). This fnding is
compared to the actual results achieved under the group policy of pricing of tangible
goods based on the resale price method target of 15% gross proft.
A similar analysis is prepared for the Japanese and French subsidiaries with similar
results. Based on the supporting proft split analysis, the results of the resale price
method analysis is confrmed and the transfer prices are judged to be defensible arms-
length prices.
308. Proft split method
This method establishes transfer pricing by dividing the profts of a multinational
enterprise in a way that would be expected of independent enterprises in a joint-
venture relationship. It might be appropriate to use this method where transactions are
so interdependent that it is not possible to identify closely comparable transactions,
particularly in circumstances where both parties in a related party transaction have
contributed valuable intellectual property. The OECD Guidelines state that expected
profts should be used rather than actual profts, in order to avoid the use of hindsight.
Many multinational enterprises (MNEs) have responded to this by including a year-end
true up calculation as part of their inter-company agreements.
To compute arms-length prices using the proft split method, it is necessary to know
how profts would be split between unrelated parties based on the same facts and
circumstances as in the related party situation. Because this information is almost
never publicly available, a comparable proft split derived from formulae used by
third parties is rarely possible. More frequently this method relies on the judgement
of the user to determine an appropriate proft split formula that refects the relative
contributions of tangible and intangible assets made by each of the parties to the
transaction (in the terminology adopted in the US regulations this is known as a
residual proft split).
For this method, it is necessary to compute the revenues and costs of each legal
entity involved in the transaction. For example, if, for a given geographic market, a
multinational conducts R&D and manufacturing in one legal entity and marketing and
distribution is conducted in a second, the revenues and costs in each entity relevant to
the specifc geographic market must be computed. This can be extremely diffcult, and
may lead to extensive disclosure requirements in order to ensure that transfer pricing
documentation standards are met.
Typically, the proft split analysis is conducted at the operating income level, although
sometimes it is applied at the gross proft level. In each instance, the income in
question must be solely the income attributable to operations, i.e. non-operating
income should be excluded from the analysis.
Example
Wheels AG (WAG) is a German company that manufactures luggage carriers that are
lighter than those sold by its competitors and which fold into a small package for use
by airline passengers. Key parts are manufactured at the parent company and sold
to a subsidiary located in the UK. The UK subsidiary assembles the fnished luggage
carriers, and markets and distributes the products in the UK market. It has been in
existence for 15 years. No comparables are available that would allow the application
of the CUP, resale price or cost-plus methods; so WAG has decided to use a proft split
method to determine transfer prices.
Table 3.1 Wheels AGs sales in the UK market (1992)
WAG WUK Consolidated
Sales 75 100 100
Cost of sales (60) (75) (60)
Gross prot 15 25 40
Selling 0 (20) (20)
General and administrative expenses (1) (8) (9)
Operating income 14 (3) 11
The frst step in the application of the proft split method is to produce basic income
statement data for the transaction, as follows: The proft split at the gross proft level is
15/40 or 37.5% for WAG and 25/40 or 62.5% for WUK. The proft split at the operating
income level is 127% for WAG and negative 27% for WUK. It is obvious that the transfer
prices used here produce an inequitable proft split and are unlikely to be acceptable to
the UK tax authority.
309. Transactional net margin method
This method was the OECDs response to the US comparable profts method (CPM).
The TNMM looks at the net proft margin relative to an appropriate base (e.g. costs,
sales, assets) that a taxpayer makes from a controlled transaction. In substance, it is
similar to the US CPM, although there has been considerable debate as to the extent
to which they are the same in practice. Neither method requires the same level of
comparability in product and function as is required for the traditional methods.
However, the OECD Guidelines express concern that there should be suffcient
comparability in the enterprises being compared so that there is no material effect on
the net margins being used or adjustments to be made.
It is interesting to note that the debate over the US CPM was an important driver of
the revision to the earlier OECD work on transfer pricing. There was some concern
outside the US that the CPM would be used in inappropriate circumstances. Under
the TNMM, the focus is initially on transactions (rather than business lines or perhaps
the operating income of a company) and the argument is that this imposes a greater
discipline to look closely at the inter-company transactions and to justify why they may
be aggregated together for the purposes of the analysis. Under the US CPM there is a
requirement that is similar in effect that requires the taxpayer to consider whether the
test is being applied to an appropriate business unit.
This is obviously an area in which taxpayers can easily fnd areas of disagreement if
they chose to do so. In practice, by focusing on areas of commonality of approach, it
is often possible to establish transfer pricing policies and procedures that satisfy the
requirements of both the US CPM and the OECD TNMM.
Although before 2010 such proft-based methods were described as methods of last
resort under the OECD Guidelines, in practice they were widely used largely because
of the availability of comparable data at the net proft level based on the published
fnancial statements of independent companies. This is in contrast to the paucity of
accessible data about the direct pricing of independent comparable transactions or
about gross margin returns. As a result, it is often only the operating income that
can be defned with suffcient clarity to be useful in making comparisons from one
company to another.
310. Return on assets
Return on capital (i.e. equity) is generally the economists preferred rate-of-return
measure but it is often diffcult to use this measure directly in an inter-company pricing
framework. This is because the capitalisation of a subsidiary will usually be determined
by the parent company in the light of internal group fnancing requirements and not
by the market forces of banks, shareholders and bondholders, who effectively control
the capitalisation of a quoted company. The overall capitalisation of a wholly owned
subsidiary is therefore not necessarily arms length.
As a substitute for return on equity, return on assets (ROA) is frequently used as a PLI,
as is now recognised in the 2010 update of the OECD Guidelines. In the US, ROA is
frequently selected as an appropriate PLI in an analysis that applies the CPM, and in
many other countries it has historically been similarly applied as part of a transactional
net margin or cost-plus method analysis.
For example, such analyses are frequently applied to manufacturing activities. When
using ROA, the defnition of assets used in the manufacturing activity can be a potential
area of diffculty. Return on the net book value (NBV) of all assets may be used in some
situations. In this case, the numerator is the operating income before interest and
taxes. The denominator is the NBV of all assets reported on the balance sheet, which
are used in the manufacturing activity, excluding fnancial and non-operating assets.
In addition, the age of the plant and equipment must be considered when comparing
the ROA in a related party with those earned by independent companies. For example,
if the manufacturing company within a multinational group has a new plant with
very high depreciation expense, its ROA may not represent a valid comparison with
independent companies that operate with old, fully depreciated plants (or vice versa),
unless the assets are all revalued to a current basis.
Example
Clipco SA, a Belgian company, manufactures and sells razors. Its R&D activity is
conducted at the parent company in Belgium; its manufacturing is done by a subsidiary
in Ireland and its distribution is done by a subsidiary in Germany. No publicly available
information exists, which can be used to apply the CUP, resale price or cost-plus
methods to determine transfer prices between the Irish and German subsidiaries.
Financial statements are available, however, which allow a typical ROA to be computed
for the manufacturing activities. Specifcally, fnancial statements for manufacturing
companies that produce razors for sale to unrelated distributors are available.
The balance sheets reveal that liquid assets (cash, short-term investments and accounts
receivable) for Clipcos Irish subsidiary represent 40% of total assets while the same
assets for the independent manufacturers represent only 10% of total assets these
are excluded from the calculation. Further analysis reveals that the plants (related and
independent) are approximately the same age and the accounting principles used in
constructing the balance sheets are similar. The ROA is calculated and this ratio is used
to determine transfer prices for Clipcos Irish subsidiarys sales to Clipco-Germany.
311. Berry ratio compared to return on sales (ROS)
ROS has traditionally been the primary PLI applied to the proftability of distribution
operations in order to evaluate the arms-length nature of the underlying inter-
company pricing arrangements in many countries. In contrast the Berry ratio focuses
on comparing the gross proftability of an activity and operating expenses necessary
to carry it out, i.e. gross proft divided by operating expenses. In substance the Berry
ratio may, as a result, be seen as a cost-plus method applied to selling entities. It has
been frequently used as a PLI for the application of the US CPM to certain categories of
distribution activities.
By way of illustration, consider the case of a parent company that has performed all
the R&D required to bring a product to market and has also manufactured the product.
A related entity is responsible for arranging the sale of the goods to the end-customer,
and maintains a local sales offce for this purpose. The distributor may either directly
sell the goods to the customer or may be compensated by way of a sales commission
paid by the manufacturer. In this situation, the simple entity is the selling entity and
the complex entity is the manufacturer.
To compute the Berry ratio, it is necessary to determine the markup that a typical
distributor earns on selling, general and administrative (SG&A) expenses, which
it incurs in the process of providing sales services on behalf of the manufacturer.
Specifcally, the Berry ratio is calculated as the ratio of gross proft to operating costs
and is used to mark up the SG&A costs of the selling affliate in the inter-company
transaction. All remaining income is attributed to the manufacturing entity.
It is noted that in practice a transactional method such as RPM or cost-plus will often
have to be applied during the companys budgeting process in order to ensure that the
actual invoice pricing of the goods on a day-to-day basis will achieve the desired overall
Berry ratio target established for the companys fnancial year.
The advantages of the use of the Berry ratio include the ease of administration and
the lack of concern for the size of the distributors used as comparables. Its use is
appropriate when the distribution activity in question consists of a limited range of
functions and risks, and may be properly characterised as the provision of a service
to the manufacturer. In contrast, distributors that operate with a higher degree of
independence, that may own intangible assets, or which conduct value-added activities
in addition to mere resale of tangible goods may be better evaluated by use of ROS. As
in all matters relating to the choice of an appropriate PLI, a comprehensive functional
analysis is essential in making these distinctions in functionality, levels of risk-taking
and assets employed, and ensuring that a valid comparison is made with third-party
comparables that exhibit similar characteristics.
Example
US Pills Inc. (USP) is a US pharmaceutical company that has begun to manufacture a
new drug in a subsidiary located in Sweden. The parent developed and patented the
drug in the US and has licensed the Swedish subsidiary to manufacture it. The parent
purchases the drug from its subsidiary and distributes it in the US. The fnal sales price
for the drug in the US is USD2 per tablet. Sales of the drug are expected to be 600
million tablets per year. The distributors operating costs are USD14.4 million per year.
To determine the transfer price, the Berry ratio for distributors in the US is computed.
It is found to be 125%. This means that the operating costs of the distributor are
marked up by 25% to determine transfer prices, i.e. the distributors gross margin
is USD18 million per year. Using this gross margin, the price of the tablets to the
distributor is USD1.97 per tablet.
This analysis implies that the distributor will earn a gross margin equal to 1.5% of
sales. The Berry ratio method will be acceptable in this case only if the functional
analysis has clearly established that the distribution activity does not involve the use
of any locally developed intangible assets, involve any local value-added functions, or
exhibit any other unique characteristics that the tax authorities may consider should
attract a higher rate of return.
Again, careful analysis of the facts and circumstances is critically important. It is often
found that distributors that are members of multinationals perform different functions
from independent, entrepreneurial distributors. One area that can be particularly
complex to analyse, for example, concerns advertising expenses. It is important
to understand how these are dealt with in both the controlled and uncontrolled
transactions under review and this may be very diffcult to establish from public
sources for comparable businesses.
The nature of the sale is also important. For instance, it will be important to consider
the impact the distributor actually has on the customer in comparison with the
customers desire to buy the product (from the parent). Stated differently, can it be
demonstrated that independent local activities of the distributor can drive a pricing
differential in the market? If the answer to this question is yes, then use of the Berry
ratio may not be appropriate.
312. Non-arms-length approach: global formulary
apportionment
A global formulary apportionment allocates the global profts of a multinational group
on a consolidated basis among the associated enterprises, using a preset formula.
The OECD Guidelines review the argument for this to be a suitable alternative to the
arms-length principle. Those arguing in favour asserted that it would provide more
administrative convenience and certainty for taxpayers. Whatever the diffculties in
applying the arms-length principle in practice, the debate led by the OECD has been
unable to produce any justifable substitute to the arms-length principle that is still felt
to ensure the most manageable and stable fscal climate within which multinationals
operate. The OECD Guidelines identify numerous practical problems associated with
the idea of using an infexible predetermined formula as the basis of setting transfer
prices, and consequently member countries rejected global formulary apportionment
and confrmed that they should retain the arms-length principle as the best available
approach to the analysis of inter-company transfer pricing.
313. OECD commentary on other matters impacting
transferpricing
Safe harbours
Establishing transfer prices is a fact-intensive, judgemental process. This could be
alleviated by establishing a simple set of rules (a safe harbour) under which tax
authorities would automatically accept the transfer prices. Safe harbours would
reduce the compliance burden and provide certainty both for taxpayers and tax
administrations. However, there are some problems that need to be addressed if safe
harbours are to be used, including:
A risk of double taxation and mutual agreement procedure diffculties;
Tax planning opportunities for taxpayers; and
Potential discrimination and distortion of competition.
On balance, the OECD does not recommend the use of safe harbours.
Advance pricing agreements (APA)
An advance pricing agreement sets out appropriate criteria (for example, a method,
comparables and critical assumptions) for determining transfer pricing over a
fxed period. APAs involving the competent authority of a treaty partner should be
considered within the scope of the mutual agreement procedure (MAP) under art. 25
of the OECD Model Tax Convention. An APA can help taxpayers by providing certainty
through the establishment of the tax treatment of their international transactions.
Until recently, relatively few OECD member countries have used APAs, and therefore
the Committee on Fiscal Affairs intends to monitor any expanded use of APAs. APAs
are discussed in some detail in Chapter V of the OECD Guidelines. This intention to
monitor use of APAs gave rise to the OECD Guidelines annex on APAs, issued by the
OECD in 1999.
The annex explains that the OECD encourages use of bilateral APAs achieved through
the MAP provisions of tax treaties, and so focuses on such bilateral processes in the
annex. The aim of the annex is to encourage consistency between APA procedures by
looking at: issues arising from the application process; the scope of APAs; behaviour
of the taxpayer and the competent authorities (i.e. tax offcials who administer the
MAP for each state); the content of APA proposals; and implementation issues, such as
critical assumptions on which the APA is based and monitoring of the agreement.
Documentation
The OECD Guidelines provide direction for tax authorities on the development of rules
and procedures on documentation. Each taxpayer should try to determine transfer
pricing, in accordance with the arms-length principle, based upon information
reasonably available at the time of the determination. The information needed will
vary depending upon the facts and circumstances of the case. In fact, as will be seen
from the country commentaries later in this book, there are numerous different
regulatory approaches to the issue of transfer pricing documentation. Compliance with
the rapidly growing range of requirements is becoming a considerable challenge to
international business.
The mutual agreement procedure and corresponding adjustments
Tax authorities consult with each other in order to resolve disputes about the
application of double-tax conventions and agree to corresponding adjustments
following transfer pricing examinations. The OECD Guidelines note the concerns of
taxpayers about these procedures and recommend:
Extending domestic time-limits for the purposes of making
correspondingadjustments;
Reducing the time taken for mutual agreement proceedings;
Increasing taxpayer participation;
The publication of domestic rules or procedures; and
The suspension of collection of tax during the procedure.
Secondary adjustments
In addition to the transfer pricing adjustment, some countries have a second
adjustment based upon a constructive transaction for the transfer of the excess proft,
for example constructive dividends. The Committee on Fiscal Affairs has decided to
study this issue further in order to develop additional guidance in the future.
Authority of the OECD Guidelines
The OECD Guidelines, as their name suggests, do not have any direct legal force in
the member countries. However, they do have a major infuence on the tax authorities
of the OECD countries (and increasingly on non-member countries), particularly
those that do not have detailed transfer pricing regulations and, traditionally, have
followed the OECD Guidelines. In particular, OECD countries tend to rely on the OECD
Guidelines as a basis for resolving matters submitted to the competent authorities
under the treaty mutual agreement process. The Council of the OECD, when
publishing the OECD Guidelines, recommended that:
Tax administrations follow the OECD Guidelines when determining
taxableincome;
Tax authorities should encourage taxpayers to follow the OECD Guidelines; and
Governments should further develop cooperation between the tax authorities.
Increased cooperation between tax authorities
One result from the process of agreeing the OECD Guidelines has been the increasing
internationalisation of the review of multinationals transfer pricing. This is because
the tax authorities have improved their communication procedures through having
more discussions in the forum of the OECD, which in turn has resulted in a signifcant
increase in the use of the exchange of information article included in most bilateral tax
treaties. Clearly, it can no longer be assumed that tax authorities will act in isolation.
Member countries of the OECD
The current OECD member countries are: Australia, Austria, Belgium, Canada,
Chile, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary,
Iceland, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands,
New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden,
Switzerland, Turkey, the UK and the US.
314. Recent developments at the OECD
As noted above, the OECD has recently taken on a number of signifcant projects
that potentially mark a major expansion of the role and infuence of the OECD in
international tax and transfer pricing matters.
New Article 7 (Business Profts) of the OECD Model Tax Convention and
Report on Attribution of Profts to Permanent Establishments
On 22 July 2010 the OECD released a new Article 7 (Business Profts) of the OECD
Model Tax Convention and related commentary changes. Together with the OECDs
issue of the Report on the Attribution of Profts to Permanent Establishments, the
intention is to refect certain changes and clarifcations in the interpretation of
Article7.
With these changes, the OECD intends to achieve greater consensus in terms of
interpretation and application of the guidance on the attribution of profts to
Permanent Establishments (PEs) in practice among OECD and non-OECD countries.
The revised Commentary describes the central directive of Article 7 as being the
separate entity approach under which the profts attributed to a PE should be those
that it would have realised if it had been a separate and distinct enterprise engaged
in the same or similar activities under the same or similar conditions and dealings
wholly independently from the rest of the enterprise. The Commentary embodies the
two-stage approach set out in the Report, frstly identifcation of the activities carried
on through the PE, and secondly determination of the appropriate compensation by
applying the principles set out in the OECD Guidelines. In a non-fnancial services
business, risks and assets are allocated between the home offce and the PE based
on the location of signifcant people functions. In a fnancial services business the
location of key entrepreneurial risk taking functions will be determinative. The force
of attraction principle under which income arising in the territory may be fully taxable
even if it is not attributable to the PE is rejected.
The main developments included in the Commentary may be summarised as follows:
The calculation of profts attributable to a dependent agent should be consistent
with the two-stage approach described above;
The deduction of expenses incurred in the operation of a PE should be allowed;
Recognition of the attribution of an arms-length amount of interest to a PE
based on attributing an appropriate amount of free capital in order to support
thefunctions;
Encouragement of taxpayers to produce contemporaneous documentation in order
to reduce the potential for controversies; and
Emphasis is placed on arbitration as a means of resolving disputes.
Transfer Pricing Aspects of Business Restructurings
On 4 August 2010 the OECD released a fnal paper on the Transfer Pricing Aspects
of Business Restructurings, which is now incorporated into the OECD Guidelines as
Chapter IX. The new chapter covers the transfer pricing consequences of internal
business reorganisations designed to shift risks, intangible property and income among
members of a multinational group of corporations. The following issues are addressed:
The allocation and transfer of risk among related parties;
Whether and when internal business restructuring transactions require arms-
length compensation and/or indemnifcation;
How transfer pricing rules should be applied to the parties in a business
restructuring transaction following the restructuring; and
Whether and when governments have the ability to disregard a taxpayers
restructuring for purposes of applying transfer pricing rules.
The fnal text of Chapter IX has been welcomed as a signifcant improvement over the
original 2008 draft. In response to concerns in the business community the OECD
Guidelines are now clear that the circumstances in which transactions may only be
disregarded or recharacterised should be rare or unusual, such as when there is a
mismatch between substance and form. The mere fact that an associated enterprise
arrangement is not seen between independent parties is not evidence that it is not
arms length. Nevertheless, the new chapter signifcantly widens government authority
to challenge business restructuring transactions.
Other important issues addressed in Chapter IX include changes to the commentary
on taxpayer allocation of risk, such that mismatches between the contractual location
of risk and the location in which control over risk is exercised are now more likely to
be addressed through pricing adjustments rather than through recharacterisation of
a transaction. However, a tax administration is entitled to challenge a contractual
allocation if it is not consistent with economic substance. In respect of transfers of
proft potential, the OECD Guidelines are clear that a mere decrease in the expectation
of future profts does not necessarily create the need for compensation under the
arms-length standard, but concerns have already been expressed that the use of the
term something of value in the context of asset transfers is too vague and that there
is insuffcient guidance on the transfer of a going concern, which is broadly defned
as a transfer of assets bundled with the ability to perform certain functions and bear
certain risks. The OECD has announced a new project designed to address the transfer
pricing aspects of intangible transfers, and it is to be hoped that further clarifcation
will emerge during this process.
Perhaps the most controversial aspect of the new chapter is the concept of options
realistically available, which is now prominent in the OECD Guidelines. This should be
considered at the individual entity level and implies that the alternatives theoretically
available to each party should be taken into account in determining appropriate levels
of compensation to be paid. The fnal version of the OECD Guidelines clarifes that the
primary purpose of the concept is in its application to pricing decisions rather than
recharacterisation, and that while a realistically available option that is clearly more
attractive should be considered there is no requirement to document all hypothetical
options. The use of hindsight is prohibited.
Establishing a transfer pricing policy
practical considerations
4.
International Transfer Pricing 2011 51 Establishing a transfer pricing policy practical considerations
401. Arms-length pricing market prices
By defnition, use of the arms-length standard to determine inter-company prices
demands an examination of the market conditions surrounding both the inter-
company and unrelated party transactions.
Market prices are driven by the characteristics of the particular transaction. For
instance, a product that is sold with a well-known and highly valuable trademark sells
at a premium compared with a product that is identical in every respect, except that
it is sold with an unknown trademark. In this case, additional proft accrues to the
owner/developer of the valuable trademark. The premium for the market leader may
well decline over time, provided that the unknown brands can establish reputations for
quality and value for money.
An example to consider in this area is the way in which prices for personal computers,
branded by leading manufacturers such as IBM, Dell and others, have been driven
down as the reliability of inexpensive clones has improved. By way of a further
example, a distributor that provides marketing and technical support to its customers
should be able to earn a higher proft margin than a distributor that does not provide
these services.
These two examples illustrate the basic principle that prices in third-party situations
are determined by the facts and circumstances present in any given situation.
Similar factors apply in an inter-company situation. In the latter case, a functional
analysis must be performed to identify which party is responsible for manufacturing,
research and development (R&D), materials purchasing, logistics, sales, distribution,
marketing, after-sales service, etc. Once these facts are known, the entities can
be characterised as manufacturing-type companies, sales/distribution-type
companies, contract R&D companies, service providers, etc. as appropriate. From
the characterisations, the analyst may look to comparable companies operating
independently in the open market. The next step is to determine the method to be used
for transfer pricing within the group. It is interesting to consider how prices are set in
comparable unrelated party situations as, in many jurisdictions, it pays dividends to
mimic the mechanism used as far as possible. However, it is not easy to identify how
independent companies set their trading prices. Instead, the data usually available
concerns the results of these transactions. In such cases, the inter-company transfer
price will be based on the most appropriate method in all the circumstances and will
try to emulate as clearly as possible fnancial results observed from the independent
trading situation.
Establishing a transfer pricing policy practical considerations 52 www.pwc.com/internationaltp
Obviously, if the facts change, the characterisation of the entities involved in the
inter-company transactions will change accordingly and the prices used in the inter-
company transactions must be adjusted. Consequently, the frst step in establishing
a transfer pricing policy must be to gather all the relevant facts and circumstances
surrounding a particular inter-company transaction. These facts can be summarised in
three categories: functions (see section 405), risks (see section 406), and intangible and
tangible assets (see section 407).
402. Functional analysis
Functional analysis is a method of fnding and organising facts about a business in
terms of its functions, risks and intangibles in order to identify how these are allocated
between the companies involved in the transactions under review.
To obtain a comprehensive understanding of the facts surrounding the inter-company
transactions, it is necessary to gather information from numerous sources. Firstly,
operating employees within the multinational must be interviewed to obtain in-depth
information regarding functions, risks and intangibles of each legal entity. These
interviews identify further areas for review, including relevant contracts and fnancial
data. Secondly, industry experts and publications about the industry must be consulted
to understand standard operating practices within the industry as well as the relative
values of the intangibles involved in the transaction.
403. Interviews
The analyst obtains much information about the criteria under review through
interviews. She/he should draw up a list of key employees who are able to state clearly
what functions, risks and intangibles are relevant to the operations for which they are
responsible. Personnel from each entity involved in the inter-company transactions
should be interviewed. It is important to hear all sides recount the facts. Frequently,
human perspectives are different, particularly when the individuals involved are
working at corporate headquarters or at a subsidiary. Hearing all sides allows the
analyst maximum opportunity to determine the truth of the inter-company relationship
and hence the most appropriate transfer pricing policy to ft the circumstances.
On-site interviewing is preferable to questionnaires or telephone conferences.
Questionnaires are subject to many interpretations, are usually inadequately completed
and make it impossible to determine the tone of the response (i.e. the nuances of the
relationship). Furthermore, questionnaires make follow-up questions diffcult.
Another non-tax reason for interviewing all affected parties is that the implementation
of new transfer pricing policies can be highly controversial within a company. When
all parties feel that they have played a role in the proper determination of a transfer
pricing policy, it is usually easier to deal effectively with the political problems, which
inevitably arise.
As the functional analysis progresses, certain persons may be added to, or deleted
from, this list of intended interviewees, as appropriate. Appendix 1 provides a list
of questions that may be used as a starting point to design the interviewing process.
These questions should not be viewed as covering every area of importance. During
the interview process, various questions are discarded and many more added so that a
thorough understanding of the facts is obtained.
International Transfer Pricing 2011 Establishing a transfer pricing policy practical considerations 53
The interviews typically cover the following topics, as they apply to each entity
involved in the manufacture and distribution of products as well as performance of
inter-company services:
Manufacturing functions: production scheduling, production process, materials
purchasing, supplier approval, personnel education and training, quality control
procedures, quality control implementation, reporting relationships, process
technology and improvement;
Marketing functions: strategic marketing plans, advertising, trade shows, sales
force, the relative autonomy of various entities in marketing the companys
products, forecasts, selling techniques, key marketing personnel, new market
penetration, reporting relationships, training;
Distribution functions: warehousing and distribution, inventory, warranty
administration, third-party distributor relationships; and
Administrative, management or other inter-company services performed on behalf
of other related parties and/or third parties.
404. Other information or documents required
In addition to carrying out interviews, analysts should examine documents and other
information from the entities. This information includes: organisation charts; existing
inter-company pricing policy statements; inter-company agreements such as licences
and agreements covering distribution, R&D, cost-sharing, management services,
etc.; and product and marketing information. Examples of product and marketing
information include product brochures and literature, stock analyst reports, trade press
articles, in-house news publications, reports on competitors, advertising literature
and information regarding customers. This information aids in understanding the
information gathered at interview and the economics of the markets in question.
Note that the company itself is not the only source of information to the person
conducting the functional analysis. The analyst should also gather information on
trade associations, competitors, academics, etc., to learn as much as possible about the
company, its industry, its products and the markets it serves. These days, it is also likely
that information of relevance is publicly available on the internet (as the internet is
accessible worldwide, tax authorities are also making use of the available data in the
conduct of their transfer pricing investigations).
405. Functions
Functions are defned as the activities that each of the entities engaged in a particular
transaction performs as a normal part of its operations. Table 4.1 provides a list of
some typical business functions. In general, the more functions that a particular entity
performs, the higher the remuneration it should earn, and its prices should refect this.
It is not enough simply to determine which entity has responsibility for a particular
function, risk or intangible. The proper development of a transfer pricing policy
requires that the transfer pricing analyst also determines the relative importance of
each function in that transaction, industry and market. For instance, it is common in
many industries for a foreign distribution subsidiary to be responsible for marketing
and advertising, as well as distributing the parents product. However, marketing and
advertising activities may be far more important in the consumer goods market, where
products may be differentiated by image and brand name recognition, than in the
chemical industry, where the companys name may be of limited importance compared
with the specifc chemical properties of the product.
Several functions are particularly important in the context of a manufacturing
company. The frst is the materials purchasing function. For instance, does the parent
corporation purchase raw materials on behalf of its manufacturing subsidiary and then
consign those materials to its subsidiary, or does the subsidiary purchase its own raw
materials? The selection of materials will naturally have a signifcant impact on the
price and quality of the fnished goods, the reliability of supply and other areas of the
business process.
Another major function in manufacturing is production scheduling. Does the parent
corporation tell its manufacturing subsidiary what to produce, how much to produce
and when to produce it, or does the subsidiary plan its own production schedule?
Quality control is also an important area. The analyst must determine which legal
entity is responsible for establishing quality control policies, the implementation
of those policies and the monitoring of their differences. Does the manufacturing
subsidiary have limited control over the policies that it uses, or does it develop and
implement its own quality control procedures?
Table 4.1 Typical business functions
Product research, design and development
Purchasing materials, supplies and equipment
Controlling stocks of raw materials and nished goods
Developing and administering budgets
Quality control
Production of nished goods
Packaging and labelling of products
Sales
Marketing
Shipping of products to customer
Facilities engineering
Personnel
Manufacturing engineering
Maintenance: building, grounds and equipment
Electronic data processing
Public relations
Production planning and scheduling
Industrial engineering
Management and supervision of offshore operations
Manufacturing site selection
Administrative services
Government affairs
Finance and control
Accounting services
Arranging product liability insurance
Table 4.1 Typical business functions
Establishing and controlling pricing policy
Technical service
406. Risks
A signifcant portion of the rate of return (ROR) earned by any company refects the
fact that the business is bearing risks of various kinds. Table 4.2 provides a list of some
potential business risks.
Market risk relates to the potential loss that may be associated with selling in an
uncertain marketplace. If a parent company has made arrangements to protect its
manufacturing subsidiary so that it does not incur operating losses if it encounters
adverse market conditions, then the subsidiary should sell to affliates at considerably
lower prices (and earn lower levels of proft) than if it bears the full risk of market
fuctuations. In such a case, the plan will probably have been for the marketing
subsidiary to carry the risk of the market. It is particularly important to document
this fully and to ensure that the marketing company has suffcient capital resources
to support the risk it is taking. This should assist in fending off a tax authority attack
on losses contained in the marketing company (tax authorities often tend to assume
that such companies do not carry the risk of the market and therefore seek to disallow
losses accruing in this way).
Table 4.2 Typical business risks
Market risk
Inventory risks: raw materials, work in progress and nished goods
Defective products and warranty
Credit risk
Product liability risk
Foreign exchange risk
Environmental risk
There are various ways to judge whether market risk exists. One way is to determine
the time in the product development cycle at which manufacturing responsibility for
the product was transferred to the subsidiary by the parent company. For example,
if the product is frst manufactured by the subsidiary immediately after it leaves the
groups pilot manufacturing plant, then the manufacturing subsidiary has considerably
more market risk than if the product had been manufactured frst by the parent and
was frmly established in the marketplace at that time.
The extent of market risk depends also on the degree of competition and economic
structure in the market. For instance, where the parent has limited competition in a
particular industry, the manufacturing subsidiary may face considerably less market
risk than if it faced stiff competition from several companies that produce close
substitutes for its product.
The existence of limited competition within a particular industry or product sector can
arise from a number of factors. Barriers to entry by new frms, such as government
regulation or the need for an extremely large initial investment (the development
and commercialisation of new drugs in the ethical pharmaceutical market is a good
example). Even if there is more than one frm in the industry in question, a company
can establish a competitive advantage by developing a patent or proprietary know-how
that essentially bars or inhibits competition in a particular product or market. If such
barriers exist, they can have a material impact on the degree of market risk faced by a
particular frm.
Market risk can also vary with the sensitivity of the industry to general economic
conditions. The performance of some industries, such as the automotive industry,
varies dramatically over the business cycle. When the economy is in recession, these
industries are in recession, and when the economy is booming, so too are they. Other
industries, such as pharmaceutical and medical supplies, may be more immune to
the impact of fuctuations in the national or world economy. People fall ill and suffer
injury during good and bad times alike. As a consequence, the protection that a parent
may provide for its subsidiary against market risk can be signifcantly more valuable in
some industries than in others. It depends on the market structure and the underlying
demand profle for the product.
Inventory risk is another factor that should be investigated in every transfer pricing
study. Both raw materials and fnished products inventory risk are particularly
important, but work in progress may also be material (for instance, the value of work in
progress for a whisky distiller, which needs to age the stock for many years before it can
be sold as premium aged Scotch).
If a company wishes to maximise profts in a manufacturing subsidiary, it must be
prepared to take all write-offs associated with inventory in that subsidiary. This
responsibility reduces profts in the year of the write-off; however, that experience can
be used to demonstrate to a tax authority that inventory risk lies within the subsidiary.
Some manufacturers rarely own any raw materials or fnished goods; their inventory
risk is minimal or nonexistent. On the other hand, some manufacturers do face
inventory risk since they typically purchase raw materials, schedule production and
hold a stock of fnished goods. In short, inventory risk is a critical component of the risk
assumed by parties engaged in an inter-company manufacturing transaction.
Other important risks include defective product, warranty and environmental risks.
If a product is returned as defective by the fnal customer, for instance, who bears
the cost of that return? Is it the company that distributed the product or the foreign
manufacturer? Who bears the warranty costs? If an environmental accident occurred
at the manufacturing subsidiary, which party would bear the cost of the clean-up?
With increased attention being paid worldwide to environmental problems in virtually
every industry, it is becoming increasingly important to develop a clear understanding
of which party assumes this risk and how these risks vary across countries.
It is also important to consider how contract law might be used to deal with the
location of risk in this area. For instance, it might be that a manufacturing operation
is obliged by local law to be responsible for all environmental risks associated with
its activities. However, its parent company might be able to establish indemnity
arrangements to cover this risk, effectively shifting the local, legally imposed risk to
another jurisdiction.
It is important to recognise that risks can vary markedly across industries and
geographic markets. In some businesses, there is no credit risk because customers are
required to pay before delivery is made. The retail trade is often operated in this way.
By comparison, in other industries it is standard practice to request payment within
three to nine months of delivery. Differences in judicial systems across countries can
mean that, within a given industry, underlying product liability risk is a much more
signifcant factor in one geographic market than another.
407. Intangibles
Table 4.3 provides a list of typical intangible assets.
Table 4.3 Typical intangible assets
Patents
Unpatented technical know-how
Formulae
Trademarks and brand names
Trade names
Licences
Copyrights
Technical data
Ability to provide after-sales service
Customer list
High-calibre personnel, such as a strong sales force
Intangibles are ordinarily divided into two categories: manufacturing and marketing.
Manufacturing intangibles are characterised as one of two types patents or
nonpatented technical know-how and arise out of either R&D activity or the
production engineering activities of the manufacturing plant.
Marketing intangibles include trademarks, corporate reputation, the distribution
network and the ability to provide services to customers before and/or after the sale.
This category of intangibles is very broad indeed, and regard must be had to the
question of ownership of such assets as well as to their maintenance and development.
It is not necessary that the asset appears on the balance sheet for it to have signifcant
value for transfer pricing purposes. The accounting practices that apply to particular
categories of asset vary enormously from one country to another and any apparent
balance-sheet value may therefore be of little relevance. For instance, goodwill arising
on the acquisition of a highly successful business might be written off immediately or
carried forward and depreciated over 40 years, depending on the accounting practice
adopted in the acquiring country. In both cases, the goodwill might, in reality, be an
appreciating asset.
It must be determined which intangible assets play a role in the transaction under
consideration, as well as their relative values. Specifcally, the transfer pricing analyst
must determine which type of intangible manufacturing, marketing, or both
accounts for the success of a particular product. Does the products design explain
its success? Or is it the companys ability to deliver the product when promised? Or
is it the companys trade name? In this connection it must be borne in mind that all
marketing intangibles are not created equal. A trade name that is well-known and
thus valuable in one market may be completely unknown and of no initial value in
anothermarket.
The return earned by the various entities should vary directly with the importance of
the functions performed, the degree of risks undertaken and the value of intangibles
provided. Looking at the production intangibles, is it a proprietary manufacturing
process that enables the company to produce goods at 20% below the cost of its nearest
competitor? Or is it a combination of this and other intangible assets?
Companies that have developed valuable proprietary manufacturing know-how
may decide not to patent the technology for fear of making the process known to
competitors. This know-how can range from design changes made on a standard
machine to a more effcient plant layout, to an innovative production process. A
particularly pertinent question to ask when visiting a plant is whether there is anything
in the plant that the company would not show to a competitor. If the answer is yes,
the analyst may have found a valuable manufacturing intangible, though further
investigation would be necessary to establish who developed the know-how, its value
to the company, etc.
408. Characterisation of businesses
Characterisation of the related parties is an important component to a transfer pricing
analysis and is typically used as the foundation in developing the economic analysis.
Characterisation of businesses means making comparisons of the functions and risks
of the related entities under review and comparing those to uncontrolled entities that
exist in the same or similar industry. Such characterisation involves using information
from the functional analysis and information about the industry.
409. Contract manufacturers and fully fedged
manufacturers
There are two general characterisations of manufacturing businesses: the
contract manufacturer and the fully fedged manufacturer. (A subtype of contract
manufacturing is toll manufacturing, whereby the contract manufacturer does not
take legal title to the raw material or products manufactured.) Both contract and fully
fedged manufacturers are found in almost all industries, an important point because
the ROR received by contract manufacturers is generally signifcantly lower than the
ROR received by fully fedged manufacturers (see Table 4.4).
Contract manufacturers provide manufacturing services to fully fedged
manufacturers. They do not develop their own product lines but offer expertise in
performing certain manufacturing functions only. They may or may not perform such
functions as materials purchasing and production scheduling or own the inventory
(raw materials, work in progress and fnished goods). Over the course of a contract,
they do not face direct market risk because they have a guaranteed revenue stream
from the customer with which they are under contract. They may be remunerated on
a fee basis (cost-plus), or on a pre-established price per unit (which will probably have
been determined on a cost-plus basis). The contract manufacturers intangibles are
limited and typically consist of know-how pertaining to the manufacturing processes.
Fully fedged manufacturers develop their own product lines and may have substantial
R&D budgets or may obtain the technology they require through licences.
They perform all manufacturing functions, such as vendor qualifcation, materials
purchasing, production scheduling and quality control procedures. Also, they are
typically extensively involved in marketing to the ultimate customers (or end-users) of
the product. They bear several types of risk, including inventory risk and market risk.
Table 4.4 below summarises the critical features that distinguish contract
manufacturers from fully fedged manufacturers. As a general rule, manufacturing
companies within a multinational group do not fall precisely into one or other
category; rather they gravitate towards one end or the other. Identifcation of the
differences between the model and the multinationals circumstances provides
information that can be used in adjusting potential comparables to create a justifable
inter-company price. (Of course, it is possible to determine the risks incurred by a
contract manufacturer within a multinational and also to determine the functions it
performs. This offers the group considerable fexibility of structure and hence tax-
planning opportunities.)
Table 4.4 Characterisation of manufacturing entities
Contract manufacturer Fully edged manufacturer
Does not own technology Owns technology
Little risk Full of risk
Purchasing
Little discretion in production scheduling Production scheduling
Does not totally control equipment
Scheduling
Select own equipment scheduling
Quality control usually dictated Direct control over quality by customer
Usually manufacturing high-volume,
mature products
Manufacturing products at all high-volume,
mature products stages of product life cycle
Note that, as shown in the diagram above, greater functions/risks may not only have
greater proft potential but may also have greater loss potential.
410. Characterisation of distribution/selling companies
The four general characterisations of distribution/selling companies are, in order of
increasing functions, manufacturers representative (or commission agent), limited
distributor, distributor and marketer/distributor. This characterisation is important
because the prices paid/profts earned vary, sometimes considerably, between these

Manufacturing profitability
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Increasing functions, risks and intangibles of manufacturer
various types of selling entities, with the manufacturers representative earning the
least proft of all.
A manufacturers representative does not take title to the merchandise it sells. It bears
neither credit risk nor inventory risk. It does not have any marketing responsibilities
and is typically paid a commission based on the sales revenue it generates for the
company it represents.
A limited distributor takes title to the merchandise. It has limited inventory risk and
credit risk. It has limited marketing responsibilities but typically does not bear foreign-
exchange risk on purchases from its suppliers.
A distributor takes title to the merchandise, bears credit risk and inventory risk. It has
limited marketing responsibilities, and may or may not have foreign-exchange risk.
A marketer/distributor takes title to the merchandise, has credit risk, inventory risk
and may have foreign-exchange risk. It has total marketing responsibility for its product
lines, including, generally, the determination of marketing strategy for its market. This
typically occurs in inter-company situations where the subsidiary is mature or where
it is located in a different time zone from the parent company or where, for cultural
reasons, the parent is unable to compete effectively in the foreign marketplace.
Table 4.5 summarises the salient characteristics of each type of sales entity and
indicates their relative proftability.
411. Goals of the multinational corporation
A companys fnancial goals are important considerations in developing a transfer
pricing policy because it is often possible to achieve them through transfer pricing.
Financial goals include managing cash fows, supporting R&D, funding capital
expansion, paying interest on debt, meeting tax liabilities in accordance with overall
group tax strategies and funding dividend payments to shareholders. Satisfying each
requires placing income in the legal entity where the funds are ultimately required
and transfer pricing can be used to move funds as required, so long as the substance
of the relationship between the related entities supports the policy adopted. It may be
possible to achieve this result by altering the previous arrangement of functions, risks
and intangibles within the group.
A company may have overriding business reasons for wanting to place functions,
risks and intangibles in certain locations. For example, the goal may be to rationalise
global production, or centralise management, fnancial and marketing functions to
improve effciency and reduce costs, or it may be necessary for a variety of reasons
to manufacture the product within the market in which it will be sold. These reasons
may include transportation costs, legal requirements that a product be manufactured
where it is sold, customs and indirect tax reasons, etc. The realisation of these goals has
implications for the transfer pricing policy adopted by the group.
A key goal of most multinationals is to minimise the global tax charge. Corporate
income tax rates vary across countries and form an important consideration in
establishing a transfer pricing policy. Because the arms-length standard for transfer
pricing requires that pricing, and so proft, be based on the substance of a transaction,
corporate restructuring, which places important functions, risks and intangibles
in jurisdictions that have lower tax rates, results in a lower overall tax rate for the
group, maximising earnings per share. Some examples of these possible restructuring
techniques are set out in sections 412419.
Table 4.5 Characterisation of distribution/selling companies sales/distribution protability
Manufacturers
representative
Limited
distributor

Distributor
Marketer/
Distributor
Does not take title Takes title Takes title Takes title
No credit risk minimal/
parent controls policy
Credit risk Credit risk Credit risk
No inventory risk Inventory risk minimal
Inventory risk
Inventory risk Inventory risk
No marketing
responsibilities limited
Marketing
responsibilities
Marketing
responsibilities limited
Total marketing
responsibilities
No FX risk No FX risk May or may not have
FX risk
May or may not have
FX risk
Note that, as shown in the diagram above, greater functions/risks may not only have
greater proft potential but may also have greater loss potential.
412. Manufacturing opportunities
It is self-evident that the more income that can be placed in subsidiaries located in
low-tax jurisdictions, the lower will be the multinational corporations effective tax
rate. In recent years, the effective use of tax havens has become increasingly diffcult
as tax authorities have found ways of attacking taxpayers planning schemes. However,
in many instances the use of tax havens continues to be benefcial, if carefully planned.
The key to success is to be certain that the low-taxed affliate is compensated properly
in respect of the functions, risks and intangibles for which it is responsible. In this
way, offshore profts that are not taxed directly by anti-avoidance laws (such as the US
subpart F or the UK controlled foreign companies legislation) may remain offshore,
tax-free.
Manufacturing in tax havens is desirable only when it makes commercial sense.
For example, if a company can serve a certain geographical region from a single
manufacturing location (for example, a plant located in Ireland to serve the European

Manufacturing profitability
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Increasing functions, risks and intangibles of manufacturer
market) and the tax haven has the infrastructure, the labour force, etc. needed to
support the manufacturing activity, then manufacturing in the tax haven is plausible.
To place as much proft opportunity in the tax haven as possible, the manufacturer
should be a fully fedged rather than a contract manufacturer (although there is
normally a risk of loss as well, depending on the economics of the business). This can
be contrasted with the situation where, if manufacturing in a high-tax jurisdiction
is necessary for commercial reasons, it may be possible to structure the activity as a
contract manufacturer (if established this way at the outset), thereby minimising the
income that must be reported in that jurisdiction.
413. Centralised support activities
Many multinationals, responding to the globalisation of business, have centralised
certain support services in an attempt to minimise costs. In various situations, support
activities can be placed in low-tax jurisdictions to reduce the total income subject to tax
in higher tax jurisdictions. For example, trading companies can be used to centralise
foreign-exchange risk and/or worldwide inventory control. Trading companies can be
placed in any country where the requisite substance can be established.
Support activities, such as accounting and marketing, can be centralised in a low-tax
jurisdiction and affliates can be charged for the services rendered. Typically, these
entities are limited to charging their costs plus a markup. Nevertheless, this is a means
of reducing income in higher tax jurisdictions, provided that the service entities do
have the substance needed to support the charges made. In practice, the absence of
good communications and an appropriately qualifed workforce is often a real barrier
to shifting important support functions to pure tax havens. Opportunities exist,
however, in using low-tax vehicles located in more mainstream countries, such as the
Belgian Coordination Centre. However, both in the context of Ecofn Code of Conduct
and EU state aid developments, it was decided that the regime will be safeguarded
until 2010 and that, in any event, no refund of tax savings would be required. As an
alternative regime, many groups are contemplating the use of the Belgian notional
interest deduction related to equity funding of Belgian enterprises. This incentive
consists of granting business relief for the risk-free component of equity and is available
to all Belgian enterprises, so as to avoid any challenges on the deemed selective nature
of the measure.
414. Selling companies
As a general rule, selling companies are located close to their customers, often in high-
tax jurisdictions. If the multinational is actively seeking to minimise its worldwide tax
rate, it may be possible to reduce the level of income that must be earned by a given
selling entity. For example, if the reseller operates as a marketer/distributor, possibly
the marketing function could be moved to a central location and thereby remove
marketing income and related intangibles from the high-tax jurisdictions. Alternatively,
it may be possible, in certain limited circumstances, to set up the marketing activity as
contract marketing (if done at the outset) so that the marketer is paid on a cost-plus
basis for the marketing activity performed. An important consideration is that this
arrangement is established before any marketing intangible is generated to ensure
that the contract service provider is economically limited to the remuneration that it
receives for performing such contract services. In other words, there is no pre-existing
marketing intangible that it may have created before entering into a contract service.
415. Contract service providers
In addition to contract manufacturers (see section 409), there are other types of
contract service companies these include contract R&D and contract marketing.
Such entities are typically established for commercial reasons and can be structured as
service providers to minimise tax or to place ownership of valuable intangibles created
by the R&D or marketing activity in a central location.
416. Contract research and development
Contract R&D frms provide facilities and personnel to assist their customers (typically
a fully fedged manufacturer or a parent companys R&D activity) in developing
intangibles. As long as they honour the terms of the contract, they do not bear the risk
that their R&D may not lead to a commercially successful product or application, nor
are they entitled to the profts of exploiting viable new ideas or products developed
under the contract. (This technique was found to be acceptable in a US tax case
Westreco, Inc. v Comr., 64 TCM (CCH) 849 (1992).)
This construction is useful in the inter-company pricing context when the parent
wishes to conduct R&D in several countries, but wishes to retain legal ownership of the
intangibles (and therefore the proft created by the R&D) in a single country. Contract
R&D places the risk in the country that will ultimately own the technology.
Example
Militia Inc. is a US corporation that develops, manufactures and markets industrial
applications for use in the defence, aerospace and automotive industries in the US and
internationally. The company recently established Militia Canada Company, a wholly
owned Canadian subsidiary to develop and manufacture certain raw materials that
are needed to manufacture Militia Inc.s products. The original manufacturing process
and know-how for these raw materials was developed in the US and was transferred
to the Canadian subsidiary. Currently, all of the intellectual property resides in the
US regarding the development and manufacture of these raw materials. However,
as Militia Canada Company begins operations, the company believes it will be most
effcient to have its Canadian subsidiary conduct all the research and development
activities for these raw materials.
The management of Militia Inc., however, also believes that maintaining legal
ownership of all intellectual property in the parent company maximises the companys
ability to protect and defend this property from predators. The decision has therefore
been taken to place all economic and legal ownership of intangibles in the parent
company. In addition, the parents vice president in charge of R&D will be assigned to
coordinate and manage the R&D activities of Militia Canada Company.
In this situation, a contract R&D arrangement would allow the group to maintain
economic ownership of intangibles in the parent company. Militia Inc. will effectively
employ Militia Canada Company to perform certain R&D functions under its guidance,
paying them on a cost-plus basis and reserving all rights to the intangibles developed
under the contract. By ensuring that an executive employed by Militia Inc. is overseeing
the R&D operations of Militia Canada Company, the substance needed to defend the
use of this technique (i.e. centralised decision-making from the parent) appears to
exist. Documentation of this arrangement is critical.
417. Other reasons for establishing contract research and
development
Contract R&D is a useful technique to employ when a subsidiary has special expertise
available to it, which the parent wishes to exploit but where the subsidiary does not
have funds available to cover the costs. By setting up a contract R&D arrangement,
the parent company can fnance the R&D activity that is conducted by the subsidiary.
Similar to a contract marketing service provider, an important consideration is that this
arrangement is established before any R&D intangible is generated to ensure that the
contract service provider is economically limited to the remuneration that it receives
for performing such contract services. In other words, there is no pre-existing R&D
intangible that it may have created before entering into a contract service.
Example
Semi-Chips Inc. (a US company) has been manufacturing and selling custom-designed
semiconductor equipment for semiconductor original equipment manufacturers
(OEMs) in the US for 10 years. It recognises that a vast majority of semiconductor
OEMs (its direct customers) have moved operations to Asia. As such, the company
has determined to establish a subsidiary in Taiwan to be closer to its customers.
At the same time, the company has noticed that because of the large amount of
semiconductor manufacturing activities in Asia, there exists a great deal of technical
expertise in Taiwan. Due to this fact, the company determines that it is more effcient
for the Taiwanese subsidiary to also conduct R&D activities for products on its behalf.
The new Taiwanese subsidiary is capitalised by Semi-Chips Inc. with USD1 million and
sets about hiring Taiwanese scientists to conduct the R&D. The subsidiary does not
have the cash to pay these scientists; therefore, the parent establishes a contract R&D
arrangement and pays the Taiwanese subsidiary its costs plus an arms-length markup
for its services.
418. Contract maintenance
Contract maintenance frms provide a labour force with the skills, instruments and
tools needed to maintain or service equipment. These companies typically use special
expertise, which is developed by the manufacturer of the product and provided free of
charge to the contract maintenance company for use in servicing the manufacturers
customers. They are usually compensated on a cost-plus basis.
The application of this concept in an inter-company pricing context offers one method
that may assist in controlling the proftability of a subsidiary responsible for selling
products and providing an after-sales service to customers. The sales activities may be
characterised as those of a basic distributor, while the service activity is treated as a
contract activity and remunerated only on a cost-plus basis. The transfer of expertise
or the method of providing service need not be compensated because the owner of
the technology receives the entire service fee except for the return on labour, which
is paid to the contract service provider. Great care must be taken in structuring these
arrangements, and this technique may not be appropriate where the service activity is
a crucial part of the overall sales activity, rather than a routine after-sales obligation.
419. Contract marketing
Contract marketers perform marketing activities on a contract basis. This technique
is used in inter-company pricing situations to prevent the development of marketing
intangibles in the affliate that conducts the marketing activity. If the arrangement
is established at the time marketing activities commence, the affliate does not bear
either the cost or the risk of marketing intangible development and therefore is entitled
to none of the marketing intangible income earned in the future.
Example
Forever Young Inc. (FY), a US company, manufactures and sells cosmetics, body and
skincare products and nutritional supplements. The company operates in the direct
selling industry, using independent distribution networks to sell their products to end-
consumers. After experiencing a tremendous success in the US market, the company
decided to enter the international market. The company expects to repeat its success
setting up subsidiaries in Germany and France. The company expects to derive a
signifcant amount of revenue in the future from those markets, but would not like
to place more income than is necessary in Germany or France for their sales support
activities. Under a contract sales support and marketing arrangement, the subsidiaries
in Germany and France would implement the marketing strategy, source all marketing
materials from the parent and promote the business model in their local countries.
All activities would be approved and supervised by the management of the parent
company. The service providers would be compensated on a cost-plus basis for their
sales support and marketing activities. As a result, the parent company would arguably
retain the economic ownership of the marketing intangibles in the local markets.
420. The evaluation of pricing options
This chapter has examined the way in which functional analysis can be used to
characterise a business and has looked at some examples of particular ways in which
operations might be structured. When evaluating the options available in particular
circumstances, the facts may lead directly to a clear choice of pricing method. If this
is not tax-effcient, changes need to be made to the functions, risks or intangibles in
order to justify an alternative pricing structure. As the decision is being made, it is
also necessary to determine how the local tax authority is likely to react so that any
exposure can be quantifed before opting for a particular structure. In order to do this it
is vital to seek local advice to be certain that the structure will not lead to tax problems
in any locations. This is especially true for companies that may be deemed to have
intangible property.
421. The search for comparables
Once a pricing structure is chosen, arms-length prices need to be computed. To do
this it is necessary to conduct a comparables search, as it is only through comparable
transactions that a business can objectively establish a clear basis on which to defend
its transfer prices. Chapter 3 discussed the methods of determining transfer prices that
are consistent with the OECD Guidelines. The following example illustrates how the
process of selecting and evaluating comparables might work.
Example
Fishy Fish KK (Fishy Fish) is a Japanese company that manufactures, develops and
distributes fshing rods, reels and tackle in Japan and internationally. Fishy Fish
distributes its products within the US through its US subsidiary, Fishy Corp. (Fishy US).
Fishy Fish has to determine whether the transfer price for which it sells its products
manufactured in Japan to Fishy US to distribute within the US market is at arms
length. After a thorough functional analysis has been carried out, it has been
determined that Fishy US is a distributor that conducts limited additional marketing
activity, similar to what an independent distributor would conduct. Fishy US is also
determined to take on certain limited business risks, such as product liability risk,
market risk and credit risk, but Fishy Fish is assessed to be the primary entrepreneur of
the group, and therefore the primary risk-taker of the operation.
Further, it is determined that the fshing products are successful in the US market
primarily because of the design and quality of the fshing equipment. Both of these
attributes are the responsibility of Fishy Fish, the parent.
Fishy Fish now wishes to identify comparables that can be used to determine
and support transfer prices between the manufacturing activity in Japan and the
distribution activity in the US by Fishy US.
The preferred method of determining the price for this transaction is the comparable
uncontrolled price (CUP) method. There are three methods of identifying a CUP for
this transaction:
The Japanese parent may have sold the same fshing equipment to an unrelated
distributor in the US;
The US subsidiary may have purchased the same fshing equipment from an
unrelated manufacturer; and
An entirely separate operation, Company A, may have manufactured identical
fshing equipment and sold it to Company B (unrelated to Company A), which
serves as its distributor in the US.
Rarely do transactions such as these exist due to the stringent product comparability
requirements. However, if it is possible to identify such transactions, it would be
necessary to determine whether they could be applied directly or whether adjustments
must be made to the CUP to account for elements of the CUP that differ from the
related party transactions (see section 304).
In the event that a CUP cannot be found, the most likely method that would be used in
this example is the resale price method. To apply this method, it is necessary to identify
distributors of fshing equipment (or, if these cannot be found, other sporting goods)
in the US. These distributors must purchase their sporting goods from unrelated
manufacturers. If these types of transactions are identifed, income statements for the
distributors need to be obtained and the gross margin (sales less cost of sales) for the
distributors calculated. Adjustments must be made to the gross margin if there are
substantial differences between Fishy Fishs relationship with its subsidiary and the
relationship between the unrelated parties involved in the comparable transaction.
It should be recognised that Fishy Fish may sell fshing equipment to unrelated
distributors within the US. In this event, it may be possible to use these relationships
to determine an arms-length discount to apply the resale price method. (While the
CUP method would not apply because of differences in market prices across the US,
distributor margins are frequently very similar across the US.)
In this example, the resale price method would be the next option to be sought.
However, there may be diffculties in using what may appear to be an obvious solution.
These include the following:
There may be no published accounts for comparable distributors;
If accounts are available, they may not disclose the gross margin; and
If gross margin is disclosed in the accounts, it cannot be analysed with suffcient
certainty to enable reliable comparisons to be made with Fishy USs gross margin.
When these obstacles to using the resale price method cannot be overcome, as is often
the case, the transactional net margin method (TNMM) under the OECD Guidelines or
the comparable profts method (CPM) in the US transfer pricing regulations, discussed
in chapter 3, would most likely be applied. When using the CPM/TNMM, the degree
of functional comparability between the tested party and the uncontrolled distributors
is less than that required under the resale price method to obtain a reliable result.
To search for comparables under the CPM/TNMM, a search for external comparable
independent distributors with broadly similar functions as the tested party (i.e.
Fishy US) using information obtained from the functional analysis, is conducted.
Once this set of comparable companies is established, the proftability results of the
distribution business of Fishy US are benchmarked against the proftability results
of the uncontrolled distributors. If Fishy US proftability results fall within the range
of proftability results established by independent distributors, Fishy Fish should be
treated as having reasonably concluded that its transactions with Fishy US were at
arms length.
422. Identifying appropriate comparables
It is crucial to bear in mind the underlying aim in searching for comparative
information. A comparable can be used to support the validity of the terms of a
transaction if, in commercial terms, it can be shown that third parties at arms length
have agreed terms similar to those set between the affliates. A comparables search
may be undertaken to identify CUPs, gross proft margins for use in applying the
resale price method, cost markups for use in applying the cost-plus method or other
information required to apply or support other pricing methods.
Comparables may be sought from a variety of sources and, broadly, fall into two
categories: those that may be identifed internally within the group and those
identifed from external sources, which refect transactions not carried out by
groupcompanies.
423. Internal comparables
It is advisable to perform a thorough analysis of group transactions to ascertain
whether any comparable transactions with third parties exist. Internal comparables
may be preferable to external comparables for a number of reasons, including:
They are more likely to ft the affliated transaction as they occur within the
context of the groups business;
More information about the comparable situation should be readily available; and
One internal comparable may be suffcient to support a defence of the transaction
under review, whereas a wider base of support may be required if external
comparables are used.
A broad perspective is required in reviewing the groups business for comparative
transactions, as their existence may not be immediately obvious, as illustrated in the
following example.
Example
Healthy Life Inc. (HLUS), a US manufacturer of medical devices, must determine
transfer prices with its subsidiary in Ireland. The Ireland subsidiary (HLI) is a
manufacturer that employs certain specifc technologies from its parent company to
manufacture its medical devices.
HLUS would like to identify comparable agreements that can be used to determine
an appropriate royalty rate for the licence of its intangible property to Ireland. After
discussions with HLUS management, it was discovered that HLUS licensed similar
intangible property (under diverse agreements with third parties) compared to the
intangible property used by Ireland in their manufacturing process.
The preferred method of determining the price for this transaction is the comparable
uncontrolled price (CUP method using internal comparable licensing agreements. As
a result, it is possible to construct a range of royalty rates using the internal licensing
agreements for similar intangible property.
Identifcation of internal comparables may be made through:
Discussions with management of all the entities involved in the transaction; and
Review of the management accounts of the entities.
424. External comparables
Detailed information regarding transactions carried out by independent entities may
not be easy to obtain, and the extent to which useful information is available varies
from country to country.
The main sources of information regarding third-party comparables are as follows:
Government (e.g. statutory public fling requirements and government trade
department publications);
Commercial databases;
Industry associations; and
Knowledge of employees.
Of the many sources of information for conducting a search for comparable
transactions, the most important source may be the operating personnel who know
their industry and the characteristics of competitors. These individuals can frequently
provide valuable sources of information about competitors and potential comparables.
Trade associations are also important because they publish trade journals or other
helpful documents. In addition, many trade associations have conducted studies of
the market and/or employ experienced industry experts who may provide a wealth of
valuable information.
Online databases are useful for identifying potential comparables and obtaining
fnancial information about them. Other business research resources may also
be consulted, as necessary. Appendix2 contains a list of some of the currently
availableresources.
To establish whether a comparable transaction is, in fact, appropriate, it may be useful
to approach the third-party comparable to ask for help in comparing the relevant
aspects of the transaction. Although, when approached for this purpose, third parties
may be unwilling to discuss their business, in some instances, very useful information
can be obtained.
The search for comparables, as well as adjustments that are made to those
comparables, is an art rather than a science, for the information collected is rarely
wholly complete or perfect; judgements must be made at many points during the
process of analysis. For this reason, it is important to test the reasonableness of the
results before fnally determining appropriate transfer prices.
The test of reasonableness should be based on a fnancial analysis of the projected
results on applying the comparative information (see section 428).
425. Functional analysis and comparable information
an overview
While the process of completing a functional analysis of a business and identifying
useful information on comparables should be detailed, it is imperative always to bear
in mind the importance of the basic arms-length principle that underlies the pricing
review. For instance, it is easy to become so engrossed in the analysis of functions that
this tool of information provision becomes confused with the methods of computing a
transfer price. Functional analysis is not an alternative to searching for comparables; it
is a way to establish what sort of comparables need to be sought.
Example
Never Fail Motor Co. (NFM) is a US-based manufacturer of electric motors used in
a variety of applications, including the medical, aerospace and military industry.
Customers of NFM are manufacturers that purchase NFM products to incorporate in
their equipment and systems.
As part of its strategic business expansion, NFM acquires shareholding interest in
Never Fail Computer Co. (NFC), a manufacturer of computer products, which could
use NFM motors to create a new highly reliable computer product. Subsequent to the
acquisition, NFM sells its motors to NFC to incorporate in NFCs new product. NFM
charges NFC for the motor at a price comparable to the price of motors sold to its
unrelated customers under similar contractual arrangements.
The functional analysis establishes that both NFM and NFC are manufacturers that
develop and own signifcant non-routine intangibles and assumes entrepreneurial
risks in their operations. The analysis further indicates NFC does not purchase similar
products from unrelated parties. As a result, the sale price of products sold by NFM
to its unrelated customers should be used as a comparable transaction. However, this
transfer pricing policy results in a signifcantly lower proft on products sold to NFC.
While internal comparable transaction seems to exist based on the functional
interview, the contradicting operating results is an indication that there are differences
in the functions performed by NFM in its uncontrolled and controlled transactions.
Further analysis shows that NFM performs additional custom design services for the
motors sold to NFC. Such services are not required for products sold to unrelated
parties. Therefore, the price of products sold to NFC should refect these additional
design services functions performed by NFM.
426. Documentation
Contemporaneous documentation is crucial in order to prove to the tax authorities
that a transfer pricing policy is arms length. In other words, if a company can show
what its policy was, how it interpreted that policy and why the prices chosen satisfy the
arms-length standard, then the tax authority has little choice but to accept the policy.
Companies that have not properly documented their policies are likely to face severe
problems in the context of an intensive transfer pricing audit.
427. How to document a policy
In the past, little guidance was available on the appropriate level of documentation
needed to support a transfer pricing policy. In many countries, the fact that the burden
of proof lay largely with the tax authority gave little incentive for work in this area.
However, the US provided a lead at the start of the 1990s, culminating in regulations
that impose heavy penalties for transfer pricing adjustments unless the taxpayer
holds contemporaneous documentary evidence that it was reasonable to believe that
the policy was in fact arms length (see chapter 8 for a detailed discussion of the US
position). As more tax authorities began to take transfer pricing matters seriously, it
was recognised that documentation standards were important and new regulations
have now emerged in many countries. The OECD also devoted attention to the matter
in Chapter V of the Guidelines, which was part of the work published in 1995. As a
general guide, however, a defensible transfer pricing policy requires documentation
covering the following areas in order to demonstrate how the policy complies with the
arms-length principle:
A description of the transfer pricing methodology used to test the arms-length
nature of the inter-company transactions;
Guidelines interpreting the choice of the methodology;
Inter-company legal agreements;
Functional analysis of the entities involved;
Comparables supporting the policy;
Financial analyses of the comparables as well as the tested party; and
Industry evidence required to substantiate the decisions made.
428. Financial analyses
Thorough fnancial analyses and fnancial segmentations are crucial to the
documentation of a transfer pricing decision, because they act as compelling evidence
that the prices were set on a reasonable basis. The purpose of this exercise is to produce
an income statement that refects what the companys results would be if a particular
business line were its only business.
Construction of transfer pricing fnancial statements (proft and loss (P&L) accounts
and balance sheets) requires certain judgements to be made with respect to allocations
and other issues. First, business lines have to be grouped and the statements
constructed according to those groupings. Criteria that should be considered in
grouping business lines are:
Existing groupings (established based on industry practices, division or
department, or for management purposes);
Proftability (business lines that are big winners should be analysed separately, as
should business lines that are losing money or that are earning signifcantly lower
income than other products); and
Materiality (do not form a separate business line grouping if the income/cost
profle of the group is immaterial).
Once business line groupings have been formed, allocations of sales, general and
administrative expenses must be made to each P&L account. This should include an
allocation of R&D expenditure if, and to the extent that, such expenditure relates to the
given product grouping. The allocations should be based on a reasonable methodology.
Such a method will often be in current use, although in different contexts: for example
allocations used for fnancial reporting, tax or management purposes.
To the extent possible, the chosen allocation method should frst make direct
allocations where particular expenses can be defnitely and accurately matched to a
specifc business line. Then, indirect allocations of other expenses may be made on a
reasonable basis. (Examples of allocation bases for this purpose include sales, gross
proft, volume and headcount ratios.)
The aim of this exercise is to produce an income statement that refects what the
companys results would be if a particular business line grouping were its only business.
(One of the reasons for constructing such a statement is that when comparables
are found, the results of one line of business may be compared with the results of
independent companies that operate only that line of business.)
Similarly, balance-sheet assets should be allocated to correspond to the relevant lines
of business.
Example
Continuing with the example in section 421, income statements for Fishy US are
constructed. In 2007, sales to Fishy US are 80. Assume that Fishy USs sales to its
customers during this period are 100. The following income statement refects
thesetransactions:
Fishy Fish Fishy US Consolidated
Net Sales $80 $100 $100
Cost of sales 56 80 56
Gross income $24 $20 $44
Gross margin % 30.0% 20.0% 44.0%
Fishy Fish Fishy US Consolidated
Selling, general and administrative expenses 21 18 39
Operating income (loss) $3 $2 $5
Operating margin 3.8% 2.0% 5.0%
429. Evaluation of fnancial analyses
There are many ways to check the reasonableness of a transfer pricing policy, all of
which compare certain fnancial ratios for the related party transaction with their
counterparts in the industry in which the multinational trades. This analysis must be
tempered by knowledge of the unique characteristics of the inter-company transaction
at issue and should never become mechanical.
Financial ratios that are selected are determined by the availability of reliable data
as well as the particular facts of the transaction under review. For example, in some
situations, a review of gross margins, operating margins and proft splits would
be suffcient. In other situations, a review of return on assets (ROA) and operating
margins may be appropriate. The decision regarding which ratios to examine must be
made on a case-by-case basis, taking into consideration all the relevant facts.
Example
For Fishy US, it is determined that the appropriate fnancial ratios for evaluation
purposes are gross margin and operating income/sales.
The gross margin for the manufacturer is 30% and the gross margin for the distributor
is 20%. As previously mentioned, Fishy US is the tested party in our transaction since it
is the less complex party and does not possess valuable intangible assets. Comparable
manufacturing margins are much harder to judge, primarily because of the return on
intangible assets that they refect.
Fishy USs gross margin is 20% and other comparable distributors of similar products
in the US are found to have gross margins that range between 20% and 25%. Based on
this data, it is likely that the determination will be made that the gross margin for Fishy
US on the purchase of fnished products to Fishy Fish is not unreasonable.
The operating margin for Fishy US is 2%. This ratio may be compared with the
operating margin for comparable distributors of similar products.
430. Transfer pricing policy
A transfer pricing policy is a statement that the company is committed to the arms-
length standard for transfer pricing and should be included in the fnancial policies
of the parent company. The statement need not be detailed, but should set out the
philosophy upon which the company bases its pricing decisions.
431. Transfer pricing guidelines
Transfer pricing guidelines are detailed descriptions of the various inter-company
transactions that exist within the group, together with the methods by which transfer
prices will be determined for each of those transactions. Generally, guidelines do
not include numbers for markups, discounts or royalty rates. Instead, they say the
comparables (or whatever other means of computing the prices used) will be identifed
and prices will be determined annually (or semi-annually, or within whatever time
frame is appropriate). The guidelines, therefore, constitute the formulae by which
transfer prices will be determined, based on the nature of the companys inter-
companytransactions.
432. Inter-company agreements
Inter-company legal agreements are a method of formalising the relationship between
affliated companies and might include distribution agreements, licence agreements,
contract R&D agreements, etc. Each inter-company relationship that gives rise to a
transfer price should be documented through a legal agreement.
In certain circumstances, these agreements can be disregarded by the tax authorities in
certain countries (e.g. the US). In other countries (e.g. Germany), they are inviolable.
The agreements enable a company to state, for the record, what it intends the inter-
company relationship (characterisation of the entities) to be, and it is diffcult in any
country for the tax authority to disregard totally such agreements, especially if the
functional analysis supports the form that is documented.
433. Documentation of the functional analysis
The functional analysis, together with the characterisation of the entities, should
be documented so that it can be provided at the time of a tax audit. In addition,
memoranda that set out the functional analysis are extremely valuable to a company
that is preparing for an audit (to remind the relevant personnel of the facts) or re-
evaluating its policy.
434. Documenting the comparables
All information gathered about the comparables (e.g. fnancial statements and
functional analyses) should be retained in a useful form so that it can be referred to in
presenting explanations to the tax authorities. Updates of fnancial statements from
those comparables should be collected annually to be sure that the prices applied
continue to refect the arms-length standard. It is also important to update the search
for comparables on a regular basis (as independent companies enter or leave the
market) to ensure that the sample used for analysis remains as complete as possible.
435. Income statements
The income statements prepared as part of the analysis should be retained and updated
at least annually to show the reasonableness of the policy.
436. Industry evidence
This category is a potpourri of items that support conclusions reached, adjustments
made, etc. Whatever information is needed to be able to explain to the tax authority
what was done, why it was done and why it produces an arms-length result should be
retained and updated periodically.
437. Implementing a transfer pricing policy
Implementation is perhaps the hardest part of the determination and defence of
a transfer pricing policy. Calculating transfer prices and establishing the controls
necessary to be certain that the prices are not changed without prior notifcation can
be time-consuming.
The implementation process itself depends upon the nature of the business and the
pricing structure. But, in all cases, implementation is more likely to be successfully
achieved if employee politics and sensitivities are fully considered. In particular,
relocation of functions and adjustments to employee pay or bonus schemes (see section
623) require careful handling.
438. Monitoring the application of the policy
The arms-length standard requires that inter-company pricing must refect the
substance of transactions. As a business grows, evolves and possibly restructures, the
substance of transactions changes. Transfer prices may also have to change to remain
arms length. Monitoring the application of the policy is important so that the taxpayer
knows when facts have changed and no longer support the existing pricing structure.
Even in the absence of changes in the substance of the relationship, business cycles
can mean that prices change (going up during periods of high infation and down
during recession). Regular re-evaluation of the facts and the prices to determine that
they are, and remain, arms length, is advisable. Documentation should be prepared to
refect that this process is carried out and that appropriate conclusions are reached and
actedupon.
The policy should be examined quarterly until it is clear that it is working. After that,
semi-annual examinations are usually suffcient, unless the industry is inordinately
volatile. The evaluation should include an examination of the fnancial results realised
under the policy. That is, fnancial ratios and proft splits should be calculated and
examined to ensure the policy is producing the anticipated results. If it is not, the
reasons for this should be determined and appropriate adjustments made.
In addition, the facts should be checked. Has there been a change in the substance of
any transactions? Is one entity now performing a function that another entity originally
performed? Have risks changed or shifted? Has there been a change or innovation in
the industry that affects prices?
Finally, the implementation of the policy should be checked. Have the inter-
company agreements been put in place? Do appropriate personnel in the various
entities understand the policy? Are the inter-company charges refecting the
appropriatepricing?
439. Compensation of management
Transfer pricing to achieve tax or fnancial goals may result in levels of income in the
various legal entities that are inconsistent with the way in which management should
be compensated on the basis of performance-related pay or bonus schemes.
Typically, multinationals establish a separate transfer pricing scheme for management-
reporting purposes (not necessarily based on the arms-length standard), so that
management is encouraged to behave in a particular way in running the business and is
properly compensated when it obtains the desired results.
Specifc issues in transfer pricing
5.
76 www.pwc.com/internationaltp Specic issues in transfer pricing
MANAGEMENT SERVICES
501. Management fees introduction
The term management fee is often used rather loosely to describe any inter-company
charge for a transaction that is not clearly a transfer of tangible property or the right to
use an intangible property. In this chapter, the term is used to describe charges paid for
general administrative or technical services or payments for commercial services that
are provided intragroup from one or more providers to one or more recipients. Chapter
2 considered the types of services that might be provided between related companies.
This chapter focuses in more detail on some of the problem areas, on the methods of
determining arms-length charges for the services and the documentation needed to
support the arrangements.
502. The importance of management fees
For many years it has been recognised that multinationals fnd it necessary to provide
certain services from a central point to one or more affliates, and that for many
such services it is appropriate for a charge to be made. The central point for service
rendering is often the parent company itself, although this is by no means always the
case. It is becoming common for one affliate to provide services on a central basis to
several other affliates. Examples include company HQs located in Europe to provide
centralised marketing, management and accounting assistance to all European entities
in a non-European group. In these situations, cost-contribution (or shared-service)
arrangements can be constructed to charge the costs of the service providers to the
affliates that beneft from the services they provide.
Whatever the detailed arrangements in any particular group, it is usually relatively
diffcult to fnd a comparable price for such services or to evaluate the beneft received.
Because of this diffculty, rightly or wrongly, many tax authorities regard the area of
management fees as particularly prone to potential abuse and are therefore devoting
increasing resources to auditing such transactions, as these charges are considered
the low-hanging fruit and support for them is often lax. At the same time, the
increasingly competitive global marketplace is demanding greater effciency from
multinational businesses. They must take every opportunity to minimise costs down,
so there is an ever-greater need to arrange for the centralisation of business functions
where possible.
International Transfer Pricing 2011 Specic issues in transfer pricing 77
It is important to understand that centralisation does not necessarily mean that the
functions are all grouped together in one location. It may be the case that specialised
departments are spread throughout the group in what are commonly called Centres
of Excellence, depending on the particular needs of the group and the location
of its resources. If the group wishes to avoid serious double taxation problems, it
is of paramount importance that it operates a tightly controlled management-fee
programme, aiming at the funding of central resources and allocating expenses to the
correct companies, ensuring that tax deductions are obtained for these costs.
503. The tax treatment of management fees an overview
The world can be divided broadly into two camps regarding the tax treatment of
management fees. The developed nations have adopted laws and regulations dealing
with inter-company services, which accept the deductibility of inter-company charges
as long as they comply with the general requirements of the national tax code and with
the arms-length principle. The rest of the world typically does not recognise these
types of inter-company charges and refuses deductibility for tax purposes. Included in
this category are authorities (e.g. some South American jurisdictions) that offer limited
deductions but place restrictions on remittances of funds through foreign-exchange
controls and withholding taxes. These limitations often create a more effective barrier
to establishing service arrangements than anything else.
504. Management fees in the developed world
Before any meaningful structure can be devised for a management-fee arrangement, it
is vital to establish the following:
The exact nature of the services that are to be performed;
Which entities are to render the services;
Which entities are to receive the services; and
What costs are involved in providing the services.
Once these facts are known, consideration can be given to selecting the basis
for charging the recipient group companies. The fee structure and the general
circumstances of the arrangement should be recorded in documentation evidencing
the arrangements between provider and recipient (this might take the form of a
bilateral or multilateral service arrangement). Such documentation should include,
in addition to a written agreement, suffcient evidence of costs involved and services
actually rendered. The documentary evidence required by tax authorities varies from
territory to territory, and it may be necessary to provide timesheets, detailed invoices
and/or other detailed worksheets or evidence of costs incurred. Recently, multinational
groups are fnding that even having the aforementioned documentation may not be
suffcient to ward off a potential adjustment or disallowance of a deduction in the
recipient jurisdiction. Often, the recipients are required to prove that beneft is derived
from the services received and that such benefts are of a more than just remote or
indirect beneft. As a result, depending on the facts and circumstances, it may be
imperative for the multinational group to maintain more than just the documentation
referenced above, but also documentation of the facts and circumstances of the service
arrangement and the benefts received.
Specic issues in transfer pricing 78 www.pwc.com/internationaltp
505. Dealing with shareholder costs
Central services include services provided to:
One or more specifc companies (perhaps including the parent company) for the
specifc purposes of their trading activities (e.g. marketing advice;)
A range of companies (perhaps including the parent) for the general beneft of their
businesses (e.g. accounting services);
The parent company, in its capacity as shareholder of one or more subsidiaries.
The costs in the last category are generally known as shareholder costs. They are
the responsibility of the parent company and should not be borne by other group
members. If incurred by the parent, the cost should remain with the parent. If
incurred elsewhere, the expense should be recharged to the parent, possibly at a
markup. Once costs for shareholder functions have been dealt with, it is necessary
to consider charging for other services. Recent developments in the US (i.e. the
Temporary and Proposed Service Regulations) have put a renewed emphasis on
the evaluation of inter-company service transactions dealing with myriad issues in
this area. Of the many services considered, these new regulations have redefned
or narrowed the defnition of shareholder expenses to those expenses that solely
beneft the parent company. The focus of the new US regulations were to be more
consistent with the OECD Guidelines; however, the new defnition in the context
of shareholder expenses may prove problematic because of its restrictiveness. This
creates a new aspect that multinationals (particularly US-based companies) must
now consider, as the potential for challenges of deductibility for non-shareholder
costs may be initiated by the provider country (see chapter 71).
506. Analysing the services
The correct allocation of shareholder costs should be the frst step in determining inter-
company service fees. The next step is to identify the specifc additional services that
are provided. This is most easily done through a process of functional analysis, which is
described in chapter 4.
As a result of interviews with operating personnel, it will be possible to identify specifc
services that are provided to related parties as well as the companies that provide those
services. At the same time, care must be taken to identify the nature of the benefts
received by the recipient. Where a direct relationship exists between the rendering of a
service and the receipt of beneft, it should normally be possible to charge a fee for the
service and obtain a deduction in the paying company.
Example
EasternMed (EM), a US company, operates a worldwide network of distribution
companies that sell alternative nutritional supplements. The nutritional supplements
are manufactured in the US by EM (or by vendors for EM) and sold to each non-US
location for further resale to the local customer base. EM has operations throughout
the Western European countries, Canada, the AustraliaAsia region and Bermuda.
EM has engaged external advisers to assist in determining inter-company charges
for services rendered by the parent company to its subsidiaries. The study on inter-
company charges was jointly commissioned by the parent company and the subsidiary
to provide assurances regarding appropriate inter-company service fees, which would
be deductible to each of the subsidiaries and acceptable from EMs viewpoint in the US.
As a result of the functional analysis performed, the following services were identifed:
Accounting assistance to the subsidiaries by the parent to assist them in keeping
their local accounts;
Management of the groups internal IT system, which the group members use to
track its customer accounts;
Marketing assistance in the form of recommendations for advertisements and
promotional campaigns; and
Provision of marketing assistance in the form of sales brochures that have been
localised to the local customer base and used by the foreign affliates in their
distribution operations.
After discussions with each of the subsidiaries, it was determined that:
Bermuda is a tax haven, and the Bermudan government does not care how much
the parent extracts from the Bermudan subsidiary in the form of management
fees; in contrast, the tax authorities dealing with other EM subsidiaries require
satisfaction that any service charges are computed on an arms-length basis.
All subsidiaries agreed that the accounting assistance was extremely helpful
in establishing an accounting framework for their businesses. The cost of the
accounting assistance can therefore be charged to all affliates.
No subsidiary located outside the US uses any aspect of the advertising and
promotion information provided by EM because it applies only to the US market,
which is signifcantly different from the markets in the rest of the world. None of
the costs of the advertising and promotion information can therefore be charged.
The costs associated with the sales brochures are actually used by each subsidiary
in its sales efforts and therefore a charge is appropriate for these costs.
The cost of the transfer pricing study can be spread between the affliates as part of
the cost base of the services covered by the management fee.
The remaining matters to be considered are whether a markup can be applied and
whether it makes sense to make a charge to Bermuda, given that no effective tax relief
will be obtained.
The preferred method for the determination of inter-company charges is generally
the comparable uncontrolled price (CUP) method. In other words, if the provider of
the service is in the business of providing similar services to unrelated parties, or if
the service is also obtained from third parties, then the arms-length charge is that
which the third party would pay/charge. Typically, a CUP is not available in respect
of management services because of the unique nature of the services provided within
agroup.
The reports of the OECD (see section 301) state that there may be circumstances
in which comparable data may be available, for example where a multinational
establishes its own banking, insurance, legal or fnancial services operations. Even
here, however, great care is needed in comparing group activity with third-party
businesses. Third parties face the challenge of the real market, whereas group
companies are often forced to buy the internal services when available. A group
insurance company deals with the risks of one business only, rather than a multitude
of different customers. These examples merely illustrate that comparables are hard to
fnd for group service activities, even where similar services appear to be offered by
thirdparties.
507. The cost base for service charges
Where services are rendered for which no fee can be established under the CUP
method, the cost-plus method is typically applied to arrive at an arms-length service
fee. This requires an analysis of the costs incurred in providing the services.
Since the services are rendered to several companies in the group, the costs involved
must be charged to the various benefciaries on a pro rata basis. Therefore, the
aggregate amount of costs that the service unit incurs in providing the services must
be allocated to the recipient companies in accordance with an acceptable allocation
key. Costs of a central personnel department may be allocated, for example, by the
time spent on assisting each subsidiary. When the central services are more general
in nature, allocation by reference to a relative headcount of each company may
beappropriate.
Allocation keys need to be responsive to the nature of the costs to be divided; other
keys that may be appropriate are relative capital employed, turnover and number of
users (in the context of IT systems).
508. The cost-accounting method
The costs actually incurred in providing the services are ascertained by using an
acceptable cost-accounting system. National tax laws and regulations do not generally
prescribe a particular cost-accounting method, but leave it to the individual group of
companies to determine which cost-accounting method is most suitable for them in the
specifc circumstances, provided that the chosen cost-accounting method is generally
acceptable and consistently applied.
509. The computation on a full-cost basis
Since the charge determined under the cost-plus method ought to refect all relevant
costs, the aggregate amount of service costs must include direct and indirect costs. It is
not acceptable, under generally accepted practice, for costs to be computed on the basis
of incremental cost only.
Direct costs to be considered are those identifable with the particular service,
including for example, costs attributable to employees directly engaged in performing
such services and expenses for material and supplies directly consumed in rendering
such services. Indirect costs are defned as those that cannot be identifed as incurred
in relation to a particular activity but which, nevertheless, are related to the direct
costs. As a result, indirect costs include expenses incurred to provide heating, lighting,
telephones, etc. to defray the expenses of occupancy and those of supervisory and
clerical activities as well as other overhead burdens of the department incurring the
direct costs.
Although it may often be diffcult in practice to determine the indirect costs actually
related to a particular service, the supplier of the service is normally expected to charge
the full cost. Therefore, an apportionment of the total indirect costs of the supplier on
some reasonable basis would be accepted in most countries.
The US Temporary and Proposed Service Regulations, effective for tax years
commencing after 31 December 2006, require the inclusion of stock-based
compensation in the costs associated with a particular service. This change has proven
controversial, as third-party dealings typically do not include such costs in their
service cost base nor does stock-based compensation ever enter into consideration in
third-party negotiations. Nevertheless, the inclusion of stock-based compensation is
part of the new regulations and hence companies should consider the impact of these
regulations on their inter-company service transactions. There will undoubtedly be
controversy related to this issue in the recipient jurisdictions as US multinationals are
forced to comply with these new rules, especially in those jurisdictions where stock-
based compensation is nondeductible, or if deductible, subject to stringent policies in
non-US jurisdictions (see chapter 71).
510. When should a proft margin be added to cost?
The question arises as to whether a proft markup should be added to the costs in
calculating a service charge. Nearly all tax authorities expect a group service company
to render charges to affliated enterprises in accordance with the cost-plus method
and therefore to add a proft markup to the allocable cost. On the other hand, double
taxation is avoided only if the tax authorities of the country in which the recipient
company is resident allow a deduction, and not all countries accept the markup
element of the charge as deductible.
In an arms-length situation, an independent enterprise would normally charge for
its services to third parties in such a way as to recover not only its costs but also an
element of proft. Consequently, any enterprise that is engaged solely in the business
of providing such services should seek to make a proft. This is particularly true in the
following three situations:
1. Where the service companys only business activity is rendering services;
2. Where service costs are a material element in the cost structure of the service
provider; and
3. Where the service costs represent a material part of the cost structure of the
servicerecipient.
Most tax authorities in developed countries accept these conditions as relevant in
reviewing the application of a markup to service costs. However, a more formalised
approach is taken in certain instances, particularly in the US. As noted in chapter 71
of this book, the US temporary regulations on services require the addition of proft
margin to the intragroup charge for services rendered where the services provided
are not considered low-margin services or the median arms-length markup for such
services exceeds 7%.
When it is appropriate to include a proft element on service charges, arms-length
markups are determined by reference to comparables where possible. Once the service
is identifed, the cost of providing the service is determined and comparables are
sought to determine the arms-length markup for those costs. In practice, many tax
authorities expect to see certain levels of proft margin as the norm, typically between
5% and 10% of costs for most support services. However, as global competition gears
up, companies should take care to ensure that the higher historical norms are not
allowed to prevail in inappropriate circumstances, or the internal service provider may
prove to be a cost-creating mechanism rather than a vehicle to enhance effciency.
Furthermore, great care must be taken in deciding which costs should be marked
up. It is the service function for which a charge is being made. If the service provider
incurs third-party expense (for instance arranging for advertising space to be made
available for its client), then it may well be correct to evaluate the advertising costs as
an expense reimbursement (covering disbursements, fnancing and handling charges).
It will invoice for the service of arranging it (labour, phone, offce costs, etc.) on a cost-
plus basis. The total costs recharged would be the same, but the proft recognised in the
service provider would differ signifcantly.
511. The determination of an arms-length service charge
The following example sets out how an arms-length service charge might
bedetermined.
Example
Continuing the example in section 506, it has been determined that three services have
been provided for, which it is appropriate to make inter-company charges:
Assistance with the determination of arms-length service fees;
Provision of marketing assistance in the form of sales brochures; and
Accounting assistance.
The next step is to determine the fully loaded cost of providing those services. The
costs of providing transfer pricing assistance consist of the external advisers fee plus
the costs of the companys tax department personnel involved in the study. The cost of
providing tax personnel and the accounting assistance can be determined by reference
to the amount of time the relevant individuals have spent in providing the services
and the departmental costs in terms of salaries and overhead expenses. Once the time
devoted to the pricing study has been identifed, this can be expressed as a percentage
of the total resources used by the relevant department during the year. Looking at
the accounting support, for example, suppose one person was involved and spent
50% of the year on the project. There are three people in the accounting department.
Therefore, the cost of providing the service is one-half of the affected persons salary
and benefts plus one-sixth of the overhead expenses of the accounting department.
If we assume that a markup is deductible in each of the countries to which charges
should be made, comparables must be identifed for tax consulting (for the service
fee project) and for accounting assistance. An obvious comparable is the markup the
external adviser earned on the project. However, this information may not be publicly
available, so other benchmarks must be used. Likewise, for accounting assistance,
companies that provide accounting services and for which publicly available fnancial
information exists may be identifed. Once this is known, the inter-company charge can
be determined. In practice this process may not be necessary, as many tax authorities
accept that a margin of 5% to 10% on cost is prima facie acceptable. Nevertheless,
a properly recorded and documented margin always offers a stronger position. For
charges relating to the creation and printing of the sales brochures, one could allocate
the departmental costs involved in the developing the brochures as well as any external
printing costs. The charges could be allocated on the relative basis of brochures
shipped or other allocation keys deemed more appropriate.
512. Documentation
Documentation in the area of management fees is every bit as important as in the case
of the sale of inventory or the transfer of intangibles. At a minimum, it is necessary to
provide documentation regarding the services that are provided, the costs of rendering
those services and support for the appropriateness of any markup. It is imperative to
have an inter-company agreement that sets out the circumstances under which services
will be provided as well as the charges that will be made.
The support that might be needed to document each of these types of items could
include the following:
A written description of the different services provided, summarising the type
(specialist skills, seniority, etc.) and number of employees involved, any reports or
other end products of the services, and a statement of the aims of the services (to
save costs, increase sales, etc.);
A full analysis of the cost base, including explanations of allocation formulae,
how they apply and why they are appropriate; a detailed list of the expenses to
be allocated (salaries, overhead expenses, etc.); and invoices from other entities
where they substantiate expenses suffered;
A detailed computation of the amount of each invoice submitted to the recipient
entities it should be possible for a computer to produce this relatively easily once
the cost base and allocation formulae have been established; and
A justifcation of the markup applied referring to comparables or market practice.
In a Canadian case, the court gave detailed consideration to the subject of
documentation of management fees and concluded that the following items of
evidence would be of key signifcance:
Evidence of bargaining between the parties in respect of the amount to refute
any inference that the taxpayer passively acquiesced to the charge;
Working papers supporting the expenses charged;
Details explaining how the charges were calculated, including support for
the apportionment of employee work performed or other expenses such as
allocations of rental costs;
A written agreement for the management charge; and
Evidence that the expenses relate to the period of charge rather than a
priorperiod.
The above comments are based on a 1991 case that predates the detailed OECD
Guidelines chapter on Intra-Group Services. Today, most tax authorities expectations
are likely to mirror the OECD Guidelines.
Contract services and shared service centres
Multinationals are increasingly looking for ways to achieve effciency to improve their
competitive position in the global marketplace. The traditional model for expansion,
whereby the parent sets up one or more new companies for each new country of
operation, has been successful in a number of ways. However, it has also encouraged
bureaucratic and territorial approaches to business, which carries with it signifcant
hidden costs. For instance, does each company really need its own personnel director,
marketing director, fnance department, inventory warehouse and buffer stocks,
etc. or can these functions be fulflled from a central point? With respect to strategic
approaches to the market, the parent will want to encourage a global market view,
while the old country company model tends to narrow horizons to a very local level.
All these pressures and others are driving the creation of shared service centres which
fulfl a wide variety of support functions for companies in many countries.
Another way in which multinationals are seeking to improve is through building on
best-in-class techniques. If one of their operations appears to be particularly skilful in
performing an activity, perhaps this entity should provide this service to others, rather
than allow the latter to continue to operate at less than optimal standards.
Finally, the search for access to the best resources for a task at the lowest price is
leading to the creation of contract research and development (R&D) centres and
contract manufacturing activities. The idea here is that the multinational can tap into
what it requires without impacting its strategy for managing intellectual property or
manufacturing, while tightly controlling the costs. The best-known example of contract
R&D comes from the US case, Westreco, in which the Swiss group Nestl was involved.
Nestl wanted to conduct research into the US market in order to design successful
products for that market. If this research had been fnanced by Nestls US operation,
any intangibles created would have belonged in the US and subsequent profts derived
would have been taxable there. Instead, Nestl established a contract research
operation that sold its services to the Swiss operation, which thereby owned the
resultant intangibles. Subsequent exploitation by way of licence was therefore possible.
The key to the establishment of a successful contract R&D activity (or contract
manufacturing operation, which is a similar concept) is to draw up a service agreement
that sets out clearly the activities required to be performed, service quality standard,
timelines, etc. The service providers remuneration should be set by reference to
appropriate comparables and is typically a cost-plus approach. Capital risk is a
particularly important area to monitor, however. If the service provider needs to make
signifcant investment in order to fulfl the contract, will the purchaser cover the
fnancing costs and risk of disposal at this end of the contract? This question can be
answered in many ways, but the answer will materially affect the proft, which it will
be appropriate for the service provider to earn. As usual, risk should be compensated
by the prospect of future reward.
TRANSFER OF INTANGIBLE PROPERTY
513. Transfer of intangibles introduction
Generally, intangible assets can be transferred between related parties in three ways:
contribution to capital, sale or licence. In addition, the parties may have agreed to
share the costs and risks of the development of an intangible through a cost-sharing
arrangement or otherwise referred to in the OECD Guidelines as a cost-contribution
arrangement.
514. Sale for consideration
When intangibles are sold, tax laws in most countries require that the developer/owner
receive the fair market value of the intangible at the time of transfer. The geographic
rights to the property that is sold can be broad or narrow. For example, the developer
may sell the North American rights to the property. Alternatively, the developer may
sell the worldwide rights for uses other than for the use that it wishes to keep for itself.
For example, in the pharmaceutical industry, the developer may keep the rights for
human use while selling the rights for animal use.
Once the sale has taken place, the party that purchased the intangible is the legal
owner of the property and is entitled to receive any third-party or related-party
royalties that accrue to the property. The owner also has the right to sublicence or
dispose of the property.
515. Licence
The typical method of transferring intangible rights between related parties is through
the use of an exclusive or a non-exclusive licence agreement. When a licence is used,
the developer continues to own the property and can dispose of it as she/he see ft.
The rights given to the licensee may vary. In general, the licence is evidenced by a
document specifying the terms of the licence. The key terms of a licence are likely to
The geographic rights the licensee is granted;
The length of time for which the licensee may use the property;
The uses to which the licensee may put the property;
The exclusivity of the licence (i.e. exclusive or non-exclusive and the basis of
exclusivity);
The amount and type of technical assistance that the licensee may receive from the
licensor (together with fees for assistance above that which is provided as part of
the licence);
The royalty rate, method of computing the royalties and the timing of
payments;and
Whether the licensee has sublicensing rights.
It is important that licence arrangements be committed to writing. It should also be
noted that several of the points listed above play a signifcant role in the determination
of the royalty rate. For example, an exclusive licence typically carries a royalty rate
signifcantly higher than a non-exclusive licence. Broader geographic rights may result
in a higher royalty rate, although this is not always the case.
516. Determination of arms-length royalty rates
Determining the proper compensation due to the developer/owner of intangible
property can be diffcult. In setting an arms-length royalty rate it is important to
distinguish, as precisely as possible, what property is to be licensed. Once the property
is identifed, the rights granted to the licensee and their relative value is determined.
The property may be an ordinary intangible in that it provides some, though not
complete, protection from competitors (this type of intangible is sometimes referred to
as a typical or a routine intangible). Alternatively, it may constitute a super-intangible,
which effectively gives the licensee a monopoly or near-monopoly over the market
in question. There is no difference in the approach to setting an arms-length royalty,
however. The concept of super-intangibles is mentioned here for completeness only.
It arose following the 1986 Tax Reform Act in the US. One of the key issues included
was a requirement that the licence income to be enjoyed by a licensor in the US from
an overseas affliate should be commensurate with the income associated with the
intangible. There was concern that insuffcient royalty income was being derived from
US intangibles that proved to be valuable after being licensed overseas. There was
considerable concern outside the US that excessive use has to be made of hindsight in
this area.
The optimal method for determining an arms-length royalty is to refer to licences
between unrelated parties under which identical property has been transferred. Such
licences can be identifed where the developer has licensed a third party to use the
technology under terms identical or similar to those granted to the related party, or
where the inter-company licensor has received the technology from a third party. If
such a licence agreement is identifed, adjustments can be made for differences in
terms in order to determine an inter-company, arms-length royalty rate.
Example
Abbra Cadabbra AG (ACAG), a German company, has developed a method of removing
grass stains from clothing, which does not also remove the colour from the cloth. It
has obtained a patent on its invention and is manufacturing the product for sale in
the German market. It has recently decided to establish a manufacturing affliate in
Ireland, where it will beneft from a favourable low-tax regime for the earnings of the
Irish subsidiary.
The Irish subsidiary will manufacture the product for resale throughout Europe.
ACAG wishes to maximise the income that it places in Ireland. Therefore, it is taking
all steps necessary to ensure that the Irish subsidiary is a full-fedged manufacturer.
To this end, it has decided to licence the patent and related technical know-how to the
Irishsubsidiary.
It will grant the Irish subsidiary an exclusive licence to make, use and sell the product
in all European markets. A written agreement is drawn up containing all the relevant
terms. The remaining issue is to determine an arms-length royalty.
Assume that ACAG licensed ZapAway Inc., an independent US company, to make,
use and sell the product in North America. The technology provided to ZapAway
is identical to the technology licensed to ACAGs Irish subsidiary. Both licences are
granted for the life of the patent and both provide for 20 workdays of technical
assistance in implementing the technology. The only signifcant difference between
the two licence agreements is that the third-party licence gives the licensee the rights
within North America and the related-party licence grants the licensee the rights to
European markets.
The question that must be addressed is whether the North American and European
markets are economically similar so that the royalty rate applied to the North American
licence would be expected to be the same as the royalty rate for the European licence.
The economics of the two markets must be examined in order to answer this question.
In general, if the differences are small, then the third-party licence should form the
basis for the related-party royalty rate. If signifcant differences exist, adjustments can
be made to account for them so long as they can be valued. The underlying question
here, of course, is that both licensor and licensee, at arms length, give thought to
the proft potential of the intangible when arguing a royalty rate. If markets are
different from one another, potential investment returns will also differ and hence the
acceptable royalty rate.
517. Determining an arms-length royalty rate in the absence
of perfect comparables
If a perfect comparable does not exist (a common occurrence), then licence
agreements between unrelated parties for economically similar technology may be
used to determine the appropriate inter-company royalty rate. Typically, this is done by
reference to third-party licences within the industry.
Example
Assume that the ZapAway agreement (see section 516) does not exist (i.e. ACAG does
not licence the property to any third party). However, another competitor licences a
similar product (another grass stain remover) to a third party. This licence agreement
is subjected to the same analysis discussed in section 516. If the differences do not
affect the royalty rate or can be valued, then this third-party licence arrangement can
be used as a basis for the determination of the arms-length royalty between ACAG and
its Irish subsidiary.
In a situation where no comparables exist, it is possible to impute a royalty rate by
reference to the factors that unrelated parties would consider in negotiating royalty
rates. For example:
The expected profts attributable to the technology;
The cost of developing the technology;
The degree of protection provided under the terms of the licence as well as the
length of time the protection is expected to exist;
The terms of the transfer, including limitations on geographic area covered; and
The uniqueness of the property.
518. Super-intangibles
Super-intangibles are those that give the owner a monopoly or a near-monopoly in
its product class for a signifcant period of time. It is unlikely, due to their nature,
that close comparables exist for these intangibles. However, occasionally a developer
may not wish to market the product resulting from an invention (or does not have the
capital required to exploit the invention) and chooses to licence it to a third party. Even
in the case of super-intangibles, a comparables search should be completed to ascertain
whether comparables exist.
519. Valuation of royalty rates for super-intangibles
In the absence of comparables, the determination of arms-length royalty rates is
extremely diffcult. Chapter VI of the OECD report reviews the important issues on
intangibles, but recognises the great diffculty in determining arms-length pricing for
an intangible transaction when the valuation is very uncertain, as is usually the case
at the outset of a business venture. The OECD urges companies and tax authorities
to give careful attention to what might have happened at arms length, all the other
circumstances being the same. Consequently, parties might opt for relatively short-
term licence arrangements or variable licence rates depending on success, where
future benefts cannot be determined at the start. This commentary is essentially
highlighting the dilemma shared by companies and tax authorities in this area; neither
can foresee the future. Companies wish to take a decision and move forward, while
tax authorities usually must consider, in arrears, whether such decisions represent
arms-length arrangements. Tax authorities should not use hindsight. Equally, it is
often diffcult for companies to demonstrate that they devoted as much effort in trying
to look forward when setting the royalty rate, as they might have done at arms length.
Where particularly valuable intangibles are involved, or tax havens are in the structure,
a residual income approach may be adopted by the tax auditor in the absence of other
evidence. This avoids a direct valuation of the royalty but determines the value of the
other elements of a transaction (e.g. the manufacturing of the product) and calculates
a royalty based on the total income accruing as a result of the transaction less the cost
of these other elements, so that the residue of income falls to be remitted as a royalty.
Example
Clipco Inc. (CI), a US company, is a manufacturer of shaving equipment. It has recently
developed a new razor that is guaranteed never to cut, nick or scrape the skin of its
users. Its success is tied to a microprocessor, contained in the blade, which signals the
blade to cut or not cut, depending on whether the substance it senses is hair or skin.
Clipco has been granted a patent on this device and is currently marketing the razor in
the US where it has obtained a 90% market share.
Clipco has established an Irish subsidiary to manufacture the razors for the European
market. Clipco (Ireland) (CIre) will manufacture the razors and sell to third-party
distributors, which the parent company is currently supplying.
The issue is the proper royalty rate to be set for the use of the patented technology and
related technical know-how that the parent company provides to CIre. The functional
analysis is summarised in Table 5.1.
Table 5.1 Functional analysis
US PARENT
Functions Risks Intangibles
Research and development
Marketing (on royalty)
Technical assistance
Foreign exchange (on royalty)
Trademark
Patent
Unpatented know-how
IRISH SUBSIDIARY
Functions Risks Intangibles
Manufacturing Warranty
Obsolete products
None
In this simplifed example, the Irish subsidiary is a manufacturer, nothing more
(perhaps a contract manufacturer, although the risk pattern is inconsistent with that
conclusion). The US method of determining the royalty rate in these circumstances
may be to fnd comparables for the value of the manufacturing activity (usually on a
cost-plus basis). All remaining income, after compensating the Irish subsidiary for its
manufacturing activity, is as a royalty for the use of the technology.
This method usually overstates the return on the base technology by including all
intangible income except for the intangible income that is specifcally allowed to
the manufacturing company. Hence, this valuation method is one that the typical
company will seek to avoid when its manufacturing operations are located in a low-tax
jurisdiction. It may, however, be useful when manufacturing in high-tax jurisdictions.
COST-SHARING
520. Cost-sharing introduction
In 1979, the OECD published a paper on transfer pricing and multinational enterprises.
This document included a discussion of the experience of multinational enterprises
in establishing and operating cost-contribution arrangements for R&D expenditure.
The OECD summarised its knowledge of these arrangements and the experiences
multinational companies have undergone in handling cost-sharing arrangements
(which are referred to as cost-contribution arrangements (CCAs)) with tax authorities
around the world. The OECD commentary has been widely regarded as best practice
by many tax authorities and the comments in that paper, to a large extent, remain valid
today. There are, however, differences beginning to develop in practice, particularly
in the US, as tax authorities obtain more experience of the operation of cost-sharing
arrangements and become more sophisticated in dealing with multinational
corporations. For its part, the OECD issued Chapter VIII of its Transfer Pricing
Guidelines, which governs the tax treatment and other transfer pricing issues related
to CCAs entered into by controlled taxpayers. The guidelines set out in Chapter VIII
are essentially the same as draft guidelines the OECD originally proposed in 1994. The
primary principle surrounding the OECDs determination of whether a cost allocation
under a CCA is consistent with the arms-length principle is whether the allocation of
costs among the CCA participants is consistent with the parties proportionate share of
the overall expected benefts to be received under the CCA.
Cost-sharing is based on the idea that a group of companies may gather together and
share the expenditure involved in researching and developing new technologies or
know-how. By sharing the costs, each participant in the arrangement obtains rights
to all the R&D, although it funds only a small part of the expense. As soon as a viable
commercial opportunity arises from the R&D, all contributors to the cost-sharing
arrangement are free to exploit it as they see ft, subject to any constraints laid down by
the agreement (see sections 522 and 523). Such constraints typically include territorial
restrictions on each participant regarding sales to customers.
Cost-sharing is an inherently simple concept, enabling R&D expenditure to be
funded on an equitable basis by a range of participants. However, there are many
complex issues, both in accounting and tax terms, which arise in practice from
the establishment of a cost-sharing arrangement between companies under
commoncontrol.
521. Advantages of cost-sharing
Cost-sharing may offer several advantages to the licensing of intangible property.
First, it may obviate the need to determine an arms-length royalty rate. If the parties
have participated in the development of an intangible, they own it for the purpose of
earning the income generated by it, and no royalties need be paid if the intangible is
exploited under the terms of the CCA. Such cost-sharing arrangements eliminate the
necessity of a royalty payment for the use of intangible property that would otherwise
be owned by another party.
Second, cost-sharing is a means of fnancing the R&D effort of a corporation. For
example, assume that the R&D activity has historically been carried out by the
parent company and it is anticipated that this will continue. Further, assume that
the parent company is losing money in its home market but the group is proftable
in other locations. This means that the parent may fnd it diffcult to fund the R&D
activity solely from the cash generated by its own business. Cost-sharing is a means of
using the subsidiaries funds to fnance the R&D activity. The corollary of this is that
ownership of intangibles will be shared with the subsidiaries rather than the parent
companyalone.
522. Cost-sharing arrangements
A valid cost-sharing arrangement between members of a group of companies involves
a mutual written agreement, signed in advance of the commencement of the research
in question, to share the costs and the risks of R&D to be undertaken under mutual
direction and for mutual beneft. Each participant bears an agreed share of the
costs and risks and is entitled, in return, to an appropriate share of any resulting
futurebenefts.
Cost-sharing arrangements of this nature are not unknown between companies that are
not related, and in many respects resemble joint venture activities or partnerships. As a
result, there is a prima facie indication that they are likely to be acceptable in principle
to the majority of tax authorities.
All participants in a cost-sharing arrangement must be involved in the decision-
making process regarding the levels of expenditure to be incurred in R&D, the nature
of the R&D to be conducted and the action to be taken in the event that proves
abortive. Members also need to be involved in determining the action to be taken to
exploit successful R&D. Their prima facie right to beneft from the R&D activity can
be exploited through their own commercialisation of products or through selling
or licensing the R&D results to third parties within their specifed rights (typically
territories) under the terms of the CCA. Typically, any income received from third-
party arrangements would be deducted from the R&D costs before allocation of the net
R&D costs among the signatories to the cost-sharing agreements.
523. Cost-sharing agreements
Because cost-sharing is a method of sharing the costs and risks of the development
of intangibles, the key to cost-sharing is that the agreement exists prior to the
development of the intangibles so that all parties share the risk of development (i.e.
cost-sharing is a method of funding the development process). Each participant in the
cost-sharing arrangement must bear its share of the costs and risks, and in return will
own whatever results from the arrangement. For a description of cost-sharing after the
development of the intangible has already begun, see section 529, Establishing cost-
sharing arrangements in mid-stream.
524. Allocation of costs among participants
The strongest theoretical basis for allocating R&D expense among members of a
cost-sharing arrangement is by reference to the actual benefts they derive from that
arrangement. However, not all R&D expenditure gives rise to successful products for
exploitation, and there must be a mechanism to deal with abortive expenditure as
well as successful expenditure. Because of this, arrangements usually try to allocate
expenditure by reference to the expected benefts to be derived from the R&D. Such a
method of allocation is necessarily complicated to devise and, in practice, considerable
regard is given to the relative sales of each participant. Hybrid arrangements are also
used from time to time, whereby current sales or other relevant business ratios are
used for determining the expense allocation and hindsight adjustments are made
where the original allocation proves to be inequitable.
Whenever R&D gives rise to intangible property that can be patented, all members of
the cost-sharing arrangements have rights to it. The fact that it may be registered with
one member of the cost-sharing arrangement does not give any priority to that member
in the exploitation of the intellectual property. In effect, the registered holder is acting
in a trustee capacity for the beneft of the cost-sharers as a group.
Although most tax authorities prefer to follow the general tests previously propounded
by the OECD and now embodied in Chapter VIII of the OECD Guidelines, some tax
authorities have special rules for dealing with cost-sharing arrangements. The National
Peoples Congress of China recently passed the Corporate Income Tax (CIT) Law which
will become effective 1 January 2008, and under Article 41 includes legal framework
supporting CCAs and provides clarifcation for a number of issues. In March 2006,
Japan for the frst time released guidelines on CCAs that provide a defnition and
guidance on the administration of CCAs, the treatment of pre-existing intangibles and
appropriate documentation. Also, Australia issued Taxation Ruling 2004/1, which
accepts and builds upon the views in Chapter VIII of the OECD Guidelines in the
context of the relevant provisions of the Australian income tax law.
The most notable exception from following the OECD Guidelines is the US. The
US issued fnal cost-sharing regulations in 1995 (the 1995 US fnal cost-sharing
regulations), proposed regulations in 2005 (the 2005 US proposed cost-sharing
regulations), and most recently in 2008 (the 2008 US temporary cost-sharing
regulations). Where authorities do have rules, such as the US rules on cost-sharing
arrangements, there is a growing tendency for the rules to be complex and restrictive.
Furthermore, prior to the issue of Chapter VIII of the OECD Guidelines, there was
some variation between different taxing authorities as to whether proft margins are
acceptable within cost-sharing arrangements. As noted above, Chapter VIII of the
Guidelines now focuses upon whether the allocation of costs among the participants
refects the relative benefts inuring to the parties. This point can be illustrated by
considering a cost-sharing arrangement.
Example
A, B and C decide to work together and spend up to an agreed amount in trying
to design the worlds greatest mousetrap. If successful, A will have rights to the
intangibles in the Americas, B in Europe and C in the rest of the world. In practice, C
is prepared to do most of the work involved, charging A and B their allocations of the
amounts to be cost-shared.
In this situation, there is no joint sharing of cost, risk and beneft, and therefore no
cost-sharing arrangement (or, technically, a CCA) under Chapter VIII of the Guidelines.
Rather, C will incur most of the costs and risks, and hence, the benefts. Under Chapter
VIII of the Guidelines, in order to satisfy the arms-length standard, the allocation of
costs to A and B would have to be consistent with their interests in the arrangement
(i.e. their expected benefts) and the results of the activity. Under these facts, the
arrangement with C for the provision of services would be evaluated for transfer
pricing purposes from the standpoint that C will incur most of the costs, risk and
benefts. Additionally, C would be the developer for purposes of the intangible property
provisions of the Guidelines.
525. Deductibility of cost-sharing payments
As noted in section 522, cost-sharing arrangements may be entered into by third
parties, and it follows, therefore, that similar arrangements should be regarded as,
prima facie arms length where entered into by related companies. However, a key
issue as far as each taxation authority is concerned, is whether the net costs borne by
the entity under their jurisdiction are deductible for tax purposes on a revenue basis.
To determine the deductibility of these costs, there will need to be reference to the tax
treatment of specifc types of expenditure under local law and practice. As a result, it
will be decided whether the costs incurred qualify as a revenue deduction or whether
they should, for example, be treated as capital (in whole or part) and therefore subject
to different rules.
The more fundamental question, however, is whether the proportion of cost allocated
to the company under review is reasonable. This necessarily requires a review of the
total cost-sharing arrangement. It is not uncommon for a tax authority to require a
detailed examination of the cost-sharing arrangement at group level and not just at the
level of the company they are looking at. Consequently, they will need to see the cost-
sharing agreement in writing and be convinced that it was entered into in advance and
that the basis on which costs are allocated is reasonable. They will require convincing
that the costs being accumulated are in accordance with the agreement and do not
include costs not covered by the agreement. They will wish to see that the company
they are auditing has a reasonable expectation that proportionate benefts will accrue
from the cost-sharing payments.
It is clear, therefore, that a multinational enterprise must expect to make a
considerable level of disclosure on a wide geographical basis if it proposes to enter into
and successfully defend a cost-sharing arrangement. Hence, it is of crucial importance
that any cost-sharing policy be fully documented and its implementation and operation
carefully managed and controlled.
The greatest problems with tax authorities are experienced, in practice, where R&D
is relatively long-term in nature or where there are signifcant levels of abortive
expenditure. The tax authorities always have the beneft of working with hindsight
and long development times, or abortive expenditure makes it more diffcult to
demonstrate the expectation of benefts at the time the contributions to the cost-
sharing arrangement were made.
Examining the nature of costs to be included and allocated under a cost-sharing
arrangement, the OECD argues that indirect costs of R&D should be shared by the
participating companies in addition to the direct costs. Indirect costs would be those
that were not directly involved with R&D, but which nevertheless are intrinsically
related to the direct cost elements and, typically, would include all the general
overhead expenses of running a research business. Since such an allocation will
necessarily involve approximations, the tax authorities are likely to scrutinise it closely.
Local country laws vary as to whether any particular item of expenditure is deductible.
If the amount being charged under the cost-sharing arrangement is the proportionate
share of assets of a capital nature, such as machines, buildings, etc., questions may
arise as to whether the cost will be treated as revenue or capital for accounting
purposes and tax purposes.
For instance, it may be necessary to look through the total allocated expense and
analyse it into its constituent parts, consisting of, for example, R&D expenditure or
depreciation on buildings. To the extent that national practices on the tax relief given
for capital expenditure vary considerably, timing and absolute differences may emerge.
Any kind of subsidy received for R&D purposes (whether through government grants,
third-party royalty income earned from exploiting technology derived from the cost-
sharing facility, etc.) should be deducted before determining the net amount of costs to
be allocated under the terms of the cost-sharing arrangement.
Particular care must be taken to demonstrate that the companies involved in the cost-
sharing arrangement are not paying twice for the costs of the same R&D. For instance,
no part of the R&D expenses dealt with under cost-sharing should be refected in the
transfer price of goods to be acquired by a cost-sharer.
Looking at the question of whether a proft margin should be added to the pool of costs
allocated among the sharers, an earlier report of the OECD concluded that it would
normally be appropriate for some kind of proft element to be included, but that it
should relate only to the organisation and management of R&D and not the general
investment risk of undertaking it, as that risk is being borne by the participants. As
noted above, however, Chapter VIII of the OECD Guidelines now focuses upon whether
the allocation of costs among the participants refects the relative benefts inuring to
the parties. A proft element is thus no longer to be allocated among the participants in
the cost-sharing arrangements.
Payments under cost-sharing schemes are not generally regarded as royalties for tax
purposes and therefore are typically not subject to withholding taxes.
526. Cost-sharing adjustments
By their nature, most cost-sharing arrangements are long-term. The allocation of costs
to participants by reference to their relative anticipated benefts is also an inexact
science and can be tested for reasonableness only over an extended period. Chapter
VIII of the OECD Guidelines recognises these diffculties and provides that adjustments
should not therefore be proposed in respect of just one fscal years apparent
imbalance between cost-sharers. It also provides that tax authorities should challenge
an allocation of costs under a cost-sharing arrangement when the tax authority
determines that the projection of anticipated benefts would not have been used by
unrelated parties in comparable circumstances, taking into account all developments
that were reasonably foreseeable by the parties at the time the projections were
established and without the use of hindsight. Consequently, the tax authority would
have to conclude that the cost-sharing arrangement was not entered into in good
faith and was not properly documented when implemented. If a tax authority does
successfully contend that a correction is required, the position can become complex.
In essence, an imputed charge to the other cost-sharers will be imposed. This charge
imposes considerable diffculties with respect to obtaining relief for the additional costs
in the other cost-sharers. In the absence of multilateral tax agreements, the group will
need to begin simultaneous requests for relief under a number of separate double tax
agreements, which is likely to prove a lengthy task.
527. Cost-sharing and risk
Cost-sharing arrangements can be implemented only prospectively. Becoming a
cost-sharer represents a change in the nature of business for the paying company. By
implication, it becomes involved in the high-risk activity of R&D and agrees to carry
the business risk of signifcant future expenditure. While the offsetting income that
it hopes to generate in the future is of value, this may not accrue for quite some time.
Overall, risk is therefore increased and the participants expect eventually to see a
corresponding increase in general levels of proftability.
However, before the future income stream starts to arise, it is likely that overall
expenses will increase in the contributing companies. Therefore, during this
transitional phase, there may be a dramatic reduction in proftability taking place at
the same time as an increase in business risk. This will increase the chance of a review
of inter-company transactions by the local tax authorities. Lost or delayed income tax
deductions and possible limitations on the deduction of startup losses might also arise
during the transitional phase. These items might magnify unproftable operations and
increase business risk.
Cost-sharing arrangements also attract the authorities attention because they typically
appear as a new category of expense in company accounts and tax returns where,
historically, cost-sharing has not been practised. Change is always an occasion when
tax authorities might identify an area as worthwhile for investigation.
Once implemented, the cost-sharing arrangement must be actively monitored by
all involved parties. Care should be taken to ensure that the legal form of the cost-
sharing agreement refects its substance. In addition, the documentation of the active
involvement of the members in policy setting, monitoring and controlling the cost-
sharing agreement on a current basis is indispensable.
528. The participants
Cost-sharing is generally performed among manufacturing, distribution or standalone
R&D companies. While cost-sharing arrangements have traditionally been most
popular between manufacturing companies, distribution and standalone R&D
companies are increasingly becoming participants. This is in part due to the increasing
use of third-party contract manufacturers. In a cost-sharing arrangement among
manufacturing companies, the manufacturers produce goods that are sold at a price
that refects the R&D costs incurred. Any associated distribution companies are
remunerated only for their distribution functions and risks.
A cost-sharing arrangement involving a distribution company may fundamentally
change the functions and risks typically performed by each participant and greatly
increase the complexity of the groups transactions. The distribution company
effectively assumes the functions and risks of a research company and distributes
goods that are sold at a price that refects the R&D costs incurred. In this type of
cost-sharing arrangement, the manufacturing company assumes the functions and
risks of a contract manufacturer that produces goods sold to the distributor (that
owns the intellectual property) for a price that refects the contract manufacturing
costsincurred.
To the extent that most of the R&D is concentrated in one company in physical terms,
cost-sharing at the distribution company level represents a purely fscal decision, since
the substantive activities of the distribution company do not directly utilise the fruits of
the R&D expenditure. While cost-sharing may be achieved in legal and fnancial terms
through the use of contracts, it remains true that arrangements that are purely fscal in
nature are coming under increasing attack by tax authorities around the world.
529. Establishing cost-sharing arrangements in midstream
If a company has historically conducted and funded R&D in one legal entity and wishes
to establish a cost-sharing arrangement in the future, the company must carefully
consider two issues:
1. Buy-in payments; and
2. The business issue regarding the location of ownership of intangible property (i.e.
which entities are characterised as the developer of the intangible under the
OECD Guidelines, the developer is the entity that acquires legal and economic
ownership of the intangible property).
530. Buy-in arrangements
When a group decides to form a cost-sharing arrangement to fund the development
phase, as opposed to the research phase of R&D, an important issue arises: whether a
payment should be made by a company entering into a cost-sharing arrangement with
the owner of existing technology. This concept, known as buy-in, has been under
debate for some time but came under widespread review following the publication
of a white paper by the Internal Revenue Service (IRS) in the US in 1988. This white
paper interpreted the transfer pricing proposals contained in the Tax Reform Act of
1986 in the US, which obtained widespread publicity. Most tax authorities are now
aware of the concept of buy-in and are in the process of considering the issues raised by
thisconcept.
The concept of buy-in is based on the view that when a new member joins a cost-
sharing arrangement, the benefts emerging from research typically not only build
on current R&D costs but also capitalise on past experience, know-how and the prior
investment of those involved in the earlier cost-sharing arrangement. Consequently,
the new member receives benefts from the historical expenditure of the earlier
participants, although it did not contribute to those costs. In the international context,
the US has made the point very strongly that it is inappropriate for a new member to
receive these benefts free of charge.
While the need for a buy-in payment is well-established, the required computation may
be controversial. The IRS has advocated that a valuation be carried out to determine
an amount that would be appropriate to be paid to the original cost-sharers by the new
member, refecting the fact that the latter has obtained access to know-how and other
valuable intangible property, which it will not be paying for through its proportionate
share of future R&D expenditure.
The 1988 white paper indicated that the buy-in valuation should encompass all pre-
existing, partially developed intangibles, which would become subject to the new
cost-sharing arrangements, all basic R&D not directly associated with any existing
product, and the going-concern value of the R&D department, the costs of which are to
be shared.
The 1995 US fnal cost-sharing regulations provide that buy-in payment is the
arms-length consideration that would be paid if the transfer of the intangible was
to, or from, an unrelated party. The arms-length charge is determined under the
pertinent part of the US regulations, multiplied by the controlled participants share of
reasonable anticipated benefts.
The 2008 US temporary cost-sharing regulations refer to buy-in payments as platform
contribution transactions (PCTs) and expand the defnition of intangible property
subject to a PCT payment as any resource, capability, or right that a controlled
participant has developed, maintained, or acquired externally to the intangible
development activity (whether prior to or during the course of the CSA) that is
reasonably anticipated to contribute to developing cost-shared intangibles. Under
this new defnition, the contribution of an experienced research team in place would
require adequate consideration in the PCT payment. Such a team would represent a
PCT for which a payment is required over and above the teams costs included in the
cost-sharing pool.
The 2008 US temporary cost-sharing regulations also make an important change to the
requirements under which reasonably anticipated beneft ratios are calculated for PCTs
and cost-sharing arrangements. There is now an explicit requirement that reasonably
anticipated beneft ratios be computed using the entire period of exploitation of the
cost-shared intangibles.
Furthermore, the 2008 US temporary cost-sharing regulations reiterate that the rights
required to be transferred in order to eliminate a perceived abuse where the transfer
of limited rights could result in lower PCT payments. Therefore, under these 2008 US
temporary cost-sharing regulations, the PCT payment must account for the transfer of
exclusive, non-overlapping, perpetual and territorial rights to the intangible property.
The 2008 US temporary cost-sharing regulations also consider other divisional bases in
addition to territorial basis, including feld of use.
Similar to the 2005 US proposed cost-sharing regulations, the 2008 US temporary
cost-sharing regulations do not allow a reduction in the PCT for the transfer of existing
make or sell rights by any participant that has already paid for these rights.
Another signifcant change in the 2008 US temporary cost-sharing regulations is the
so-called periodic adjustment rule, which allows the IRS (but not the taxpayer) to
adjust the payment for the PCT, based on actual results. Unlike the commensurate
with income rules, the temporary regulations provide a cap on the licensees profts
(calculated before cost-sharing or PCT payments) equal to 1.5 times its investment.
(For this purpose, both the profts and investment are calculated on a present
value basis.) Notably, this periodic adjustment is waived if the taxpayer concludes
an Advance Pricing Agreement with the IRS on the PCT payment. There is also
an exception for grandfathered CSAs, whereby the periodic adjustment rule is
applied only to PCTs occurring on or after the date of a material change in scope of
the intangible development area. The 2008 US temporary regulations also provide
exceptions to the periodic adjustment rule in cases where the PCT is valued under a
CUT method involving the same intangible and in situations where results exceed the
periodic adjustment cap due to extraordinary events beyond control of the parties.
In addition, the 2005 US proposed cost-sharing regulations introduced the investor
model approach, which provides that the amount charged in a PCT must be consistent
with the assumption that, as of the date of the PCT, each controlled participants
aggregate net investment in developing cost-shared intangibles pursuant to a CCA,
attributable to external contributions and cost contributions, is reasonably anticipated
to earn a rate of return, equal to the appropriate discount rate. The 2008 US temporary
cost-sharing regulations signifcantly change the application of the investor model. This
model indicates that the present value of the income attributable to the CSA for both
the licensor and licensee must not exceed the present value of income associated with
the best realistic alternative to the CSA. In the case of a CSA, the 2008 US temporary
cost-sharing regulations indicate that such an alternative is likely to be a licensing
arrangement with appropriate adjustments for the different levels of risk assumed in
such arrangements. The 2008 US temporary cost-sharing regulations also recognise
that discount rates used in the present value calculation of PCTs can vary among
different types of transactions and forms of payment. These new proposed rules are
discussed in more detail in the US chapter. Furthermore, the requirements under the
Temporary Regulations for application of the Residual Proft Split Method will likely
restrict the use of this method to certain cases where the licensee brings pre-existing
intangibles to the CSA. In cases where the licensee does not possess pre-existing
intangibles, the Income Method, Market Capitalization Method and Acquisition Price
Method are likely to predominate.
Chapter VIII of the OECD Guidelines supports the use of buy-in payments as the
incoming entity becomes entitled to a benefcial interest in intangibles (regardless of
whether fully developed), which it had no rights in before. As such, the buy-in would
represent the purchase of a bundle of intangibles and would need to be valued in that
way (i.e. by applying the provisions of the Guidelines for determining an arms-length
consideration for the transfers of intangible property).
Note that the terminology employed in Chapter VIII of the Guidelines, the 1995 US
fnal cost-sharing regulations and the 2008 US temporary cost-sharing regulations with
respect to this concept is somewhat different. Under Chapter VIII, a buy-in is limited
to a payment made by a new entrant to an existing cost-sharing arrangement for
acquiring an interest in the results of prior activities of the cost-sharing arrangement.
Similarly, a buyout refers only to a payment made to a departing member of an existing
cost-sharing arrangement. Chapter VIII refers to any payment that does not qualify as a
buy-in or a buyout payment (e.g. a payment made to adjust participants proportionate
shares of contributions in an existing cost-sharing arrangement) as a balancing
payment. In contrast, the 1995 US fnal cost-sharing regulations use the terms more
broadly. Buy-in and buyout payments refer to payments made in the context of new as
well as existing cost-sharing arrangements under these regulations. There is no such
thing as a balancing payment in the 1995 US fnal cost-sharing regulations. In further
contrast, the 2008 US temporary cost-sharing regulations refer to buy-in payments as
PCTs for which the controlled participants compensate one another for their external
contributions to the CCA. In addition, post-formation acquisitions (PFAs) occur after
the formation of a CCA and include external contributions representing resources or
capabilities acquired by a controlled participant in an uncontrolled transaction.
If payments are to be made to another participant in the cost-sharing arrangement
(regardless of whether the payment is characterised a buy-in, a buyout or a balancing
payment), consideration must be given to the tax deductibility of such payments made
by the paying entity and their accounting treatment. Unless there is symmetry between
their treatment as income in the recipient country and deductible expenditure in
paying countries, a related group might well face signifcant double taxation as a result
of the buy-in payment. The buy-in payment issue must be addressed on each occasion a
new company becomes involved in the cost-sharing arrangement.
531. Ownership of intangibles
Since cost-sharers own the technology developed through the cost-sharing
arrangements, when technology is partially developed prior to the commencement of
the arrangement and then modifed or further developed as part of the arrangement,
an issue arises concerning the ownership of the resulting technology. This is a murky
area and may lead to signifcant business problems if defence of the property rights
becomes necessary.
Example
Bozos Unlimited (BU), a US company, manufactures toy clowns sold to children
worldwide through wholly owned subsidiaries located in Canada, Germany, France
and the UK. Its manufacturing activities are conducted in the US and in a wholly
owned subsidiary in Ireland. Currently, the Irish subsidiary pays a 3% royalty to the
parent for the technology that it uses and all R&D has, to date, been conducted in the
US and paid for by BU.
To meet child safety requirements throughout the world, as well as to reduce
manufacturing costs so that its product remains competitive, BU has decided to embark
on a major R&D effort. The cost will be signifcant, and BU realises that it will need
the fnancial resources of the Irish subsidiary to help fund this project. It has decided
that neither dividends nor an inter-company loan are desirable, and a cost-sharing
arrangement is therefore selected.
To implement the cost-sharing arrangement, BU must address the following issues:
The need for a buy-in payment;
The amount of the cost-sharing payment to be made by the Irish subsidiary; and
The rights which will be given to the Irish subsidiary.
Because the Irish subsidiary has been paying for the pre-existing technology through
the licence agreement, it is determined that this arms-length royalty rate is suffcient
under Chapter VIII of the OECD Guidelines to compensate BU for the existing
technology. However, under the 1995 US fnal cost-sharing regulations, the buy-in
payment is required to be the arms-length charge for the use of the intangible under
the pertinent provisions of the US transfer pricing regulations, multiplied by the Irish
subsidiarys anticipated share of reasonably anticipated benefts. The prior royalty
payments will likely be insuffcient, and the Irish subsidiary will have to pay a buy-in
payment to the parent to the extent that the royalty payments made are less than the
required buy-in payment amount. In further contrast, under the 2008 US temporary
cost-sharing regulations, the prior royalty payments would be considered make or
sell rights, which cannot reduce the amount of the buy-in for the existing technology.
Under Chapter VIII of the OECD Guidelines, the cost of the R&D is calculated by
aggregating the direct and indirect costs of the R&D activities; this is divided between
BU and its Irish subsidiary, based on the relative sales of both entities. Under the 1995
US fnal cost-sharing regulations and 2008 US temporary cost-sharing regulations,
the cost of the R&D is calculated by aggregating certain operating expenses other than
depreciation or amortisation charges (i.e. expenses other than cost of goods sold, such
as advertising, promotion, sales administration), charges for the use of any tangible
property (to the extent such charges are not already included in operating expenses)
plus charges for use of tangible property made available by a controlled party. Costs
do not include consideration for the use of any intangible property made available to
the cost-sharing arrangement. Under the 1995 US fnal cost-sharing regulations, 2008
US temporary cost-sharing regulations and Chapter VIII of the OECD Guidelines, these
costs are allocated between BU and its Irish subsidiary in proportion to their shares
of reasonable anticipated benefts from the developed R&D. However, the 2008 US
temporary cost-sharing regulations specify the reasonable anticipated benefts shares
be computed using the entire period of exploitation of the cost-shared intangibles.
The rights that will be granted to the Irish subsidiary under the agreement are the
use of the technology in respect of sales outside North America. Under the 2008
US temporary cost-sharing regulations, the rights granted to the Irish subsidiary
must be the exclusive and perpetual use of the technology in respect of sales outside
NorthAmerica.
532. Other types of cost-sharing agreements
Costs other than those involving R&D can also be shared through a cost-sharing
arrangement. For example, common costs such as accounting, management and
marketing can be the subject of a cost-sharing agreement among the affliates that
beneft from the services offered. (See sections 501511 for further discussion of this type
of cost-sharing arrangement.)
FOREIGN EXCHANGE AND FINANCE
533. Foreign exchange risk introduction
Unexpected foreign exchange-rate fuctuations pose one of the most diffcult
commercial challenges to an effective inter-company pricing policy. On several
occasions over the past 20 years, the value of currencies such as the US dollar and
UK pound sterling have moved by up to 40% over a relatively short time, only to
rebound by a similar amount. Exchange-rate fuctuations affect the competitiveness
of a multinational frms various worldwide operations. A depreciating US dollar, for
instance, tends to improve the export competitiveness of US-based manufacturers. If a
multinational frms transfer prices do not respond to changing competitive pressures,
the composition of the frms worldwide proft profle will be distorted. These
distortions can disrupt a multinational frms production, fnancial and tax planning.
534. The arms-length standard
The arms-length standard requires related parties to set their inter-company pricing
policies as if they were unrelated parties dealing with one another in the open market.
It follows that this principle requires a multinational frms transfer pricing policy
to include an exchange-rate adjustment mechanism similar to that which would be
employed by unrelated parties in similar circumstances.
Unfortunately, frms across different industries, and even within the same industry,
respond to exchange-rate changes differently. Sometimes, the manufacturer bears the
exchange risk, sometimes the distributor bears it, and sometimes the two share it. The
choice of which party will bear the exchange risk depends on the multinational frms
unique set of facts and circumstances. If, for instance, the manufacturing arm of the
frm sells to many different related distributors in many countries, it may make most
sense for it to centralise foreign-exchange risk. The profts of the company bearing the
exchange risk will fuctuate with the relevant exchange rates. When these fuctuations
are unusually large, they are likely to draw the attention of the domestic or foreign tax
authorities.
535. Types of exchange-rate exposure
The exchange-rate exposures of a multinational enterprise can be categorised as
translation (see section 536), transaction (see section 537) and economic (see section
538) exposure.
536. Translation exposure
Translation exposure, often referred to as accounting exposure, relates to the
multinational frms need to translate foreign currency denominated balance sheets
into its domestic currency, so that the multinational frm can create a consolidated
balance sheet. It measures the change in the consolidated net worth of the entity,
which refects changes in the relevant exchange rate.
537. Transaction exposure
Transaction exposure concerns the impact of unexpected exchange-rate changes on
cash fows over a short time, such as the length of existing contracts or the current
fnancial planning period. It measures the gains or losses arising from the settlement
of fnancial obligations, the terms of which are stated in a foreign currency. If the
currency of denomination of a transaction is the domestic currency for instance, if
the invoices are stated in terms of the domestic currency the domestic frm could still
bear transaction exposure if the domestic currency price varies with the exchange rate.
For example, assume that a contract between a Japanese manufacturer and a Belgian
distributor states the price of goods in euros. It would appear that the Belgian company
bears no exchange risk. However, if the euro price is adjusted to keep the Japanese
companys yen revenues constant when the yen/euro exchange rate changes, then
the Belgian company is exposed to exchange risk. Consequently, transaction exposure
depends not on the currency of denomination of a contract or transaction but on the
currency that ultimately determines the value of that transaction.
538. Economic exposure
Economic exposure measures the change in the value of the business resulting
from changes in future operating cash fows caused by unexpected exchange-rate
fuctuations. The ultimate change in the frms value depends on the effect of the
exchange-rate movement on future volumes, prices and costs. Economic exposure
consequently looks at the effects once the market has fully adjusted to the exchange-
rate change. Factors that determine the degree of economic exposure include
thefollowing:
Market structure;
Nature of competition;
General business conditions; and
Government policies.
Example
USM, a US-based manufacturer of auto parts, exports its product to UKD, its UK-based
distribution subsidiary. UKD sells parts to unrelated retailers throughout the UK. USM
denominates the transfer price in pounds and converts its pound receipts into dollars.
USM has adopted a resale price approach to set its transfer price for goods sold to UKD.
The resale price method calculates the transfer price by deducting an arms-length
markup percentage for UKDs distribution activities from the resale price.
Given this pricing method, USM bears all the foreign-exchange transaction exposure.
When the value of the dollar appreciates, USM reaps unexpected exchange-rate gains
on its dollar receipts; when the value of the dollar depreciates, USM incurs unexpected
exchange-rate losses.
539. Planning opportunities
The presence of foreign exchange risk in inter-company transactions provides some
potentially valuable planning opportunities to multinational frms. These opportunities
relate to the strategic placement of foreign-exchange risk. The more risk that a
particular entity bears, the higher the compensation it should earn, and a multinational
can place foreign-exchange risk in one entity or another by the way that it sets its
transfer prices.
Example
A large automotive company manufactures auto parts in many countries, operates fnal
assembly plants in several other countries, and then sells products in virtually every
country around the world. This frms inter-company transactions generate enormous
exchange-rate exposures. For example, each assembly plant purchases parts from its
affliates located in as many as 15 countries and then sells fnished automobiles in over
50 countries. The frm has a number of choices to make concerning the management of
its foreign exchange risk.
Each of the plants incurs expenses denominated in local currency, such as wages,
rent, interest and taxes. In an effort to help smooth out the cash fow of these local
companies so they can pay local expenses with a minimum of concern about exchange-
rate fuctuations, corporate management may wish to insulate them from exchange-
rate exposure. The company could, for instance, establish a trading company that
would buy and sell raw materials, parts and fnished products from and to each of
the local operating companies in the companys local currency. The trading company
would, in these circumstances, bear all of the frms foreign-exchange risk.
Because all goods sold inter-company would pass through the trading company, this
company could also centralise and coordinate the purchasing of supplies for the frms
worldwide operations. By acting as the central agent, the trading company could
ensure that supplies were always procured from the suppliers offering the lowest
prices, and could capitalise on volume discounts where available.
Clearly, in order to be tax effective, the creation of the trading company would
need to be supported by a well-established business plan that signifcantly altered
the operations of existing entities and placed real business functions and risks in
the trading company. Furthermore, the trading companys employees must have a
level of expertise and be suffcient in number to conduct its business. For instance,
if it reinvoices and manages foreign-exchange risk, it needs accountants to handle
the invoicing and the collection activity plus foreign-exchange managers to deal
withhedging.
As with all inter-company transactions, it is necessary to apply an arms-length pricing
policy between the trading company and its affliates. The more functions and risks
transferred to the trading company, the higher the return that the trading company
should earn.
Instead of centralising foreign-exchange risk in a trading company, the automotive
frm could decide to place all foreign-exchange risk in the local operating companies.
In this way, it would force the local managers to control and minimise all of the risks
generated by their operations. The return earned by each of the operating companies
would then have to be adjusted upwards by enough to compensate them for the
additional foreign-exchange exposure.
540. Loans and advances
The fnancial structure is important when considering a range of planning moves with
a multinational group, such as:
Starting a business in another country;
Financing expansion;
Underwriting losses of troubled subsidiaries; and
Determining or establishing a trading account between two affliates.
The use of debt frequently aids in the movement of earnings from one country to
another in a tax-effcient manner. The fnancial structure may also be important in
establishing commercial viability in another country. Various types of credit may be
involved, including:
Demand loans;
Term loans;
Temporary advances;
Open trading accounts; and
Cross-border guarantees or other collateralisation of an affliates outstanding debt.
541. Characterisation of loans
For tax purposes, the issue of the characterisation of funds placed with a subsidiary
as debt or equity was considered in section 215. In summary, many countries have
specifc rules or practices that restrict the permissible level of related-party debt, and it
is crucial to review these before adopting any amendments to the groups international
fnancial structure.
542. Interest on loans
The arms-length principle is applicable to the rate of interest paid on inter-company
debt. Developed countries have rules that embody the arms-length principle. However,
application of the principle by the tax authorities in each country and by each countrys
courts vary signifcantly.
The basic principle is that the interest rate to be charged between related parties is
the market rate of interest that would be charged at the time the indebtedness arose
between unrelated parties, assuming similar facts and circumstances. The facts and
circumstances that should be taken into consideration include:
Repayment terms (i.e. demand, short-term, long-term);
Covenants;
Collateralisation;
Guarantees;
Informal and temporary advances;
Open lines of credit;
Leasing arrangements that are not bona fde leases;
Trading accounts;
Credit risk of the debtor (i.e. debt-to-equity ratio);
Volatility of the business;
Reliance on R&D or other high-risk investments such as oil and gas exploration;
Track record of affliate;
Location of exchange risk; and
The market differences may exist among the markets of various countries, the
regional market such as the European market or the Eurodollar market.
This general principle is used in most countries, but some provide a safe harbour.
Consequently, although a provision is made for arms-length interest rates, if an interest
rate falls within a specifed range, other factors of comparability will be ignored.
For instance, in Switzerland, the tax authorities have issued required minimum and
maximum rates based on the Swiss market. However, deviations from the rate may be
made when the debt is in foreign currency or the difference is modest and the rationale
is reasonable. The US also has an extensive system of safe harbours.
543. Loan guarantees
Generally, the tax authorities are silent on the treatment of guarantees of indebtedness
provided by related parties. Presumably, such guarantees should require an arms-
length fee for the guarantee. The fee would be determined by the fee that would
be charged for such a guarantee between two unrelated taxpayers under similar
circumstances. Since such guarantees are infrequent, the arms-length principle may
be diffcult to apply. However, when the interest rate between the borrower and the
lender is reduced by virtue of the guarantee, the interest rate reduction can be used as
a measure of the value of the guarantee. This concept has recently attracted signifcant
attention from the OECD in its working papers on global dealings as well as in the
US. As such, one can expect to see more activities in the examination of these types of
arrangements in the near future.
544. Bona fde leases
Leasing as a form of loan fnancing is discussed in section 221. The use of a bona fde
lease as a means of securing the use of tangible property without bearing the risk
of ownership is another type of fnancing. In this context the transfer pricing rules
relating to interest rates are not appropriate. However, rules prescribed by the tax
authorities on arms-length rental rates are minimal. The OECD does not provide
guidelines, and most countries do not address the subject, even in a general manner.
It is thought that cross-border leasing of equipment (using bona fde leases) is not
common practice (being focused mainly on individual, high-value transactions
requiring individual treatment), probably because cross-border leasing is commercially
complex and raises myriad business and tax issues. For instance, owning equipment
located in some countries may create a permanent establishment problem for the
foreign-based lessor. In addition, there may be withholding taxes on rentals payable
under certain jurisdictions.
545. Establishing an arms-length rental rate
Most countries accept proof of an arms-length rental rate based on one of the
following methods:
A comparable uncontrolled price;
Pricing based on economic depreciation of the leased asset;
Pricing based on interest and a proft markup for risk; and
Pricing based on any other method for establishing a reasonable rent.
E-BUSINESS
546. Introduction
There are no transfer pricing rules specifc to e-business and none are currently being
proposed. However, this has not prevented a great deal of discussion taking place about
the impact of e-business and new business models on the application of traditional
transfer pricing concepts.
Instantaneous transactions across international boundaries which are quicker, more
frequent, often highly automated and involve the greater integration of functions
within a multinational group potentially make it harder to perform a traditional
analysis of functions, assets and risks. What is it that creates value, for instance, where
huge costs may be taken out of the supply chain by the use of a software platform
that links the entire chain from raw materials supplier to ultimate customer? Can one
readily ascertain which party performs which specifc function, and where? Given
that current tax regimes work within international boundaries, and transfer pricing
rules require one to attribute value to location, has it become even more diffcult to
establish where proft is made? And if one can successfully identify the transaction
and its essential attributes, is there a readily available comparable transaction
given the unique factual circumstances which, for now, may relate to certain
e-businessactivities?
547. Transfer pricing issues for the business community
If one looks at the new business models emerging, one begins to realise that there are
opportunities to reduce the tax burden. Let us start with electronic marketplaces. These
are the online exchanges and networked business communities, usually involving
established businesses, which allow these businesses to buy and sell products and
services. These exchanges are often multi-member joint ventures with geographically
diverse investors and newly hired management and staff. They are lean operations
with high potential value and no loyalty to any particular geographical or business
location. Despite the defation of the dot.com bubble, interest in such business models
continues, with some caution over the measure of benefts expected.
The playing feld is by no means level and the right choice of location can have a
great positive impact on the rates of return for investors. Tax is a signifcant factor in
choosing where to set up a new business and, despite what some may say, competition
in this area is alive and well.
There is also the issue of how established businesses are starting to transform
themselves. The new technology has allowed new businesses fnally to integrate
changes that took place in the 1990s in particular, restructuring and business process
standardisation and a focus on core skills. These changes have brought the emergence
of brand owners, or entrepreneurs, who outsource non-core physical activities across
the supply and demand chains. They may even move out of manufacturing entirely and
simply have fnished products shipped from external suppliers.
Bring tax and transfer pricing into this process and the who, what and where of what a
business does has a crucial impact on the earnings that a business generates. Whether
a website or server has a taxable presence in another country into which the business
is selling pales in importance beside the priority of ensuring that the value in this
streamlined and more mobile business is created in the most friendly tax jurisdiction.
The change in business model has afforded the established business an ideal
opportunity to revisit the tax effciency of how and from where they operate.
548. Issues for tax authorities
Tax authorities have been concerned about the perceived diffculty of identifying,
tracing, quantifying and valuing web-enabled cross-border transactions. A number
of countries including Australia, Canada, Ireland, New Zealand, the UK and the US,
issued reports on the tax implications of e-business, which included discussions about
the impact of e-business on existing transfer pricing rules and practices. However, there
has been a general recognition that the response, if needed, has to be international
and has to be coordinated. Consequently, tax authorities within and outside the OECD
have used the OECD as the forum to address the issues and produce appropriate
international guidance.
This debate at the OECD has produced some conclusions. These have been
incorporated in the latest version of the OECD Model Tax Convention on income and
on capital, which was released in January 2003. For instance, it has been concluded
by most OECD countries that a website by itself does not constitute a permanent
establishment, as it is not tangible property and so cannot be a fxed place of business.
However, if the enterprise that carries on business through the website also owns or
leases the server on which the website is located, then the enterprise could have a
permanent establishment in the place where the server is located, depending on the
nature and extent of the activities carried on through the server and the website.
Other issues, such as the attribution of proft to a server permanent establishment,
however, remain to be resolved and the work of the OECD on the taxation of
e-commerce continues.
Managing changes to
a transfer pricing policy
6.
International Transfer Pricing 2011 107 Managing changes to a transfer pricing policy
601. Introduction
From time to time, it will become necessary to change a groups transfer pricing policy,
and these amendments themselves can give rise to a considerable range of problems.
In addition to deciding exactly what changes to make, the group must address the
challenges involved in communicating the changes to all those involved, ensuring
that the new procedures are implemented smoothly, and monitoring the effects of the
changes on the proftability of the legal entities involved.
Additionally, several strategic questions must be dealt with concerning, in particular,
the timing of the changes and the evaluation of their possible effect on the perception
of the groups operations, both by the users of the groups accounts and the tax
authorities that deal with the affairs of the group in various countries.
The purpose of this chapter is to guide the reader through these diffcult areas and to
highlight the critical points that require attention.
602. Transfer pricing committee
To guarantee the smooth operation of a transfer pricing policy, all aspects of the
transfer pricing process need to be carefully monitored on an ongoing basis. The
functional analysis must be kept up to date, as must information on industry-
standard operating practices, comparables and the fnancial performance of each
legal entity within the group. In particular, it is necessary to consider alterations
to the transfer pricing policy, which may be required to allow for changes in the
business, such as acquisitions, major new product lines, new geographic markets and
competitors. For any group with signifcant inter-company transactions, this can be a
mammothundertaking.
A helpful approach is to establish a committee to assist in the management of pricing
policy. The committee should consist of individuals with a clear understanding of
each of the major commercial departments within the company, including research
and development (R&D), manufacturing, marketing and distribution, logistics, and
after-sales service. The interests of each division or business unit should be represented
so that the transfer pricing policy clearly refects business reality and meets the
needs of the group as a whole. On the fnancial side, the committee should include
representatives from accounting, fnance, tax and treasury.
Managing changes to a transfer pricing policy 108 www.pwc.com/internationaltp
The responsibility of the committee is to advise on whether the arms-length transfer
pricing policy that the group has adopted is properly and effciently implemented
and continues to work effectively. It must recommend that appropriate transfer
pricing policies are implemented for new products, new geographic markets, etc. The
committees brief will be to monitor changes in the business, whether they be major
restructurings made for operational reasons, intended acquisitions, new product
lines or changes in operations, and to determine whether the policy is effective or
recommend changes that need to be made to correct any defciencies.
The transfer pricing committee will therefore have a wide brief to look at the groups
operations as a whole and review how the pricing policy operates. Its members must
be prepared to take a broad view of the business, and the committee must be given
authority to obtain the information they need and to make recommendations from an
independent viewpoint.
The chairperson of the committee should therefore be chosen with care as he or
she will, from time to time, have to make recommendations for change, which
will invariably be unpopular somewhere in the organisation. The fnal choice of a
chairperson will naturally depend on the individuals available within the group, but it
would be preferable for someone with the broadest overview of the group to take this
role. In general, the chairperson should not be a tax person for the pragmatic reason
that this would give the wrong message to the groups personnel as well as to the tax
authorities as to the nature of the committees activities. The choice of chairperson
might be more or less controversial in different jurisdictions (for instance, in the US
a tax person as chairperson would certainly be inappropriate), but it must be borne
in mind that the committee is not a tax-planning device but a key tool in the effective
fnancial management of the company. It would be inappropriate for other executives
or the tax authorities to reach the conclusion that the committee exists purely for
taxpurposes.
The transfer pricing committee is responsible for policy but may delegate various
detailed activities to fnance personnel, sales managers and plant managers. The
committee should meet when major operating changes are envisaged, but otherwise a
regular quarterly meeting is advisable.
603. Setting the groups initial pricing policy
The frst occasion on which a group begins to carry on part of its business on a cross-
border basis is the point at which it must establish a defensible transfer pricing policy.
Needless to say, this is often seen as the least important consideration for those
involved (if they consider it at all), who will be far more interested in operational
business issues and ensuring that the new operation is a commercial success. At this
initial stage, the sums involved may be small and people may be unwilling to invest the
necessary effort in establishing the policy. However, whether a company is expanding
overseas for the frst time or an existing group is adding a new line of business to its
multinational operations, getting it right frst time must be the objective of those
who are responsible for the groups pricing policies. Any more limited objective will
inevitably give rise to diffculties in resolving the groups tax liabilities in the countries
concerned and, in the medium- to long-term, necessitate making changes to the policy
that could have associated tax costs and adverse fscal implications.
International Transfer Pricing 2011 Managing changes to a transfer pricing policy 109
Managing changes to a transfer pricing policy
604. Active planning of the global tax charge
It is not unusual for a group to begin its international operations with a transfer
pricing policy that is not effcient from an effective tax rate perspective. Apart from the
diffculty in devoting suffcient resources to pricing and planning when developing new
markets, it is diffcult to predict accurately how the overseas operations will progress
in terms of sales and expenses. If the pricing policy is still less than optimal when these
transactions become a material portion of the total business of the group, there will be
correspondingly serious tax problems to be addressed.
The group should undertake a review to consider the possible courses of action that
may be pursued to rectify the policy. This analysis may conclude that only fne-tuning is
needed to achieve an arms-length result.
The substance of the operations of a given legal entity determines the amount of proft
that should accrue to that entity. Therefore, the only effective way of managing the
worldwide tax rate, when the existing policy is arms length, is to change the manner in
which the group conducts its operations. As a result, the group will make substantive
changes in its operations to reduce income in high-tax jurisdictions and increase
income in low-tax jurisdictions.
However, the impact of a major change in operations of a group should not be
underestimated. What appears attractive from a tax management perspective may
have adverse commercial results. It is also not for the short-term tax rates may
change rapidly, but it is not easy or cheap to decommission a factory. Having said that,
it may be easier to move some of the business risks around the group rather than the
functions. For example, exchange risk can be moved by changing the currency in which
transactions are denominated, and risks of delivery and usage could be transferred
by a subcontracting arrangement. One must also consider the tax consequences
of transferring substantial functions and risk from a particular jurisdiction. Tax
jurisdictions are well aware of these functional and risk moves and are legislating,
or clarifying, their existing statutes to address the deemed notion of transfers of
business or goodwill upon restructure of the operations, which potentially may attract
signifcant tax consequences.
605. Change in the operating structure of the company
If the group does decide to alter its operations through rationalisation of
manufacturing plants, centralisation of certain support services, etc., pricing policy
changes can often be handled fairly easily. It is generally the case that a new transfer
pricing mechanism will be necessary to achieve an arms-length result.
If it can be demonstrated that both the present and previous transfer pricing policy
adhered to arms-length standards, then the only issue should be to ensure careful
contemporaneous documentation of the changes in the business which necessitated
the change in policy. The change in policy should be implemented at the same time as
the change in the business (or as soon thereafter as possible).
606. Parent company pressure
Transfer pricing policy amendments are sometimes made solely to meet the needs of
particular problems within the group not directly related to tax law or commercial
law and not necessarily in accordance with arms-length rules. For instance, a parent
company seeking to pay signifcant dividends to its shareholders requires not only
profts available for distribution but also cash. Where profts and cash are locked up in
subsidiaries outside the home country, there will always be a choice between paying
dividends to the parent or effecting remittances to the parent in some other form,
for example through the mechanism of a management fee, payment of royalty or
technology transfer fees, interest on borrowings from the parent, or perhaps through
increasing transfer prices for goods sold from the parent to the subsidiary for onward
distribution. One should navigate cautiously when executing these strategies because,
in addition to the income-tax implications, if these policies are deemed inconsistent
with the arms-length principle by a taxing authority, indirect tax issues may crop up.
The problem created by policies of this sort is the risk of tax audit when the policy is
clearly not arms length. It is a fact of life that such problems crop up, but a successfully
managed group will resist submitting to such pressures unless the changes proposed
can be accommodated within a fully arms-length pricing policy.
607. Tax audit settlements
When resolving disputes with a tax authority, it is good practice, where possible, to
ensure that the methodology agreed between the company and the authority for
settling the current years tax position is also determined as acceptable for some period
into the future. This may necessitate an amendment to the existing transfer pricing
policy. It is important to consider both sides of the transaction. In settling a tax audit, a
competent authority claim (see chapter 10) may be necessary to involve the authorities
of the other state. In going through this claim with these authorities, it is important
to address proposals for the future at the same time, if possible. If both countries
agree on the approach to be adopted, a change to the transfer pricing policy should be
uncontroversial. However, where different positions are adopted, great care will need
to be exercised. In circumstances such as these, the company may wish to consider
alternate measures to address the forward-looking issues by means of an advance
pricing agreement (see chapter 10).
When assessing the full cost of any settlement, it is important to take account of
any late payment interest or penalty charges that may apply. Such charges are, in
some jurisdictions, themselves not deductible for tax purposes. These liabilities may
sometimes be open to negotiation.
For further discussion of tax audits, see chapter 7.
608. Problems with current policy
A group may often fnd that an existing inter-company pricing policy no longer
provides the results it requires. This is usually caused by one or more of the
followingfactors:
Changes in business conditions (e.g. recession or infation) which cause changes in
prices or volumes of third-party sales;
Market-penetration activities that are designed to increase market share
by reductions in market prices or by substantially increased marketing and
promotional expenses. This could also be brought about due to breakthrough
technology advances that force companies to re-engineer their pricing;
Market-maintenance activities that are designed to protect market share in the
face of intense competition. This can be accomplished through pricing policies or
through marketing/promotion expenses;
Where a group acquires a business with a different transfer pricing policy from
that used elsewhere, the policy for the new expanded group should be reviewed.
Even if, initially, there will be little cross-trading, over time it is inevitable that
there will be transactions between the two groups. If pricing policies are not in line,
there may be problems with local tax authorities, which will see similar intragroup
transactions taking place in a single company; and
Where there are regulatory changes that affect pricing, which typically takes place
in the pharmaceutical industry due to drugs going off-patent or due to the prices of
drugs being agreed upon with the regulators.
609. Making corrections through fne-tuning
In this paragraph, it is assumed that the change needed to rectify the situation is fairly
limited and represents fne-tuning. The situation where the current transfer pricing
policy must be changed in a material way is dealt with in section 610.
Transfer pricing policies should be reviewed frequently. If the policy is monitored
periodically (e.g. quarterly), it will be immediately apparent if it is not working
properly. In this case, changes to transfer prices can be made for the subsequent
quarter and the error in the result of the transfer pricing policy at the end of the
year will generally be fairly small and, over a long period of time, the results of each
company within the group will refect the correct operation of the policy. There may
be cut-off errors between one period and another, but they will even out over time,
and dealing with corrections on a prospective basis is a more defensible position than
retroactive changes, which third parties rarely make except where serious disputes
areinvolved.
It is important to be aware of pressures in some countries to bring transfer prices up to
date on as regular a basis as possible. For instance, while minor cut-off errors are likely
to be ftted into the acceptable arms-length range of transfer prices for US purposes,
errors that mean that US profts cease to meet the arms-length test will require
adjustment for that year.
Transfer pricing policies should be managed within a range rather than on the basis
of an exact formula, as it is impossible to maintain a precise transfer pricing result.
An arms-length range of acceptable results should be determined, with management
within that range as the groups objective. So long as prices (and proftability) remain
within the range, no changes should be necessary. Once prices move outside the range
(or are predicted to move outside it), adjustments should be made. If the policy is
monitored regularly, changes can be made prospectively without the need to be overly
concerned about past mistakes or aberrations.
610. Massive change: alteration to business reality
A transfer pricing policy must address signifcant changes in the business environment.
If a manufacturing company sells fnished goods to a related distribution company
using a resale price method, then changes in the market price of the product
automatically vary the transfer price. These fow-through price changes merely
keep the arms-length policy in place. If a reduction occurs in prices in this market and
the discount that is used to apply the resale price method has to be increased from,
say, 25% to 26% in order for the distributor to trade proftably, then this should be
viewed as fne-tuning and should not create signifcant problems if it is properly
documented. However, assume that a massive recession occurs so that the market
price of the goods and the volume sold declines precipitously. In addition, the discount
earned by independent distributors declines from the previous norm of 25%15%.
Without a change in the transfer pricing policy, these factors could easily produce
losses in the distribution company (because volume has signifcantly decreased
without a corresponding change in overheads) or in the manufacturing company
(same reason). Such a situation is not unusual in some industries and provides a very
diffcult problem for transfer pricing as well as for the business generally.
It is important in these situations to realise that transfer pricing changes cannot solve
the business problem (i.e. the market has collapsed and losses arise on a consolidated
basis). All that a transfer pricing policy can do is to allocate the losses to the
appropriate legal entities on an arms-length basis.
611. Changes in law
If a group has established an arms-length transfer pricing policy that is working well
in all the countries in which it operates, how should it deal with the situation when a
new law in one of its territories means that existing policies are no longer acceptable
in that particular country? All cross-border transactions have an impact on the
accounts of at least two separate legal entities, and if a policy is changed to meet the
requirements of one countrys laws, will the new policy be acceptable to the country
affected on the other side of the transaction? While the arms-length principle is widely
recognised, individual countries have different views of exactly what this means. There
is, therefore, always a risk of asymmetric treatment of transactions for tax purposes in
different jurisdictions, resulting in double taxation.
A groups reaction to the different legal requirements, country by country, will
necessarily be driven by its evaluation of the tax risks involved. If it seems inevitable
that one particular country will apply its laws aggressively, resulting in double taxation
if the groups policy for that country is not altered, then it may be necessary to amend
the policy to produce the lowest tax result for the group as a whole. In these cases,
monitoring the position in other countries will be of crucial importance.
Example
Cool EC (Cool) is a group of companies engaged in the manufacture of refrigerators
operating entirely within the European Union (EU). Cools engineering department
is located in the UK company (Cool UK) and has for many years provided technical
assistance to the groups sales companies throughout the EU. The services have
been provided under the terms of a formal agreement, and charges are made for the
engineers time and expense in exactly the same way as charges are invoiced to third-
party customers for the same services. This arrangement has been accepted by all the
EU tax authorities, with the result that the service income is taxed only in the UK and
tax deductions for the same amount are taken in the paying companies.
Cool has recently secured a large order for its machines from the biggest distributor of
domestic electrical goods on the African continent. New subsidiaries will be established
to service this market and to deal with customer services. However, as with the EU
operations, Cool UKs engineers will also be required to provide their services from
time to time. Unfortunately, Cool UK has found that it is likely to suffer extensive taxes
if it seeks to charge for the engineers services in the same way as in the EU countries.
The position varies in detail from country to country, but the range of problems
include the diffculties in arranging foreign exchange clearances to obtain currency,
withholding taxes, local sales taxes and, in certain cases, direct local taxation of the full
service charge on the basis that the services represent a permanent establishment of
Cool. Cool UK has calculated that the effective tax rate on the service fees could exceed
80% in certain circumstances, in addition to causing cash-fow problems.
How then, should Cool UK react to this signifcant problem? There are three
mainoptions:
The group could pursue a policy consistent with the present arrangements in
Europe, which would be supported by the third-party comparables.
The group could decide that no charge be made, on the basis that the tax rate
effectively wipes out any beneft.
The group could fnd an entirely new way of dealing with the problem.
The frst option is unacceptable due to the resulting high tax rate.
The second option will probably give rise to transfer pricing questions in the UK. The
Inland Revenue will not accept that free services should be provided over an extended
period to overseas affliates and are likely to assess a deemed amount of income to
UK tax. There is also the possibility that the other EU authorities could challenge the
charges made to them if Cools UK operation sought to increase the inter-company
service charges to its European affliates to offset the loss-making African service.
After lengthy negotiations, Cool UK fnds that the African authorities are prepared to
give full foreign-exchange clearances for payments for the refrigerators, and no other
African withholding taxes would be applied to these payments. If the transfer price
of the refrigerators can be increased to cover the expected cost of service by the UK
engineers, then the UK authorities are unlikely to complain. Careful documentation
will be needed to support the pricing. In particular, it will be helpful to monitor what
the normal charge for the engineers time on African affairs would have been and
how this compares with the recovery made through the transfer price. It will also be
relevant to consider if the increased transfer price would cover the estimated cost of
maintenance services over the warranty period alone or would also cover after-sales
service, which may be normally paid for by the end-customers. Consideration must
also be given to the cost of spares, which would have to be imported for the service.
One possibility is to increase the price of spares to cover the service component.
Finally, it must be borne in mind that increasing the transfer price will increase the
base on which African customs duties will be calculated. This hidden tax must also be
evaluated in making the fnal decision on how to proceed.
Input from Cools transfer pricing committee will be helpful in smoothing over
management diffculties, which might otherwise arise. In particular, in this example,
the head of the engineering department had been concerned that one result of
recovering the value of engineering services through the transfer price of products
would be that the apparent proftability of his division would decrease while the sales
departments income would go up by a corresponding amount. As both managers
receive bonuses calculated on divisional profts, there is an apparent confict between
their personal interests and those of the business. One solution may be for the bonus
scheme to make adjustments for the African business. Alternatively, the engineering
department could render an internal invoice to the sales department.
612. Dealing with major changes
Occasionally, a transfer pricing policy will not be arms length and will require major
changes. For example, it is not unusual for a parent company to establish transfer
prices from its own manufacturing plant to related parties in high-tax jurisdictions
using a cost-plus approach. Often, the cost base is standard manufacturing cost. The
plus is frequently quite low (e.g. 5% or 10%). If the result of a policy such as this is
to produce recurring losses in the manufacturing entity, after deducting overheads
and general and administrative expenses, while the sales affliate is making large
profts, it is clear that the transfer pricing policy is not arms length; no independent
manufacturer would tolerate manufacturing at a loss in this way. If such a policy
has been in operation for a number of years and has not created problems with the
tax authorities in the manufacturers country, changing the policy is problematic
particularly because the need for change usually emerges as a result of a crisis. For
example, a manufacturing company may experience recurring losses and consequent
cash-fow problems. When this happens, the result is a critical need to change the
policy to rectify the problem. The issue that must then be addressed is the reaction of
the tax authorities involved.
When large changes are made to existing transfer pricing policies, the reaction of
the tax authority in the country in which higher taxes will be paid is likely to be to
investigate the reasons why the change was not made in prior years; it may be that
opportunities exist to assess further taxes for years before the change came into effect.
In contrast, the reaction in the country that loses revenue is likely to be exactly the
opposite. Sometimes the group must simply accept this risk because the crisis requires
the immediate imposition of the new policy. However, it may be possible to make
changes in the substance of the business (e.g. shift risks between countries) to provide
a basis for an argument that the business has been restructured and the new pricing
policy refects these changes.
Before the imposition of a new policy, it is necessary to evaluate the need for the
change, relative to the tax audit exposure caused by the change. The attitude of the tax
authorities involved must be considered along with the extent to which other matters
may need to be negotiated with them. In some countries (e.g. the US) it is possible
to protect subsequent years by arguing that the policy was wrong in the past. Careful
management of prior years audits will mitigate the risk in these situations.
613. Year-end adjustment
Towards the end of the fscal year, a group usually examines the forecasted fnal
income statements of the various legal entities within the group. For companies
that have failed to plan their transfer pricing policies carefully, the results of this
examination may not be acceptable. The reaction in these groups is often to process
a lump-sum payment at the end of the year to make things right. Determining the
amount to put on these invoices is generally not diffcult. It is deciding what to call the
payment and how to justify it that is problematic. If it is described as a retroactive price
change, it has the implications discussed in section 614. If it is termed a royalty, it is
necessary to show what intangible property has been provided to the licensee and why
this was not recognised and formalised in a licence agreement at the beginning of the
year. If it is called a management fee, the problem is how to demonstrate what services
were provided, their cost and why the services were not formalised in a management
service agreement at the beginning of the year.
In short, end-of-year adjustments are diffcult to defend because there is no easy way
to explain what the payment is for. Furthermore, it is usually impossible to fnd third-
party comparables supporting major changes to the pricing of done deals. This, and
other points made in this chapter, point to the need to plan transfer pricing policies in
advance so that these problems do not occur. If such changes are unavoidable, their
risks must be recognised and such documentation as can be assembled should be
produced to defend the position taken.
614. Retroactive price changes
At the end of the fscal year, companies sometimes discover that their transfer pricing
policies have not produced the desired result. The temptation is to change transfer
prices retroactively to correct the error. This behaviour is particularly likely if one of
the related entities faces urgent cash or proftability needs. These types of changes
should be resisted at all costs, if they affect years for which fnancial statements have
been audited and published and tax returns have been fled. It is diffcult to conceive of
third-party situations where such a change would be justifable, except perhaps on very
long-term contracts. Furthermore, it is hardly likely to be in the groups best interests
to withdraw their accounts and tax returns. Concern from banks, shareholders and tax
authorities regarding the implications of such a move is bound to be highly unwelcome.
When the change affects only the current fscal year, the picture is somewhat murkier.
While the income-tax authority audits the result of a transfer pricing policy, rather than
the method used, there is a smoking gun aura surrounding retroactive price changes
that undermines the credibility of the taxpayers claim that an arms-length transfer
pricing policy is in place. Having said this, the direct tax authorities tend to review
accounts rather than invoices, and if the overall effect is to produce a fair result they
may not be able to identify the late timing of events.
Companies should not be complacent, however, even where it is unlikely that the direct
tax authorities will be able to identify a year-end adjustment. The interest of indirect
tax authorities must also be considered, as there will probably be duty and value-
added/consumption tax implications of a retroactive price change.
The best approach must be to refrain from retroactive price changes unless the
business situation is so desperate that the inherent tax risks are overwhelmed by
commercialnecessity.
615. Defensible late adjustments
The question of whether a charge can be made retroactively without creating
signifcant tax problems can usually be answered by considering comparable
transactions between parties at arms length. For instance, in most forms of
professional advice that companies seek, it is normal for the consultant to charge
his client in arrears for work they undertake at their request. However, such an
arrangement will have been agreed in advance between the consultant and the client.
It will typically be evidenced in a contract between them describing the basis upon
which they will work together. Consequently, the rendering of an invoice some time
after the work has been done (and possibly indeed in a different fnancial year) will not
affect the reasonableness or validity of the charge. However, an invoice rendered for
work carried out without prior authorisation of that work by the client will often result
in a dispute and possibly non-payment for the consultant.
To take the example even further, a consultant who gratuitously provides a company
with information that could be of value to that company might do so as a speculative
activity, hoping to win the company as a client. However, it seems unlikely that
the consultant would be in a position to demand payment for such advice, even if
successful in winning the business. The initial work is an investment for the future.
If we take these examples in the context of a group of companies where the parent
company is taking a decision to charge all the subsidiaries a management fee, it will
usually be evident from the facts whether a charge made on the last day of the year to
cover the whole of the previous 365 days will be acceptable. The questions to be asked
are whether the subsidiary requested the service and whether the subsidiary benefted
from the service. It is not good enough merely for the parent to have incurred expenses
in carrying out work that might or might not have been for the beneft of, or at the
request of, the subsidiaries.
Typically, the purchase and sale of goods is a fairly simple process. Two parties enter
into a contract for the supply of a product. The contract provides that the purchaser
takes title to the goods subject to certain conditions (perhaps, for instance, full
payment of the invoice) and the purchaser usually takes the goods under some kind
of warranty from the seller as to their general condition and their ftness for their
intended purpose. The contract also specifes the price at which the sale is to take
place. As a result, most sales between parties at arms length happen once and once
only, and any subsequent transactions relating to the same goods concern warranty
costs where the purchaser has found a diffculty with the items purchased.
It would be most unusual in a third-party situation for the seller of a product to
demand more payment for what has already been sold, sometime after the original
transaction has taken place. Despite this, many groups seek to do just this when
they realise at year-end that the profts of the group have not arisen in the different
subsidiaries quite as expected.
In certain industries, such as electronic components and semiconductors, distributors
are typically afforded price protection by the manufacturer. In these situations, the
distributor may receive credit notes by means of a retroactive discount on goods that
it cannot move, due to market conditions or discounts on future purchases to affect
the credit. However, these circumstances are limited to particular industry practices
and should not be blindly applied. A group should tread cautiously in applying
these adjustments and have documentation of third-party arrangements to support
itspositions.
If the change is necessary to bring the groups position into line with an arms-length
standard, then the timing is not as important as the need to make the change itself.
Failure to make the change at that time will merely perpetuate a situation that is
known to be incorrect and is therefore inadvisable. A technique that may assist in
reducing these tensions is to include limited rights to vary certain transactions as part
of the overall policy applying between the group companies (i.e. create a situation
where invoices are issued on an interim basis and may be adjusted for certain
predetermined and mutually agreed factors). Such contracts are not unknown between
third parties, as they can offer a mechanism to share risks, such as foreign exchange,
particularly on long-term contracts, but care must be taken to ensure that indirect taxes
and customs duties are handled appropriately.
616. Timing of changes
The timing of a change in transfer pricing policy, particularly if it corrects an error
in a prior policy, is crucial. If an income-tax audit is ongoing at the time the policy
change is made, the tax authority might become aware of the change, and it could
be alleged that the prior policy was incorrect. This type of evidence is not helpful in
settling the audit favourably. It is, therefore, imperative to plan carefully the timing of
the implementation of a policy change to minimise the impact on the tax liability for
previous years. This involves weighing the risks for prior years against the potential
cost to the company of inaction, in the form of possibly higher tax rates in the future or
possible penalties. This analysis is detailed and must be done on a case-by-case basis to
arrive at a defensible answer.
617. Big bang or gradual
Where a change in an existing transfer pricing policy is to be made for the future, the
decision must be made to phase in the change gradually or to make the change in
one big bang. Assume, for example, that the change desired is to double transfer
prices. This may be implemented through a doubling of the prices on 1 January of
the next year (the big bang) or by phasing the price change in through incremental
changes over the next three years (the gradual approach). Which of these options
should be selected is largely determined by the reaction of the local tax authority of
the country that is to pay the higher prices and vice versa in the source country of
the price increases. In some countries, the big bang works so long as it can be clearly
demonstrated that the new prices are arms length and the risk of audit on prior, open
years is controlled. In other countries (e.g. Italy), phase-in is the only way to deal with
the potential objections of the tax authority. Knowledge of the size of the change and
the reaction of the tax authority that will lose revenue on the transaction is essential to
this decision.
618. Communicating the changes to the tax authorities
For certain changes in transfer pricing policies, it may be important to obtain local
government approval. In some countries (e.g. Korea and China), for instance, royalty
payments must be approved by foreign-exchange control authorities. This is especially
true when dealing with the developing countries in general and countries that are
heavy importers of technology of all kinds. Tax authority clearances may also be
required to avoid withholding taxes or to beneft from the lower rates offered by
a double tax treaty. In other situations, it may be useful to approach the authority
concerned for a ruling on the policy under review. Such an advance pricing agreement
offers certainty to the multinational, albeit at the price of higher levels of disclosure
than might otherwise be the case (see section 707). Sometimes, in the course of a
previous years transfer pricing audit, the tax authorities may also seek the fnancial
statements of the succeeding years. A change in transfer pricing policy would then
come to light earlier than expected and hence the taxpayer should be prepared to
explain the rationale for the variance in advance.
619. Tax return disclosure
Unless the change in policy has been agreed in advance with the relevant tax authority,
the mode of its refection in the tax return should be carefully considered. It is
generally important (to avoid penalties for fraudulent or negligent non-disclosure)
to ensure that reasonable disclosure is made, while avoiding drawing unnecessary
attention to the change of policy. For example, it would generally not be suffcient to
include a signifcant new management fee under a proft and loss account category
such as miscellaneous expenses, but it might be described as technical fees if it
mainly related to technical support provided to the company.
620. Accounting disclosure
In some countries, the extent and form of accounting disclosure of a change in certain
transfer pricing policies may be prescribed by statute or accepted best practice.
However, there is generally some discretion as to the wording in the accounts, which
should be considered carefully because the accounts are likely to be reviewed, certainly
by the domestic tax authorities, and possibly by foreign revenue authorities.
621. Impact on banks and other users of the fnancial
statements
Legal entities within a corporate group may publish separate company fnancial
statements that are provided to third parties, most frequently banks. In addition,
groups are continually changing through acquisition, merger or perhaps by spinning
off a subsidiary into a public company. When this is the case, the transfer pricing policy
takes on special importance and it is essential that the policy is arms length so that the
fnancial statements are fairly presented. In these situations, when the group wishes
to change its transfer pricing policy, the risks of such a change are magnifed. All the
problems and cautions referred to in this chapter apply; the burden of explaining the
change is critically important for the successful implementation of the new policy. As a
practical matter, it may be impossible to make the changes in this situation.
There may also be other, more subtle, points to consider. For instance, the subsidiary
company may have entered into arrangements with its banks that require it to meet
certain proftability levels in order for them to maintain certain levels of overdraft
facilities. Would the reduced proftability of the company concerned (as a result of
pricing policy changes) give rise to problems in its relationship with the banks (e.g.
trigger a default of a debt covenant)? Will new guarantee arrangements be needed
from the parent company in order to give the banks the level of comfort they require
for the banking facilities needed by the subsidiary? These and other matters require
careful handling as part of the pricing policy changes.
622. Communicating the changes to employees
Changes to the transfer pricing policy of a multinational will have an impact on
numerous people and organisations. There will be an immediate effect on the
employees involved in the transactions, for there may be completely new procedures
for them to follow and they need to be directed exactly how to proceed. The reasons
underlying the change and the technical justifcation for it need to be recorded as part
of the groups overall documentation of its transfer pricing policy. It may be useful,
however, to communicate the key reasons for the change to employees and to explain
what has happened and why. This will help make employees more supportive of the
change and may well be of value in future years when those same employees may be
questioned by tax authorities on the reasons why changes were made.
For example, in the area of management services rendered by a parent company to its
subsidiaries, the parent company executives may be quite clear about the nature of
the services they carry out for subsidiaries and will also have ideas about the value to
the subsidiary of their work. However, executives at the subsidiary company may feel
overawed by the parent company or, alternatively, feel that the parent company does
not understand their position. Their view of the beneft of the services they receive
will therefore be a different one, and in such circumstances it would be enormously
helpful for both sides to be clear about what is being provided and why and how the
services will be priced. The work involved in documenting these points would follow
the course of an ordinary negotiation between parties at arms length and, if followed,
should produce a result that will be fully justifable and properly understood by all
those involved. At the same time, it is not always appropriate to let too many employees
know about tax planning initiatives that the parent company is using to manage the
worldwide tax burden of the group. Loose lips sink ships is an old adage that applies
in this area. There are numerous examples of disgruntled former employees who
knew only enough about a transfer pricing policy to suggest to the tax authority that a
fraud might exist. In such cases, the employee is rarely in a position to know the whole
story and, consequently, to understand that no fraud existed at all. The end result can
be an awkward situation for the group in dealing with the tax authority. Subject to
compliance with local laws that may govern disclosures to employees or trade unions,
employees should be told only what they need to know to do their jobs properly and to
support policies that directly affect them.
623. Impact on management/employee bonus schemes
Some of the most contentious situations faced by any transfer pricing analyst occur
when employee compensation decisions or bonuses are tied to the proftability of the
legal entity that is affected by pricing changes. In such situations, a transfer pricing
policy change increases the income of some employees and reduces the income
of others. Clearly, this creates signifcant problems within the group, as focus is
shifted away from running the business into a discussion of transfer prices. Groups
with signifcant cross-border transactions should consider establishing a method
of compensating employees, which is not related to the vicissitudes of tax law. This
is normally achieved by maintaining a mirror management accounting system
independent of statutory and legal books of accounts and can measure employee
contributions differently.
624. Accounting systems
All changes to a groups transfer pricing policies will affect the way in which
transactions are accounted for, if only to the extent of their value. There may,
however, be more signifcant implications. For instance, where a management
services agreement is established for the frst time, there will be an entirely new set
of transactions to be dealt with, both in the company rendering the service and in
the company receiving it and paying the fees. It may necessitate new account codes
and possibly new procedures for authorising such payments. Furthermore, in order
to render a charge for the management services, the price of those services has to be
determined. Very often this involves an evaluation of the time spent by the executives
performing the services, plus an analysis of the direct expenses incurred in providing
them. The analysis of the charging company accounts in order to produce the basic
information necessary to calculate the management fee can be time-consuming, and
new accounting procedures may be necessary to ensure that these invoices can be
produced quickly and effciently. New computer reports and procedures are likely to be
required and the information systems department of the group would therefore need
to be involved in the implementation of any changes to transfer pricing procedures.
Training would also need to be imparted to the employees recording transactions
so that the cutover to the new policy is error-free and transaction reversals and
rectifcation entries are minimised.
625. The audit trail
Tax authorities are requiring ever-greater amounts of information during their audits.
As discussed in chapter 7, tax authorities (particularly in the US) routinely ask for
income statement data by product line and by legal entity to aid in evaluating the
appropriateness of transfer pricing policies. This information is also of importance
to the group in monitoring and developing its pricing policies, but the level of detail
available will vary from company to company. It is particularly important to ensure
that data is not lost when policy changes are made, that the transition from old to new
systems is smooth and a full audit trail is preserved. It is also important that companies
assess the degree to which accounting data that is not routinely prepared for business
purposes may be required by a tax authority in a country in which they do business.
In some countries, severe penalties are imposed for failure to provide the data that
the tax authority requires. As in many areas of transfer pricing law and practice, the
US is by far the most demanding authority in this regard. However, the US approach
is gaining increasing credence in other countries, and most companies do not have
the accounting systems required to develop these detailed income statements easily.
Care must be taken, where possible, to ensure that accounting system enhancement
programmes are designed with these criteria in mind. Having these processes built into
a companys internal control process is typically best practice.
626. Documenting the changes
The documentation of the groups pricing policy forms an important part of the
evidence supporting the values shown on invoices and eventually the profts refected
in the fnancial statements. In most countries, company directors have an obligation to
conduct themselves and the companys activities in a businesslike way and to act in the
companys best interests at all times. Proper documentation of the pricing policy and
changes to it are therefore important parts of the audit trail supporting the actions of
the directors. It is also important to document the reasons for the change so that it is
clear to all tax authorities involved that the change produces an arms-length result. In
some countries, notably the US, contemporaneous evidence is required by law. Even
where it is not, papers prepared at the time of the relevant transactions, clearly written
and supported by appropriate evidence, will always be of great value.
Dealing with an audit of transfer pricing
by a tax authority
7.
122 www.pwc.com/internationaltp Dealing with an audit of transfer pricing by a tax authority
701. Introduction
Transfer pricing is an area in which tax authorities increasingly choose to focus when
auditing the tax returns of businesses that have transactions with foreign affliated
entities. A number of reasons for this can be identifed, including the following:
Companies are becoming more international in their operations and therefore
there are ever-growing numbers of cross-border transactions between affliates.
Tax planning increasingly focuses on the optimisation of the effective worldwide
tax rate and on its stabilisation at the lowest possible level a defensible transfer
pricing policy is fundamental to the attainment of these objectives.
Tax authorities are increasingly recognising that commercial relations between
affliates may fail to refect the arms-length principle.
More and more jurisdictions are legislating, or codifying interpretations, on
transfer pricing matters into their tax statutes.
As tax authorities gain experience in transfer pricing audits, they are becoming
more sophisticated and aggressive in their approach and more skilled in selecting
cases that they believe are worth detailed investigation.
The approach of tax authorities in different jurisdictions to transfer pricing audits
varies enormously. In some developing economies in particular, transfer pricing
has not yet been identifed as a key target for serious reviews; revenue controls are
maintained through foreign-exchange control and withholding taxes. This trend
has dramatically changed in recent years, even in these emerging economies, as
new legislations are enacted and these economies have become more sophisticated
in transfer pricing as a result of cross-training from revenue authorities of other
jurisdictions. In others, a pricing audit is likely to consist of a fairly basic review of the
companys intragroup transactions by a local tax inspector. Then there are jurisdictions
where, due to the relative inexperience of the revenue authorities and the taxpayer
and owing to recent legislation, transfer pricing arrangements are regularly taken up
for audit and subjected to scrutiny, regardless of their acceptance in previous years.
In these circumstances, if the local company and its tax inspector cannot agree on
appropriate transfer prices, the matter may need to be resolved before the appropriate
revenue commission and ultimately in court. Such appellate proceedings would
normally be based on facts and relative perceived merits of the positions adopted by
the taxpayer and the revenue authorities rather than on the pure technical merits of
the case alone.
International Transfer Pricing 2011 Dealing with an audit of transfer pricing by a tax authority 123
Dealing with an audit of transfer pricing by
a taxauthority
Under other jurisdictions (notably the US) a complex framework of extensive resources
and procedures has been established to deal with transfer pricing investigations
and disputes. In some countries, it has been suggested that the natural inclination
of the local tax authority and government would be to apply fairly relaxed transfer
pricing principles, only mounting a concerted transfer pricing attack where the prices
concerned fall outside a reasonable range. However, the aggressive US approach to
transfer pricing has apparently caused these countries (Japan, Korea and Germany are
notable examples) to seek to match the extensive resources devoted to transfer pricing
in countries such as the US, UK and Australia, and to legislate to introduce clearer rules
on the subject to protect its tax base from predatory tax authorities around the world.
Transfer pricing audits are as likely as other areas of taxation to be subject to legislative
and procedural changes over time. This chapter, therefore, deals generally with those
factors that should be addressed when dealing with any transfer pricing audit. The
audit processes are covered specifcally in the country sections and demonstrate the
diversity of approach around the world. Perhaps the most important point to note
is that all the tax authorities reviewed (as well as others) are continually building
up their resources and experience in the transfer pricing area. Correspondingly,
the increased attention paid by the tax authorities also leads to questioning by less
experienced revenue agents.
The taxpayer has to consider whether to adopt a policy of responding in a passive
manner to questions that seem to be leading nowhere or whether to take a proactive
approach, which assumes that ultimately a defence of its transfer pricing policies will
be required.
702. Establishing control of the audit process
It is crucial that the taxpayer establishes and maintains control of the audit process.
Companies in the throes of a transfer pricing audit often ask how much information
the local tax authority will require and how long the process will take. Unfortunately,
unless the company is proactive in controlling the audit, the answer to this question
tends to be How much information do you have?
For the company to take control of the audit process, it must be able to take a frm
stance. All too often, a tax audit highlights the lack of knowledge a group has about its
own pricing policies and their implications. If the company fnds itself in this position,
it will need to take stock very rapidly and reach some broad conclusions about its inter-
company arrangements. For instance:
1. What functions, risks and intangibles exist in the legal entities between which the
relevant transactions have occurred?
2. What interpretation should be placed on this functional analysis (e.g. is the local
company a contract rather than a full-fedged operating entity)? (See chapter 4.)
3. What is the information available to support the groups position?
4. What very broad conclusions can be reached about the risks inherent in the tax
audit on balance, will the company win or lose if all the relevant information is
examined by the tax authority?
Control of the audit process can be established and maintained only if the taxpayer
devotes appropriate resources to this endeavour. Therefore, it is necessary to
ensurethat:
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Management support is obtained for the endeavour;
A team of appropriate and highly competent individuals, consisting of tax and
operational staff, are assigned to manage the audit process (this team should
include non-local personnel and external advisors as appropriate) and are allowed
to devote a suffcient time to the task;
All the information required by the team is made available to it on a timely
basis;and
A careful plan is established that sets out protocols on how the audit should
progress and how liaison with the local tax authority (and overseas authorities)
should be handled.
If the taxpayers audit team is operating in the context of a well-planned and executed
worldwide transfer pricing policy, its job will naturally be substantially easier than if
prices within the international group have been set on an ad hoc basis, as a result of
administrative convenience or tax imperatives existing in different locations.
703. Minimising the exposure
Tax exposure can be limited in a number of ways in the context of an imminent or
ongoing transfer pricing audit. For example:
Tax returns for prior years, which are not under audit, should be fnalised and
agreed with the local tax authorities as quickly as possible;
If it is envisaged that additional tax will be payable as a result of the audit, action
should be taken to limit interest on overdue tax and penalties if possible, perhaps by
interim payments of tax. However, an additional tax payment might be regarded as
an admission of guilt and the tactics of payment as well as the fnancial implications
will require careful consideration; and
Depending on the circumstances, it may be advisable to plan to reach a negotiated
settlement with the local tax authority in relation to prior years and agree arms-
length terms to apply in future periods in such circumstances, one should also
consider the impact of such settlement on overseas tax liabilities.
704. Settling the matter negotiation, litigation
andarbitration
Negotiation with the local tax authority representatives on transfer pricing issues is
a critical element of the audit process in many jurisdictions. Successful negotiation
requires, at least, the following:
A capable, confdent negotiating team;
Full and up-to-date information on the issues under discussion;
An understanding of local statutes, case law and practice;
A well-laid-out strategy concerning the issues at hand, identifying what positions
could be compromised and others on which the company would not budge;
Experience of the general attitude of the local tax authority towards the type of
issues under consideration; and
A clear view of the fnancial risks of reaching or not reaching agreement.
The old adage know thine enemy is of crucial importance in pursuing a favourable
outcome to a transfer pricing dispute. At all stages of the audit, the company will need
to consider the nature and experience of the tax authority team. For example, is it
a taxauthority
dealing with a local tax inspector, a revenue commissioner in transfer pricing, a trained
economist or a professional revenue attorney?
The implication of not reaching an agreement is, of course, ultimately, litigation in the
local jurisdiction. The company needs to consider the implications of local litigation on
transfer pricing issues very carefully, as the chances of success in the courts may vary
widely in different countries. Again, the extent to which transfer pricing issues, being
substantially questions of fact, can be escalated in the legal system would have to be
borne in mind relative to other available administrative relief measures. The burden of
proof is different from jurisdiction to jurisdiction, and at various times local courts may
refect public concern that foreigners are shifting taxable income out of the country
rather than the pure technical integrity of the matter. In these instances, the taxpayer
may feel that it should not pursue its case through the local judicial system. The
implication of a transfer pricing adjustment resulting in a liability is the payment of the
tax demand. This presents a cash fow situation for the taxpayer, regardless of whether
the company decides to pursue litigation or alternative dispute-resolution avenues.
Furthermore, the company must consider the implications of the transfer pricing
assessments and the dispute-resolution measures to be taken and how these matters
should be disclosed on its publicly released fnancial statements. This is becoming
evermore a critical matter in todays environment, where transparency of a companys
accounting policies is required by public markets.
When negotiation or litigation has resulted in a tax adjustment, the company must
consider whether an offsetting adjustment can be made in the other country involved.
This may be through the mutual agreement procedures of the relevant income-tax
convention or, alternatively, a special-purpose arbitration vehicle such as the European
Arbitration Convention for countries that are part of the European Union (see chapter
10). Considering all the avenues that are available to a taxpayer, it is critical to
consider the appropriate timing of when to invoke one avenue versus the another (i.e.
should the taxpayer pursue a mutual agreement procedure process if negotiations
with the local inspectors fail, should litigation be pursued instead, or should both
processes be initiated at the same time). The decision on these matters hinges on
where the taxpayer believes it will be able to reach the best solution given the factors
previouslydiscussed.
705. Preparation
Negotiation, litigation and arbitration are all procedures that demand extensive
preparation if the company is to protect its best interests. It should be borne in mind
that individuals other than those directly involved in managing the audit process may
be required to answer questions or give evidence and they must be adequately briefed
to ensure that they can deal with the questions addressed to them.
The taxpayers audit team must research the powers of the local tax authority and
plan to meet its likely requirements. For example, the local tax authority may have the
power to require the provision of substantial amounts of information about the groups
transactions within a short time frame. Further, in view of protracted revenue audit
or litigation proceedings, which may take place long after the transactions in question
have occurred, the importance of documentation at every step (by way of work papers,
notices, hearing memos, submissions and rejoinders) cannot be overemphasised.
Dealing with an audit of transfer pricing by a tax authority 126 www.pwc.com/internationaltp
Any information that is to be provided to the local tax authority (verbal or
documented) must be carefully reviewed by the audit team to ensure the following:
All of the information is correct;
All of the information is consistent with the tax returns and accounts of the relevant
entities and other information which may be available to the local tax authority;
The positive or negative implications of the information have been fully considered
(i.e. does it support the existing pricing structure, and the functional analysis of the
relevant entities activities or does it identify a tax exposure?); and
Proper consideration has been given to the possibility that the information will
be made available to other tax authorities and that the local tax authority may
have sought information of other authorities under the exchange of information
procedure in income tax conventions.
706. Dealing with adjustments to existing pricing
arrangements
If an adjustment to the existing transfer pricing arrangement is agreed with the
tax authority, it is necessary to consider what impact this has or will have on the
commercial and tax positions of the relevant entities in past and future periods. The
discussion in section 607 and sections 613615 is relevant here.
In respect of past periods, the company must decide whether it can or should refect
the tax adjustment in commercial terms by raising appropriate invoices (although
commercially desirable, this may not be possible in practice, demanding recourse to
the dispute-retention procedures in bilateral tax treaties to seek to achieve relief see
also chapter 10 for notes on the arbitration procedure in the EU). Similarly, with regard
to the future, it must decide whether to amend the transfer pricing arrangement to take
the tax adjustment into account. A key factor in each of these decisions is the attitude
of the tax authority in the country where the other affliate is located double taxation
is a risk that most taxpayers are anxious to avoid. In addition to the direct tax issues,
the company must consider whether the adjustments need to be refected in tax returns
for indirect taxes and customs duties. This may be the case where the transfer pricing
adjustments are related directly to particular shipments of goods. Further, accounting
and regulatory considerations must also be taken note of.
If the tax authority that would bear the cost of any simple adjustment refuses to accept
its validity, it may be necessary to invoke competent authority procedures under a tax
treaty or some other form of resolution (e.g. the European Union arbitration procedure
see sections 10031015) in order to reach a satisfactory conclusion. Such processes
are unfortunately very lengthy, but some form of negotiation or arbitration may be
the only way to ensure the agreement of all the relevant tax authorities to the pricing
policy on an ongoing basis.
707. Advance rulings
It may be possible to request an advance ruling on an acceptable pricing structure
(an advance pricing agreement (APA)) from a tax authority. If mutual agreement is
reached, this option provides relative certainty for the future by setting a precedent,
which may be very attractive to the taxpayer. Countries vary in their willingness to
a tax authority
provide advance comfort that a particular pricing arrangement or structure will not
be disputed. This is a rapidly developing area because, as more countries become
used to the process, it becomes more attractive for them to put resources into advance
agreements, recognising that it is often signifcantly quicker and cheaper for the tax
authority than ex post facto dispute resolution.
As a general rule, the greater degree of comfort provided, the more likely it is that a
signifcant amount of detailed information will be required by the local tax authority
to enable it to make such a ruling. This robust disclosure may be costly and time-
consuming from an administrative point of view and may weaken the companys
negotiating position in the future or on other issues that may arise.
In some instances, two or more tax authorities may be willing to work together to give
a mutually agreed solution for the future. However, some authorities consider that
they do not have suffcient resources to pursue many such projects.
Any APA or ruling is valid only as long as the fact pattern on which it is based remains
in place. Therefore, if functions, risks or intangibles are, to a substantial extent, moved
to different entities, a new agreement or ruling must be sought. Even during the tenor
of the APA, it would be essential to maintain documentation establishing that the
transfer pricing arrangements adhere to the terms of the agreement.
Financial Services
8.
128 www.pwc.com/internationaltp Financial Services
801. Introduction
Transfer pricing within the fnancial services industry raises some of the most complex
issues in the transfer pricing arena. The industry covers a wide range of business
activities, and it is not possible in this chapter to explore all of these issues in depth.
Therefore, this chapter considers the main issues and approaches to common types of
transactions associated with banking and capital markets, insurance and investment
management activities keeping in mind that these are not mutually exclusive; a
multinational groups activities may well span two or more of these sectors.
Some of the features of the fnancial services industry which, in part, contribute to
its complexity from a transfer pricing perspective are explored below, after which,
issues specifc to each of the three sectors identifed above are discussed. Perhaps
one feature that, while not wholly restricted to the fnancial services industry, is
more prevalent in this industry, is the impact that regulation, global integration and
the other factors mentioned below tend to have commercially, and the limits that
they place on businesses and their ability to structure their operations to deal with
pricingchallenges.
802. Regulation
Most parts of the fnancial services industry are subject to signifcant levels of
government regulation, for example to protect the integrity of the fnancial system
globally or to protect consumers. Historically, the regulation has involved myriad rules
and regulators at the local country level, although more recently there has been a move
towards more consistency at the international level, for example through the Bank for
International Settlements (BIS) and within the European Union (EU). Regulation often
imposes restrictions on the types of business that can be conducted and the corporate
and operating structures that can be employed. Any analysis of the transfer pricing
position should be mindful of these restrictions. Conversely, operating structures
accepted by the regulators may provide evidence that the arrangements should also be
accepted for transfer pricing purposes.
803. Global integration
Like other industry sectors, the fnancial services industry is increasingly moving
towards more globally and regionally integrated business units, with less focus on the
results of individual countries and greater focus on the global or regional results. This,
in turn, increases the challenges of identifying and monitoring the pricing of cross-
International Transfer Pricing 2011 Financial Services 129
Financial Services
border transactions and reduces the inherent comfort that businesses have the internal
checks to ensure that each country has been appropriately remunerated.
While these observations are true for many other industries, the challenges are
greater for a sector such as the fnancial services sector where capital is tangible, is
not dependent on major plant or factories and which does not involve the fow of
tangibleproducts.
804. Complexity and speed
Parts of the fnancial services industry are also highly innovative in their development
and use of new and complex products, and also in the speed with which they have
exploited and come to rely on new technology. One of the features of the industry is
that a relatively small number of individuals based in a few countries across the globe
may be largely responsible for managing substantial assets and risks with increasingly
complex interactions with other teams, products and countries. Any analysis of the
transfer pricing position should refect an understanding of not only the products
involved but also the overall businesses and the systems used to manage them.
805. Capital
The availability of capital is critical to the success of all businesses. It allows key
investments to be made and ensures cash is available when needed to keep the
business going. However, for many businesses within the fnancial services industry,
capital plays a more fundamental role. Without the required level of capital, a business
may be prevented from establishing itself or continuing to operate in its current form
by regulators. The nature and level of capital held may affect both the extent to which
other businesses will transact with it and the prices at which they are prepared to do
so. The level of capital to be held by banks, for example, is currently one element of a
major review by the BIS.
806. Branch proft allocation
While transfer pricing has traditionally concerned itself with cross-border transactions
between separate legal entities, the fnancial services industry, particularly in the
banking and insurance sectors, has historically operated through branches. Attributing
the profts or losses of branches raises issues similar to those in traditional transfer
pricing. The OECD reviewed how profts and losses of branches should be determined
and the extent to which branches should be treated as if they were separate legal
entities. In December 2006, the OECD published fnal reports (Parts I, II and III) on
the attribution of profts to permanent establishments, as well as a draft Part IV for
the insurance industry in August 2007. For a fuller discussion of this complex and
challenging area, see the OECDs papers on the attribution of profts to permanent
establishments, available on the OECD website.
807. Economic analysis
The economic analysis of transactions within the fnancial services industry is perhaps
unique in that for certain types of transactions, such as foreign currency trades, there
are highly liquid and relatively transparent markets from which to obtain pricing.
However, it is also an industry with some of the most globally integrated businesses
Financial Services 130 www.pwc.com/internationaltp
that publish few, if any, comparable transactions, and also one in which great care is
required to avoid the use of data that do not represent reliable comparables.
BANKING AND CAPITAL MARKETS
808. Introduction
The word bank is derived from a medieval expression for bench the place of
business of a moneychanger. The functions of banking institutions have grown
considerably since the era when they were discharged over a table in the town square.
From the traditional lending of funds and fnancing of trade fows, banks activities
have extended to retail deposit-taking, lending, credit cards and mortgages to private
client wealth management, commercial loans, asset-backed fnancing and fnancial risk
management products, and into capital markets activities including equity brokerage,
bond dealing, corporate fnance advisory services and the underwriting of securities.
Over the last century, banks and capital markets groups have expanded across the
globe, in part to service their internationally active commercial clients and in part
to track the fow of capital from developed countries to newer markets in search of
higherreturns.
The traditional lending activity involves a bank borrowing funds from various
investors, such as depositors, and earning a spread by lending to borrowers at a higher
interest rate based on the banks credit assessment of the borrower. However, over
the years, the spread earned by banks has reduced considerably. Consequently, banks
have made an increasing percentage of their total income from non-lending activities,
by leveraging off their infrastructure and network in the fnancial markets to provide
value-added services from straightforward foreign currency trades to more complex
structured products.
The banking sector is one of the more regulated of the fnancial services sectors, and
banking and capital markets groups have become some of the most globally integrated
and dynamic in the industry. It is also one in which there can be a signifcant range of
operating structures between different products and business lines within a group and
between the same products and business lines between different groups.
This section considers the main types of cross-border transactions and activities in
traditional banking and capital markets groups.
809. Global trading
A global trading operation involves the execution of customer transactions in fnancial
products where part of the business takes place in more than one jurisdiction or
the operation is conducted on a 24-hour basis. A simple example would be where a
salesperson in one country introduces a customer to the trader located in another
country who is responsible for trading the relevant fnancial product followed by the
execution of the customer transaction by the trader.
Transfer pricing in respect of global trading operations has been an acute issue for
many years. The OECD has provided its most extensive and detailed review in Part
III of its report on the attribution of profts to permanent establishments. The report,
however, does not address whether a PE exists, given a specifc global trading activity.
Financial Services
Part I of the report merely sets out how the profts should be allocated, given that the
PE already exists.
Moreover, the report seems more open to the use of hedge fund comparables in
appropriate circumstances. A diffculty would be whether it is possible to make reliable
adjustments for better comparability purposes.
In a proft split context, the report emphasises that where associated enterprises are
involved, the reward for capital inures to enterprise(s) that have the capital. However,
the OECD report has not commented on how to handle practical issues that may arise
from this approach.
Historically, and considering the large amounts at stake, many multinational banks
have resorted to advance pricing agreements (APAs) as a way of addressing the
uncertainty resulting from the often judgemental and subjective nature of pricing this
type of activity. Adopting an APA approach has its own disadvantages, including the
speed with which global trading businesses develop (potentially rendering an APA out
of date before it is even fnalised), the time-consuming and expensive nature of APAs,
and the practical diffculty of negotiating APAs for more than a few jurisdictions.
810. Fee-based businesses
Fee-based businesses range from relatively high-volume, low-fee-based businesses
such as equity brokerage to the relatively low-volume, high-fee-based businesses
such as corporate fnance advisory activities and the management, underwriting and
distribution of new issues of securities for clients.
Even within such well-established businesses as equity brokerage, there can be a wide
range of operating structures within a group and a signifcant variety of products
and services provided to clients. Substantial differences may also exist between the
products, markets and exchanges of different countries, including not only in the
volatility and liquidity of products but also, for example, in the settlement risks and
costs involved. Diffculties can also arise in extrapolating from data on relatively small
trading volumes to potentially much larger volumes handled within a group.
The relatively low-volume, high-fee-based businesses can be particularly challenging
from a transfer pricing perspective, particularly as many of the transactions are unique.
Several years may have been spent investing in a client relationship before a structured
transaction emerges and when it does, specialists from several countries with different
expertise may be involved in the fnal transaction.
811. Treasury and funding
The funding of a bank, both on a short-term basis, for example to meet withdrawals
by depositors and to fund new loans, and on a longer term basis as part of the overall
management of the capital of a bank, is an intrinsic part of the activities of a bank.
Although many of the transfer pricing issues surrounding fnancing transactions
identifed in sections 215 to 225 apply equally to intragroup funding within banking
groups, the nature, amount and term of internal funding may be signifcantly affected
by regulatory requirements and by pressures in the market to raise and use funds
effciently within a group. Operating structures for raising and managing funds
within banking groups vary and, even for relatively straightforward money market
transactions, care may be required to ensure that each party to the transaction is
adequately remunerated.
812. Cross-border services
Banking and capital markets groups generally undertake many of the same types
of centralised activities that are considered in the management services chapter
(sections 501512), including inter alia the provision of central human resources,
legal, accounting, internal communications and public relations activities. The same
considerations relating to the identifcation of the services provided and benefts
conferred, the entities providing the services, the entities receiving the services, the
costs involved and the application of a markup apply equally here.
Other activities that are largely unique to the banking sector and increasingly
centralised within a banking group include credit and market risk management
and regulatory compliance and reporting. Banks are also often heavily reliant on IT
systems, communication links and external data feeds. While tracking and pricing the
use of externally developed software is in principle no different from other industries,
identifying the role and pricing of internally developed proprietary software can be
especially challenging, particularly in view of the amounts involved.
813. Other issues in banking and capital markets
The above comments are by no means exhaustive. Other important but diffcult issues
include the transfer pricing treatment of relationship managers. Developments in the
banking sector have resulted in an increasing focus on trading and fee-based activities
leading to corresponding changes in the perception of the role of general banking
relationship managers. This in turn leads to a more diffcult question of whether the
relationship management function remains an originator of wealth or has perhaps
become merely a consumer of cost.
Similarly, research has historically been treated as an overall cost to a business.
Developments since the late 1990s suggest that the role of research may need to
be reassessed as the market for research becomes increasingly sophisticated and
independent from the multinational group, leading in some cases perhaps to a
potential comparable uncontrolled price (CUP) approach.
Credit derivatives is another area where there have been signifcant developments
recently, not only in the trading area where customers have been increasingly willing to
purchase protection or take on credit exposure but also in the use of credit derivatives
internally by banking groups, for example as part of the centralised management of
credit risks associated with loan portfolios.
INSURANCE
814. Introduction
In general, an insurance policy is a contract that binds an insurer to indemnify an
insured against a specifed loss in exchange for a set payment, or premium. An
insurance company is a fnancial entity that sells these policies.
Financial Services
Insurance policies cover a wide range of risks. Broadly, these can be classifed as:
General insurance (motor, weather, nuclear, credit); and
Life insurance (pension, term).
The major operations of an insurance company are underwriting, the determination
of which risks the insurer can take on; and rate-making, the decisions regarding
necessary prices for such risks, claims management and appropriate investment of the
sizeable assets that an insurer holds. By investing premium payments in a wide range
of revenue-producing projects, insurance companies have become major suppliers of
capital, and they rank among the largest institutional investors.
815. Reinsurance
Reinsurance is insurance purchased by insurers. Under a reinsurance arrangement,
the reinsurer agrees to indemnify an insurer (known as the cedant under a reinsurance
contract) against part or all of the liabilities assumed by the cedant under one or more
insurance or reinsurance contracts.
In consideration for reinsuring risks, the ceding insurance company pays a premium
to the reinsurer. Although reinsurance does not legally discharge the primary insurer
from its liability for the coverage provided by its policies, it does make the reinsurer
liable to the primary insurer with respect to losses sustained under the policy or
policies issued by the primary insurer that are covered by the reinsurance transaction.
Reinsurance is generally purchased for any of the following reasons:
For an insurer to accept risk, the number of insured must be large enough and
diverse enough for the law of large numbers to operate and thereby enable the
insurer to conclude that the risk of loss is acceptable. Frequently, however, an
insurer may accept, for business reasons, insurance of a class or amount that does
not permit the law of large numbers to operate or that could result in claims the
insurer does not have the fnancial capacity to absorb. Such risks can be diversifed,
transferred to or shared with a reinsurer;
An insurance company can reduce the volatility in its annual results by purchasing
reinsurance coverage for those losses. However, even with reinsurance in place
to help stabilise loss experience, a man-made or natural catastrophe could have
a signifcant impact on a companys capital. Catastrophe reinsurance can provide
fnancial protection against such disasters at a cost to the primary insurer;
Reinsurance may be used to help increase premium-writing capacity on existing
business. An insurers gross underwriting capacity (i.e. its ability to write business)
is limited by law or regulation based on the amount of its statutory surplus. The
greater the ratio of premiums written or liabilities to such surplus (i.e. its leverage
ratio), the less likely it is that the regulator will consider the surplus to be suffcient
to withstand adverse claims experience on business written. Through reinsurance,
an insurer can increase its gross volume of business written, while maintaining a
healthy ratio between risk retained and surplus;
Reinsurance also may be used to facilitate the growth of an insurers new products
or aid its entry into new lines of business. For example, a quota share contract with
the assuming company may call for the payment by the reinsurance company to the
insurer of an upfront commission (ceding allowance), which could fund a portion
of the insurers development and acquisition expenses and thereby reduce its
upfront cash requirements and the resulting statutory surplus strain from entering
a new product line. As noted above, the reinsurance also provides additional gross
premium-writing capacity. Reinsurance can also provide the insurer access to the
reinsurers expertise in the new line of business;
The terms of reinsurance contracts refect a consideration of the general economic
environment of the insurance industry, both recent and projected, and the risks
perceived by both the buyer and seller of the reinsurance. Many reinsurance
contracts contain terms that are intended to limit to some degree the variability
in underwriting results in order to limit business risks to the assuming reinsurer
associated with the reinsurance contract; and
Common risk-limiting features include sliding-scale and other adjustable
commissions that depend on the level of ceded losses, proft-sharing formulas,
retrospective premium adjustments, and mandatory reinstatement premiums
and limits (caps). Sliding-scale commissions and proft-sharing formulas
typically adjust cash fows between the ceding and assuming company based on
loss experience (e.g. increasing payments back to the ceding company as losses
decrease and decreasing payments back to the ceding company as losses increase,
subject to maximum and minimum limits).
Forms of reinsurance
The two methods by which risk is ceded through reinsurance contracts are:
Treaty reinsurance A contractual arrangement that provides for the automatic
placement of a specifc type or category of risk underwritten by the primary
insurer; and
Facultative reinsurance The reinsurance of individual risks whereby the insurer
separately rates and underwrites each risk. Facultative reinsurance is typically
purchased by primary insurers for individual risks not covered by their reinsurance
treaties, for excess losses on risks covered by their reinsurance treaties and for
unusual risks.
The two major forms of reinsurance are proportional reinsurance and excess-of-loss
reinsurance. Premiums received from treaty and facultative reinsurance agreements
vary according to, among other things, whether the reinsurance is on an excess-of-loss
or on a proportional basis.
1. Proportional reinsurance The two types of proportional insurance are:
Quota share The risk is shared according to pre-agreed percentages.
Surplus share agreement The primary insurer selects the amount of liability it
wishes to retain on the policy and then cedes multiples, known as lines, of its
retention to the insurer. Losses and premiums are divided between the company
and the reinsurer proportionally with respect to the portion of risk undertaken.
Surplus shares agreements are generally issued only on a treaty basis and
allow the primary insurer greater fexibility than quota shares in ceding risk to
thereinsurer.
2. Excess-of-loss reinsurance The reinsurer indemnifes the primary insurer for all
covered losses incurred on underlying insurance policies in excess of a specifed
retention. Premiums that the primary insurer pays to the insurer for excess-of-loss
coverage are not directly proportional to the premiums that the primary insurer
receives, because the reinsurer does not assume a proportional risk. Furthermore,
the reinsurer generally does not pay any ceding commissions to the primary insurer
Financial Services
in connection with excess-of-loss reinsurance. Large amounts of coverage typically
are written layers, with each layer being an excess policy, taking effect once losses
exceed some attachment point. This layering could result from placement
activities of a broker, who may be unable to place the entire amount of coverage
with a single insurer or reinsurer.
A company that provides reinsurance can, in its turn, engage in an activity known as
retrocession. Retrocession is defned as a transaction in which a reinsurer cedes to
another reinsurer all or part of the reinsurance it has previously assumed. The ceding
reinsurer in a retrocession is known as the retrocedent, while the assuming reinsurer
is known as the retrocessionaire.
Intragroup reinsurance arrangements are typically the most material transfer pricing
transactions for most insurance groups. As many group reinsurance companies are
resident in jurisdictions with benign tax and regulatory regimes, such as Bermuda,
revenue authorities have increased transfer pricing scrutiny, a trend that has gained
signifcant momentum following the OECDs work on the attribution of profts to
permanent establishments of insurance companies, Part IV of which was published in
draft form in 2007.
As described above, reinsurance transactions are generally complex in nature and
many contracts are bespoke to address the particular requirements of both the
reinsured and the reinsurer. Transfer pricing support typically comprises a combination
of the following approaches:
Commercial rationale:
The frst requirement in support of a reinsurance arrangement is to demonstrate the
commercial rationale behind the transaction. Tax authorities can seek to recharacterise
the transaction if it would clearly not have been entered into with a third party. This
is particularly critical given the OECD members current focus on an anti-avoidance
agenda in respect of reinsurance transactions and businessrestructuring.
Internal CUPs:
In some cases, a group reinsures portions of the same business to related and unrelated
parties, which may provide a strong CUP. In other cases, a group may have previously
reinsured with an external reinsurer before establishing a group reinsurer. Care needs
to be taken to demonstrate that the contracts are comparable, taking into account the
mix of business, layers of risk, volume, expected loss ratios, reinsurance capacity, etc.
Pricing process:
For complex non-proportional reinsurance, the most appropriate transfer pricing
support may often be derived from being able to demonstrate that the pricing process
for internal reinsurance contracts is exactly the same as that for external reinsurance.
This involves due diligence on the actuarial modelling and underlying assumptions,
as well as the underwriting decision, which evidences the process of negotiation,
challenge and agreement on the fnal price. The use of this approach has been
strengthened by the new US temporary services regulations, which expanded the
indirect evidence rule by reference to an insurance-specifc example.
Cost of capital:
Many large proportional reinsurance contracts are diffcult to price using either of
the above methods, as they often involve multiple classes of business that are not
commonly found in the marketplace. In such cases, it is often necessary to return to
frst principles and address the capital requirements and appropriate return on capital
based on the expected volatility and loss ratios of the portfolio of business, as well
as the cost of acquiring and supporting the business, thereby addressing the pricing
from both the cedants and reinsurers perspectives. Additionally, ratings agencies
may provide guidance and support for the pricing process through the benefts in the
sources and uses ratio due to capital relief obtained through reinsurancetransactions.
816. Centralisation
Insurance groups generally undertake many of the same types of centralised activities
that are considered in the management services chapter (sections 501512), including
inter alia the provision of central human resources, legal, accounting, internal
communications and public relations activities. The same considerations relating
to the identifcation of the services provided, the entities providing the services, the
entities receiving the services, the costs involved and the application of a markup
apply equally here. Certain aspects of centralisation which are unique to the insurance
industry are discussed further below.
Most multinational insurance groups will have formulated a group strategy to manage
their risks in one or more centralised locations. It is critical to understand the group
strategy in terms of the layering and location of risks, as well as the objectives behind
risk centralisation, in order to develop a coherent transfer pricing strategy. Such
centralisation of risk may allow a group to purchase cover on a global basis, thereby
gaining advantages of economies of scale. Consideration should be given to how this
beneft is shared between the participants.
Specifc centralisation issues can also arise when global insurance policies are sold
to multinationals where negotiation, agreement and management of risk occur at
the global or regional head-offce level. In such cases, even where the local insurance
company/branch is required to book the premium, the reality may be that the local
entity is bearing little or no risk. Alternatively, where risk is shared among the
participants, consideration needs to be given to how the central costs of negotiation
should be shared.
817. Investment and asset management
The return earned from investing the premium collected contributes to the ability
of insurance companies to meet their claims obligations. To the extent that such
investment and asset management capabilities are concentrated in certain parts of
the overall group, a charge is made for the services provided to other members of the
group. Specifc factors that may infuence the pricing of such services include the type
of assets managed, level of activities carried out, risk involved, volume of transactions,
expected returns and expenses of providing such services.
The specifc issues to be considered are described in more detail in the Investment
Management section below. However, it is worth noting here that, as insurance groups
often have very large sums to manage and the level of funds under management
represents a key business factor in pricing investment management services,
comparables used in the broader investment management sector may need to be
adjusted for the sale of invested assets before being applied within an insurance group.
Financial Services
818. Financing and fnancial guarantees
As with banking, many of the issues surrounding fnancing transactions identifed in
sections 215225 apply equally to intragroup fnancing within insurance institutions.
These include intragroup loans and loan guarantees. However, certain fnancing issues
are specifc to the insurance sector.
The provision of fnancial guarantees is an important aspect of insurance transfer
pricing. Such guarantees can include claims guarantees, net worth maintenance
agreements and keep-well arrangements. Pertinent factors that need to be considered
include the type of security or collateral involved, the differential credit ratings
between guarantee providers and recipients, market conditions, and type and timing of
the guarantee.
819. Brokerage and agency activities
With the increasing internationalisation and consolidation in the insurance sector,
insurance brokers and agents are becoming increasingly integrated. As such,
brokerage/commission sharing becomes increasingly complicated, resulting in the use
of the proft split method as a primary or secondary supporting method.
820. Other issues in insurance
Insurance companies are increasingly expanding into new areas of business, with
a view to diversifying the risks associated with the modern insurance industry. As
a result, we are seeing insurance groups undertake many of the activities that have
traditionally been associated with the banking and capital markets industry. Hurricane
Katrina and the fears of avian fu have brought new attention to ways of transferring
risk to the capital markets. The resurgence of insurance derivatives is part of the
general trend of using capital markets solutions to solve insurance industry problems.
Transfer pricing associated with the trading of insurance derivatives often raises
similar issues described above for global trading within banks, as discussed above.
One specifc issue that arises refects the history of insurance groups. As insurance
groups have grown, typically through acquisition, complicated group structures
and non-standard transactions have arisen as a result of regulatory restrictions and
historical accident. Understanding the history behind such transactions often plays
an important part in explaining how the transfer pricing approach must be evaluated
within an appropriate commercial context.
INVESTMENT MANAGEMENT
821. Introduction
Investment management activity permeates the entire fnancial services industry.
Insurance companies have a core need to manage the funds generated through their
insurance premiums, and banks may manage investments on a proprietary basis or on
behalf of their customers. Many investment management businesses are therefore part
of a wider banking or insurance operation, but there are also a signifcant number of
independent investment management frms whose sole business it is to manage assets
on behalf of their clients. In all cases, assets are reinvested on a segregated basis or,
more commonly, on a pooled basis through the medium of a notional or legally distinct
investment fund.
The diverse and global nature of the investment management industry gives rise to a
huge variety of investment fund types. Fund types include securities or bond funds,
hedge funds, property funds, private equity funds, futures and options funds, trading
funds, guaranteed funds, warrant funds and fund of funds. These funds can be further
subdivided into different share or unit classes incorporating different charges, rights
and currency classes.
Within each type of fund are different strategies of asset management. Investors select
funds based on performance and their aversion to risk. Funds can either passively
track an index or be actively managed. Indexed funds or trackers are benchmarked to
a defned market index. The fund manager is passive insofar as they do not attempt to
outperform the index through stock selection. This contrasts with the actively managed
fund where the manager selects assets with the aim of outperforming the market or
thebenchmark.
Factors such as the increasing mobility of capital and technical advances in the feld of
communications have contributed to the large number of jurisdictions with thriving
investment management industries. In many cases, investment managers offer services
from offshore domiciles to investors in selected target countries for certain legal,
regulatory or tax requirements. Investment advisory, marketing and fund-accounting
services are often then delegated to onshore subsidiaries, which beneft from better
access to a skilled workforce.
Fees for managing assets are typically charged on an ad valorem basis (i.e. as a
percentage of assets under management). However, charges and charging structures
vary depending on the nature of the funds in which the investment is made, the
investment profle of the fund and the investment objectives themselves. Private equity
and venture capital vehicles may charge investors based on the committed capital
pledged to the investment vehicle over time.
Investment funds can give rise to a number of different charges for investors, including:
Front-end loads:
A charge made on the monies committed by an individual investor on entering the
fund and paid by the investor. This is common in retail funds where an independent
fnancial advisor (IFA) brings clients monies to the fund and, in return, expects a
proportion of the load.
Management fees:
A charge (usually a fxed percentage) made on the net asset value of the fund and paid
directly by the fund to the fund manager.
Trailer fees:
A fee payable to distributors (e.g. IFAs) by the fund manager from the gross
management fee for the referral of clients monies. The fee is normally calculated as
a proportion of the net assets referred by the distributor and is usually payable by the
fund manager until the investor withdraws their monies.
Financial Services
Performance fees:
Fees typically paid in addition to a base management fee by niche market funds
(e.g. hedge funds and private equity funds) as well as for the management of
large segregated funds. The industry recognises three broad classes of investors:
institutional, retail and private client.
Institutional:
Money made available by institutions, typically pension funds and life companies,
which may outsource the actual management of the whole or a part of their assets.
These monies are often managed on a segregated basis (i.e. each clients assets are
managed separately) due to their tightly defned objectives but may also be managed
on a pooled basis (i.e. together with other clients with similar investmentobjectives).
Retail:
Essentially, money invested in collective investment vehicles by smaller investors
and members of the general public. Such monies are by defnition pooled, and
it is the overall pool of funds that is managed rather than the monies of each
individualinvestor.
Private client:
Less transparent than institutional or retail business. The business deals with high
net worth individuals (HNWI) to whom a manager may offer a portfolio of services.
Confdentiality is usually at a premium and very little market data is available. Client
service is a major factor in the private client sector since most clients put a premium
on personal contact and the prompt and reliable handling of instructions, requests for
information and reporting. HNWI are often prepared to accept a higher level of risk in
return for a better absolute rate of return. Their higher level of fnancial sophistication
and requirement for confdentiality means that they are prepared to invest large sums
offshore in a broad spectrum of jurisdictions.
Below, the main areas involving signifcant cross-border fows of products and services
are considered in more detail.
822. Asset management
Asset management typically comprises overall asset allocation and the asset research,
selection and management of individual securities, with a view to meeting the
objectives of the portfolio or fund. It is not uncommon for these functions to be
segregated to take advantage of local/specialist knowledge and expertise (commonly
referred to as subadvisors).
Investment management groups may have potential internal comparables relating to
institutional mandates. In addition, there is some publicly available information in
respect of both investment management and subadvisory fees. These should be used
carefully, since specifc factors infuence the pricing of such services, including the type
of assets managed, scope of activities carried out, risk involved, volume of transactions,
expected returns and expenses of providing such services.
Recent developments in alternative investment funds and the corresponding increase
in performance fees has raised the additional consideration of how such a fee should
be split between the various functions and jurisdictions within the investment
management business.
823. Marketing, distribution and client servicing
In considering appropriate arms-length fees for marketing, distribution and client
servicing, one of the most important considerations is the type of customer. For
example, fees are usually higher for retail investors than for institutional investors. This
refects both the additional costs associated with attracting funds for retail investors
and also the greater bargaining power of institutional investors, due to their larger size
of investment. Again, owing to the different business models applicable to different
types of customer, funds and investment strategy, great care needs to be taken in
attempting to make use of potential comparables internal and external. Industry
intelligence and anecdotal evidence could outweigh the publicly available data, as
fnancial arrangements for distribution and capital-raising services are often highly
discrete or depend on the type of client and asset class managed.
824. Administration and other centralised activities
As for banking and insurance, investment management groups or subgroups generally
undertake many of the same types of centralised activities that are considered in the
management services chapter (sections 501512), including inter alia the provision
of central human resources, legal, accounting, internal communications and public
relations activities. The same considerations relating to the identifcation of the
services provided, the entities providing the services, the entities receiving the services,
the costs involved and the application of a markup apply equally here. Certain aspects
of centralisation that are unique to the investment management industry are discussed
further below.
The administration of funds covers a wide variety of activities, for example the
preparation of reports for investors, custody, transfer agency, fund accounting,
compliance and regulatory, investor protection, regulatory and compliance execution/
settlement. Any or all of these functions might be centralised or outsourced to specialist
service providers to take advantage of economies of scale and local expertise. In
particular, investments in information technology (IT) are a hallmark of the industry.
Consideration needs also to be given to the development of bespoke investment
technologies, which act to enhance investment performance or to centralise risk and
decision-making.
The track record and skills of the portfolio managers are highly important in the
investment management business, while the ownership and development of brand and
other intangible assets feature prominently in any transfer pricing analysis.
Transfer pricing and indirect taxes
9.
International Transfer Pricing 2011 141 Transfer pricing and indirect taxes
901. Customs duty implications
Goods moved across international borders and imported from one customs jurisdiction
into another are potentially subject to customs duties and, in some cases, to other
duties and taxes such as value added tax (VAT) (which are beyond the scope of this
book). In determining the transfer price for such goods, consideration must be given
not only to the corporate income-tax repercussions but also to the customs duty
implications and, in certain circumstances, there may be an apparent confict between
the treatment of a transaction for the purposes of the two regimes. Careful planning is
then necessary to achieve a price that satisfes the requirements of the tax and customs
authorities without incurring excessive liabilities.
902. WTO valuation agreement
Most countries levy ad valorem duties and have complex regulations governing the
determination of the value of imported goods for customs purposes. All references
in this book to customs valuation (unless otherwise stated) are to the World Trade
Organisation (WTO) Agreement on implementation of Article VII of the General
Agreement on Tariffs and Trade 1994 (the WTO Valuation Agreement), formerly
known as the GATT Customs Valuation Code. Under the Uruguay Round Agreement,
all members of the WTO were required to adopt the WTO Valuation Agreement within
a specifed period; however, some developing countries have not done so. Nevertheless,
the laws of most trading countries are now based on the WTO ValuationAgreement.
The basic principle of the WTO Valuation Agreement is that, wherever possible,
valuation should be based on the transaction value the price paid or payable for the
goods when sold for export to the country of importation, subject to certain prescribed
conditions and adjustments. The most signifcant condition for acceptance of the
transaction value by the customs authorities is that the price has not been infuenced
by any relationship between the parties. While different countries have widely varying
standards to determine whether companies are related for direct tax purposes,
the WTO Valuation Agreement offers a worldwide standard for customs purposes,
which is more narrowly defned than many direct tax laws. Persons, whether natural
or legal, are deemed to be related for customs purposes under the WTO Valuation
Agreementif:
They are offcers or directors of one anothers businesses;
They are legally recognised partners in business;
They are employer and employee;
Transfer pricing and indirect taxes 142 www.pwc.com/internationaltp
There is any person who directly or indirectly owns, controls or holds 5% or more
of the outstanding voting stock or shares of both of them;
One of them directly or indirectly controls the other;*
Both of them are directly or indirectly controlled by a third person;
Together they directly or indirectly control a third person; and
They are members of the same family.
(*Control for this purpose means that one person is legally or operationally in a
position to exercise restraint or direction over the other.)
903. Relationship between customs and tax rules
Although the customs valuation rules are broadly similar to the OECD transfer pricing
rules discussed elsewhere in this book, there are some signifcant differences and
it cannot be assumed that a price that is acceptable to the revenue authorities will
necessarily also conform to the customs value rules.
At a basic level, a tax authority focuses on the accuracy of a transfer price as refected
on a tax return (annual basis aggregated across the entire business). Conversely, a
customs authority applies duties against the value of the merchandise at the time of
entry into a customs territory (at a transactional level, product type by product type).
Consequently, an immediate potential confict arises.
In addition to this inherent difference, the two governmental authorities (tax and
customs) are working at cross-purposes. On the one hand, a low value for customs
purposes results in lower duties, while, on the other hand, this same low value results
in a higher income/proft in the country of importation and results in higher taxes.
Although variations on the same theme, value for transfer pricing and for customs
purposes share a common founding principle: the price established for goods traded
between related parties must be consistent with the price that would have been
realised if the parties were unrelated and the transaction occurred under the same
circumstances. This principle is colloquially known as the arms-length principle.
904. Intangibles
Import duty is not normally applied to the cross-border movement of intangible
property. However, the value of intangibles may form part of the customs value of
imported goods if they both relate to, and are supplied as, a condition of the sale of
those goods. Consequently, some commissions, certain royalties and licence fees,
contributions to research and development (R&D), design, engineering and tooling
costs, and other payments made by the buyer of the imported goods to the seller
may be subject to duty if certain conditions are fulflled. Conversely, certain costs
and payments that may be included in the price of imported goods are deductible in
arriving at the customs value or can be excluded if they are invoiced and/or declared
separately from the goods themselves.
905. The Brussels defnition of value
Those few countries that do not subscribe to the WTO Valuation Agreement (typically
developing countries such as Cte dIvoire and Montserrat) continue to rely upon an
older international code the Brussels defnition of value (BDV) which is based
International Transfer Pricing 2011 Transfer pricing and indirect taxes 143
on the principle of an entirely notional normal value. Under the BDV, there need be
no connection between the customs value and the price paid for the goods, so that
the customs implications of importing goods into these countries have little or no
signifcance for transfer pricing.
906. Specifc duties and fxed values
Not all products are assessed a duty based on their value. Some products are assessed
specifc duties (e.g. a fxed amount per gallon/litre). In addition, some countries (e.g.
Lebanon and Sri Lanka) levy specifc duties on certain categories of imported goods
so that the actual price paid for them does not impact the duty owed. It is important
to note, however, that many countries require the value declared to be correct,
regardless of whether it impacts the amounts of duty paid, and have penalty provisions
for non-revenue loss violations. Similarly, some countries apply fxed or offcial
minimum values for certain goods, which also makes the transfer price irrelevant as a
method of determining the value of imported goods for customs purposes. However,
these latter practices are gradually disappearing as the countries concerned adopt the
WTO Valuation Agreement.
907. Sales taxes, value added taxes and excise duties
Generally, the value of imported goods for the purposes of other ad valorem duties
and taxes tend to follow the value for customs purposes. There are, however, special
rules in many countries and, while a detailed discussion of these is outside the scope of
this book, these rules must be taken into account when planning a transfer pricing and
business policy.
908. Antidumping duties/Countervailing duties
Anti-dumping duties are levied when, as the result of a formal investigation, it is
determined that domestic producers have been or may be damaged because imported
goods are sold in the country in question at less than a fair value, having regard to the
price at which the same goods are sold in the country of export or, in certain cases,
in a third country. In theory, it may appear that, if goods are sold at a dumped price,
that price will not be acceptable to the revenue authority in the country of export,
although the revenue authority in the country of import would presumably have no
problem with it. In practice, however, because dumping is a product of differentials
between prices in two markets, it is possible for a transfer price to offend the anti-
dumping regulations while being acceptable to the revenue authorities or vice versa.
Although, the need for the aggrieved industry to make its case and the administration
to be satisfed that the dumping is causing injury mean that dumped prices do not
necessarily result in the imposition of anti-dumping duties.
Whereas anti-dumping duties are assessed against companies for their business
practices, countervailing duties are assessed based on government subsidies or
assistance. These cases target the actions of all trading entities in a particular industry,
which are receiving some kind of export-generating assistance from the government
of the exporting country. As with anti-dumping duties, the government subsidies can
impact the transfer price of goods by removing some of the costs from the price of the
exported goods. Accordingly, the transfer price would then be artifcially low. However,
and as is the case with anti-dumping duties, the aggrieved industry must bring forth
the case to the importing countrys government. The complainants must show that they
have been harmed or will be harmed by the abnormally strong trading position of the
entities that received the government subsidies.
909. Establishing a transfer pricing policy technical
considerations
Where the proposed transfer pricing policy relates to international movements of
goods that attract customs duties or other taxes on imports, it is necessary to determine
whether the policy will:
1. Meet the requirements of the customs authority in the country of importation; and
2. Create opportunities for tax and customs planning to reduce the values for
customs purposes without prejudice to the transfer pricing policy.
When traders use the transfer price as the value for customs purposes, they exercise
an option that is both convenient and rife with pitfalls. The parties to the transaction
must be able to demonstrate that, at the time the customs value was reported,
supporting documentation was available to demonstrate that the transfer price was
determined using acceptable valuation methods and applicable data. In essence, the
customs value reported by related entities must mimic that which would have been
established in an arms-length transaction according to customs rules. It is interesting
to note that several customs authorities have issued written guidance specifcally
stating that a transfer pricing study, in and of itself, is not suffcient to support customs
valuerequirements.
910. Adjustments
Before attempting to validate the transfer price for customs purposes, it may be
necessary to make certain adjustments to deduct those items that can be excluded from
the customs value of the goods, even though they are included in the price, and to add
those items that must be included in the customs value, even though they are excluded
from the price.
Costs and payments that may be excluded from the transfer price of goods when
included in such price include the following:
Costs of freight, insurance and handling that are excluded by the regulations of the
country of importation (these costs are not always excludable);
Costs that relate to such activities undertaken after the goods have left the country
of export;
Import duties and other taxes (including sales and value added taxes and excise
duties) that are levied on importation of the goods into the country of import;
Charges for construction, erection, assembly, maintenance or technical assistance
undertaken after importation on goods, such as industrial plant, machinery or
equipment if separately itemised;
Charges for the right to reproduce the imported goods in the country of
importation; and
Buying commissions.
Certain costs may be excluded from the customs value if they are separated from the
price of the goods. The method of excluding these costs and payments known as price
unbundling is explained later.
It is important to note that there may also be other costs and payments that must be
included in the customs value (added to the price) of the goods when not included in
the transfer price. The costs and payments that must be added to the transfer price for
customs purposes (if they are not already included) are as follows:
Commissions (other than buying commissions;)
Freight, insurance and handling charges up to the point designated in the rules of
the country of import (this can vary by country);
Royalties, if they both relate to the imported goods and the underlying rights were
sold as a condition of the sale of the goods by the supplier (this also can vary by
country);
Assists (i.e. the value of goods and services provided free of charge or at a reduced
cost by the buyer to the seller for use in connection with the production or sale of
the goods);
Any quantifable part of the proceeds of resale of the goods by the buyer that accrue
to the seller (other than dividends paid out of the net profts of the buyers overall
business);
The value, if quantifable, of any condition or consideration to which the transfer
price is subject as per the rules of the country of import;
Any additional payments for the goods, which are made directly or indirectly by the
buyer to the seller, including any such payments that are made to a third party to
satisfy an obligation of the seller;
The cost of containers treated as one with the imported goods; and
The cost of labour and materials in packing the goods.
911. Validation of the transfer price for customs purposes
The WTO Valuation Agreement provides quantitative and qualitative criteria for
validating a price of goods. The quantitative criteria defned below are, however,
dependent upon the existence of values for identical or similar goods that have already
been accepted by the customs authority in question (or, in the case of the EU, by a
customs authority in another member state). In practice, therefore, unless there are
parallel imports into the same customs territory by buyers not related to the seller,
these criteria are not applicable. The quantitative criteria are:
The price paid approximates closely to a transaction value in a sale between a seller
and unrelated buyer at or about the same time; and
The price paid approximates closely to the customs value of identical or similar
goods imported into the same customs territory at or about the same time.
The qualitative criteria are not specifcally defned, although the explanatory notes to
the WTO Valuation Agreement do provide some examples. Essentially, the customs
authority must be satisfed that the overseas supplier and the importer trade with
each other as if the two parties were not related. Any reasonable evidence to this
effect should be suffcient, but the following circumstances, in particular, should
lead the customs authority to conclude that the price has not been infuenced by
therelationship:
The price is calculated on a basis consistent with industry pricing practices;
The price is the same as would be charged to an unrelated customer;
The price is suffcient for the seller to recover all costs and make a reasonable
proft.; and
The use of an alternative method of valuation (e.g. deductive or resale-minus
method) produces the same customs value.
If the application of any of the above criteria confrms that the proposed transfer
pricing policy yields transaction values that are acceptable values for customs
purposes, no further action is necessary other than to determine whether any
adjustments need to be made to the price and whether prior application should be
made to customs for a ruling.
Since the objective of the tax and customs rules is to arrive at a price that is not
infuenced by the relationship between the parties, there should be no substantial
difference between a transfer price that meets the requirements of both tax authorities
and one that constitutes an acceptable transaction value for customs purposes.
However, given the degree of fexibility inherent in both sets of rules, some variation is
inevitable and, in certain cases where this fexibility has been exploited for commercial
or income-tax purposes, the difference may be suffcient to result in a transfer price
that is unacceptable to the customs authority or results in an excessive liability to
customs duty.
912. Transfer prices below the acceptable customs value
If none of the methods described above enables the transfer prices to be validated for
customs valuation purposes, because they are lower than the acceptable value, the
taxpayer has the following options:
Modify the transfer pricing policy; and
Submit valuation for customs purposes on the basis of an alternative method of
determining value.
The choice between these two options depends upon the circumstances in each case,
but the following factors need to be considered:
The interest of the customs authority in the country of import is, in principle, the
same as that of the revenue authority in the country of export: both are concerned
that the transfer price may be too low. A transfer pricing policy that produces
prices unacceptable for customs purposes, may, therefore, not be acceptable to the
exporting countrys revenue authority; and
The methods of validating a transfer price are based, for the most part, on the
application of the alternative methods of valuation to determine whether their use
will yield a customs value that is signifcantly different than the actual transfer
price. The results of the validation exercise will therefore indicate the customs
values likely to be acceptable to the customs authority under each method. The
alternative methods must be applied in strict hierarchical order, except that the
importer has the option of choosing the computed (i.e. cost plus) or deductive (i.e.
resale-minus) method of valuation and is free to choose the method that yields the
lower customs value.
913. Transfer price exceeds acceptable customs value
If the application of the validation methods demonstrates that the transfer price is
higher than the value that could be justifed for customs purposes, the taxpayer has
the following options:
Consider the scope for unbundling the transfer prices;
Modify the transfer pricing policy; and
Submit valuation on the basis of an alternative method.
The transfer price may exceed the acceptable customs value of the imported goods
because it includes elements of cost and payments that need not be included in the
customs value. An exercise to unbundle the transfer price and to separate those
elements may result in a customs value that is signifcantly less than the transfer price.
Most jurisdictions have no legislative requirement to reconcile the value of imported
goods for customs purposes with the inventory value of those goods for corporate
income-tax purposes. Where such a requirement does exist, however notably in the
US due account can be taken of those elements that form part of the inventory value
but are not required to be included in the value for customs purposes. If the unbundled
transfer price still exceeds the acceptable customs value, the taxpayer should consider
whether the transfer price does in fact meet the requirements of the revenue authority
in the country of importation.
Corporate income tax is levied only on the profts of a transaction, whereas customs
duties are paid on its full value, irrespective of whether a proft or loss is made. In
certain circumstances, notably where there are losses, a high transfer price even
if it is acceptable to the revenue authorities may result in a net increase, rather
than a reduction, in the overall tax burden when the increased duty liability is taken
intoaccount.
Customs authorities do not normally entertain the argument that a transaction
value is unacceptable solely because it has been infated as a result of the relationship
between the buyer and seller of the goods. It may be, however, that the circumstances
surrounding the transactions between the buyer and seller are such as to preclude
valuation on the basis of the transfer price, namely:
The price is subject to some condition or consideration that cannot be quantifed
(e.g. the goods are supplied on consignment and the transfer price is dependent
upon when, to whom and in what quantity the goods are resold);
An unquantifed part of the proceeds of the resale of the goods by the buyer accrues
to the seller (other than in the form of dividends paid out of the net profts of the
buyers total business);
The seller has imposed upon the buyer a restriction that affects the value of the
goods in question (e.g. they can be resold only to a certain class of purchaser); and
The goods are supplied on hire or lease or on some other terms that do not
constitute a sale of the goods (e.g. on a contingency basis).
914. Alternative methods of valuation
Once it is established that the imported goods cannot be valued for customs purposes
on the basis of the transaction value, the link between the transfer price for commercial
and income-tax purposes and the value of the goods for customs purposes is broken.
The taxpayer is then free to determine a transfer price without regard to the customs
implications, irrespective of whether the price so determined is higher or lower than
the value of the goods for customs purposes, except for countries like the US where
the inventory value for tax purposes cannot exceed the customs value. Several transfer
pricing methods (TPMs) are available, many of which are suffciently fexible to apply
to a variety of transaction types. Traditional TPMs are the comparable uncontrolled
price (CUP) method, the cost-plus method, and the resale price method. Other
methods are the proft split and the transactional net margin methods.
The alternative methods of customs valuation are similar to some of the methods used
to validate transfer prices for income-tax purposes, but the WTO Valuation Agreement
requires that they be applied, with one exception, in strict hierarchical order as set
outbelow:
1. Value of identical goods. The transaction value of identical merchandise sold for
export to the same country of importation and exported at or about the same
time as the goods being valued. The value of the identical merchandise must be
a previously accepted customs value, and the transaction must include identical
goods in a sale at the same commercial level and in substantially the same quantity
as the goods being valued.
2. Value of similar goods. As in (1) except that the goods need not be identical to those
being valued, although they must be commercially interchangeable.
3. Deductive value. A notional import value deduced from the price at which the goods
are frst resold after importation to an unrelated buyer. In arriving at the deductive
value, the importer may deduct specifc costs such as duty and freight in the
country of importation and either his/her commission or the proft and general
expenses normally earned by importers in the country in question of goods of the
same class or kind.
4. Computed value. A notional import value computed by adding to the total cost
of producing the imported goods, the proft and general expenses usually added
by manufacturers in the same country of goods of the same class or kind. Note
that, as an exception to the hierarchical rule and at the option of the importer,
the computed valuation method can be used in preference to the deductive
valuationmethod.
The valuation of identical or similar merchandise is similar to the CUP method.
The CUP method compares the price at which a controlled transaction is conducted
to the price at which a comparable uncontrolled transaction is conducted. While
simple on its face, the method is diffcult to apply. The fact that any minor change in
the circumstances of trade (e.g. billing period, amount of goods traded, marking/
branding) may have a signifcant effect on the price makes it exceedingly diffcult to
fnd a transaction that is suffciently comparable.
The deductive value method is similar to the resale price (RP) method. The RP
method determines price by working backwards from transactions taking place at
the next stage in the supply chain, and is determined by subtracting an appropriate
gross markup from the sale price to an unrelated third party, with the appropriate
gross margin being determined by examining the conditions under which the goods/
services are sold, and comparing the said transaction to other third-party transactions.
Consequently, depending on the data available, either the cost-plus (CP) or the RP
method will be most the appropriate method to apply.
The computed value method is similar to the cost plus (CP method. The CP method is
determined by adding an appropriate markup to the costs incurred by the selling party
in manufacturing/purchasing the goods or services provided, with the appropriate
markup being based on the profts of other companies comparable to the parties to the
transaction. Amounts may be added for the cost of materials, labour, manufacturing,
transportation, etc. Given the variables required for the proper application of this
method, it is most appropriately used for the valuation of fnished goods. As a matter
of practice, some customs administrations do not accept the use of this method by
importers given that the accounting for costs occurs in the country of export, which
makes verifcation by local authorities diffcult.
If it proves impossible to fnd a value under any of the above methods, a value must
be found using any reasonable method that is compatible with the WTO Valuation
Agreement and is not specifcally proscribed. In practice, customs authorities often
adopt a fexible application of the transaction value rules or one of the alternative
methods in order to arrive at an acceptable value.
915. Implementation of the customs pricing policy
The procedures for declaring the value of imported goods to customs authorities vary
from country to country. In most cases, however, some form of declaration as to the
value of the goods is required at importation and the importer may be required to state
whether the seller of the goods is a related party and, if so, whether the relationship
has infuenced the price.
In some cases such as where identical goods are sold to an independent buyer in the
same country of importation at the same price the importer can declare the transfer
price with any necessary adjustments as the value for customs purposes. In most cases,
however, the position is less clear and, where the local rules permit, the importer is
strongly advised to seek a defnitive ruling in advance from the customs authority or,
at least, to obtain the authoritys opinion as to the validity of the values that it intends
to declare.
Strictly speaking, the WTO Valuation Agreement places the onus on the customs
authority to prove that a price has been infuenced by a relationship between the
parties. In practice, however, the importer would be well advised even if it is not
intended to seek an advance ruling or opinion to validate transfer prices for customs
purposes and to maintain the necessary records, calculations and documentation for
use in the event of a customs audit or enquiry.
916. Transfers of intangibles
Intangibles per se are not subject to import duty, but when supplied as part of a
package of goods and services, the value of intangibles may constitute part of the
customs value of the imports. When a package of goods and services is supplied for a
single, bundled price, customs duty is paid on that price in full, unless it contains any
elements of cost that can be separately quantifed and is permitted to be deducted from
the price. As explained previously, it is up to the importer and the foreign supplier to
unbundle the price so as to separately quantify and invoice the value of those costs that
do not have to be added to the customs value of imported goods if they are not already
included. However, the following categories of intangibles are, subject to certain
conditions, required to be included in the customs value of imported goods:
Payments by the importer, in the form of royalties or licence fees, for the use of
trademarks, designs, patents, technology and similar rights, provided that the
rights in question relate to the imported goods and that the payment therefore is a
condition of the sale of the goods by the seller to the buyer;
Intangible assists, except where the work is undertaken in the country
ofimportation;
Payments for computer software (subject to the options described in the GATT
decision of 24 September1984);
Payments for the right to resell or distribute imported goods (but excluding a
voluntary payment by the buyer to acquire an exclusive right to resell or distribute
the imported goods in a particular territory); and
Design, development, engineering and similar costs that represent part of the cost
of manufacturing or producing the imported goods.
917. Royalties and licence fees
This is the most complex area of customs valuation and each case has to be examined
carefully to determine whether a liability to import duty arises. The following
guidelines are helpful:
The key consideration in determining whether a royalty or licence fee is dutiable
is the nature of the rights for which the payment is made. The basis on which the
payment is calculated is usually not relevant;
Generally, if the imported goods are resold in the same state in which they are
imported, any royalties or licence fees payable as a condition of the importation
of those goods are likely to be dutiable. For example, if imported goods are resold
under the manufacturers trademark whether it is affxed to the goods before
or after importation the corresponding royalty payment is dutiable, even if the
payment is based on income from sale of the goods in the country of importation;
However, where goods are subjected, after importation, to substantial processing
or are incorporated into other goods, such that the resulting product does not have
the characteristics of the imported goods, it is likely that the royalty or licence
fee is not considered to relate to the imported goods, provided that the rights in
question relate to the fnished product. An example of this would be where the
rights conferred on the buyer enable him to manufacture a product using the
sellers technology, patents or know-how or to sell that product under the sellers
trademark. In such circumstances, it is unlikely that the royalty payments would
be regarded as part of the customs value of raw materials or components imported
by the buyer from the seller for incorporation in the fnished product. It may be
necessary, however, to include at least part of the royalty in the customs value of
the imported components if those components contain the essential characteristics
of the fnished product (see point (4) below);
Diffculties frequently arise where the imported materials or components are
considered by the customs authority to contain the essential characteristics of the
fnished product. For example, the buyer may be paying a royalty for technology
that supposedly relates to the manufacture of the fnished product in the country
of importation. However, if the process of manufacture is, in reality, no more than
a simple assembly operation, customs may take the view that the technology is
incorporated in the imported components rather than the manufacturing operation
and deem the royalty to be dutiable. Another example is where the sellers
particular expertise or specialty is clearly incorporated in one key component,
which is imported. As a result, royalties paid for a companys unique technology
which is incorporated in a single imported semiconductor device could be deemed
dutiable even if the whole of the rest of the system is manufactured in the country
of importation from locally sourced parts;
In circumstances where an importer is manufacturing some products locally using
the affliates designs, know-how and materials or components, while importing
others as fnished items from the same or another affliate, care must be taken
to distinguish the rights and royalties applicable to each. In such cases, it would
normally be expected that the seller would recover all its research, development
and design costs in the price of the products that it manufactures and exports to the
buyer; it is inappropriate therefore to charge royalties for those products;
The decision of whether royalty and licence fees are dutiable may be subject to
varying interpretations in different countries. Some countries, for example, may
consider periodic lump-sum licensing fees to be non-dutiable charges, provided
that payments are not directly related to specifc importations; and
Cost-sharing agreements (i.e. for R&D) can prove problematic if adequate
documentation is not maintained, establishing what portion of development costs
relates to the import of products. In such instances, the local import authorities
may take the position that all such costs in a general pooling of costs are
considereddutiable.
In the case of the products manufactured in the country of importation, however, a
royalty or licence fee is the only way in which the owner of the intangible can recover
its costs. However, if a royalty refers to the right to manufacture and distribute the
companys products in the territory, it will be deemed to relate to the imported
products as well as those manufactured in the country of export. Alternative wording
the right to manufacture the companys products in country A and to sell such
products as it manufactures in the territory may avoid unnecessary liability to duty.
Payments for the right to reproduce imported goods in the country of importation are
specifcally excluded from the customs value of imported goods.
918. Intangible assists
Intangible assists consist of designs, specifcations and engineering information
supplied by the buyer of the imported goods to the seller free of charge or at reduced
cost. If the work is undertaken within the country of importation, such assists are
not dutiable, but if the work is undertaken in the country in which the goods are
manufactured or in any other country, the assists are deemed to be part of the customs
value of the imported goods.
There are different interpretations of what is meant by the word undertaken. Some
customs authorities accept, for example, that work undertaken by the buyers designers
who are based in the country of importation but who actually designed the product
in the country of manufacture would not result in a dutiable assist; others, however,
would take the opposite view. However, even if work is performed in the country
of importation but paid for by the foreign seller and recharged to the importer, it
may constitute a dutiable cost as representing part of the price paid or payable for
the imported product. The value of an assist is the cost to the buyer of producing or
acquiring it, and it is not necessary to add a markup or handling fee.
919. Interest
Interest incurred by the manufacturer of imported goods is deemed to be part of the
cost of producing the goods and should therefore be included in the price. However,
where the importer pays interest to the seller or a third party under a fnancing
agreement related to the purchase of the imported goods, that interest need not be
included in or added to the customs value of imported goods, provided that:
The fnancing agreement is in writing (although this need only be a clause in the
agreement for the sale of the goods);
The rate of interest is consistent with contemporary commercial rates of interest for
such transactions in the country in which the agreement is made;
The buyer has a genuine option to pay for the goods promptly and thereby avoid
incurring the interest charge;
The interest is separately invoiced or shown as a separate amount on the invoice for
the goods; and
In some countries, such as the US, the interest must be treated as an interest
expense on the books and records of the importer.
920. Computer software
Contracting parties to the WTO Valuation Agreement may value software for use with
data processing equipment on one of two alternative bases, namely:
1. The full value of the software, including the carrier medium (disk, tape, etc.) and
the program data or instructions recorded thereon; and
2. The value of the carrier medium only.
The second option applies only to software in the form of magnetic tapes, disks
and similar media. Software on the hard disk within a computer or embedded in
semiconductor devices (frmware) is dutiable on the full value. Similarly, this option
does not extend to software that includes audio or visual material. Although this
exclusion was originally intended to cover leisure products, such as computer games,
movies and music, more and more serious software now incorporates audio and visual
material and, in some jurisdictions, may be subject to duty on the full value.
The terms of the present valuation options on software dated from 1985 have been
overtaken by advances in technology and commercial practice in the data processing
industry. Furthermore, the Information Technology Agreement (ITA) has resulted
in most movements of computer software becoming subject to a zero rate of duty.
It is inevitable therefore that importers will face anomalies and uncertainties in
the valuation of software unless or until the WTO Valuation Agreement is updated
to refect these developments. However, it is worth noting that software and other
goods transmitted electronically do not attract customs duty even if, in their physical
manifestation, they would be dutiable (e.g. music CDs, videos).
921. Design, development, engineering and similar charges
The costs of these activities are normally expected to be included in the price paid for
the imported goods. However, there are circumstances in which companies may wish
to recover these costs from their affliates by way of a separate charge. Furthermore,
the affliate may be supplied not with fnished products but only with components on
which it is not normal to seek to recover such costs.
Generally speaking, any payment for design and similar expenses that relates to
imported goods is regarded as part of the customs value of those goods and an
appropriate apportionment will be made and added to the price of the goods. Costs for
research, if properly documented as such, are not subject to duty.
Where components are supplied to the buyer and a separate charge is made relating to
the design of the fnished product that is manufactured in the country of importation,
some diffculty may arise. If the components are purchased by the seller from third-
party suppliers, the costs of design are likely to be included in the suppliers price and
no further action is necessary. However, where some or all of the components are
produced by the seller and design costs have not been included in the price, it will
be necessary to attempt to allocate an appropriate proportion of the total charge for
design to the components in question.
922. The impact of transfer pricing policy changes
Where the basis of customs valuation is the transaction value the price actually paid
or to be paid for the imported goods any change in the method of determining the
transfer price may affect the validity of that price for customs purposes. It may also
trigger a requirement to notify the customs authority if the buyer holds a ruling that is
subject to cancellation or review in the event of a change in commercial circumstances.
If the proposed change in pricing arrangements is signifcant, the validation exercise
described previously must be repeated to determine whether the new policy produces
an acceptable value for duty purposes. Examples of signifcant changes are:
A shift in the allocation of proft from one entity to another;
A shift of responsibility for certain functions from one entity to another;
A change in the transaction structure, such as the interposition or removal of an
export company, a foreign sales corporation or a reinvoicing centre; and
Any changes in pricing levels that exceed normal commercial margins
offuctuation.
Provided that the changes represent realistic responses to changes in commercial
circumstances, there should be no diffculty in validating the new prices for customs
valuation purposes. However, where no such justifcation for the changes exists
and particularly where the price change is substantial it may be diffcult to explain
satisfactorily why the prices now being proposed have not previously been charged
since the commercial circumstances are substantially unchanged.
If the proposal is to increase prices, the customs authority may take the view that the
values previously declared, based on the current transfer pricing policy, were too low
and, depending upon local regulations, they may be able to recover substantial arrears
of duty and to impose penalties. Conversely, even if the customs authority accepts that
the current transfer prices are higher than commercial circumstances justify, there
will probably be no basis for claiming repayment of duties overpaid, even if the seller
credits the buyer with the difference between the existing and proposed prices on a
historical basis.
923. The impact of retrospective transfer price adjustments
The WTO Valuation Agreement contains no specifc provisions for dealing with
adjustments to transaction values and, therefore, the rules and practice in each
country determine how customs authorities respond if a price already paid is subject to
subsequent adjustment for commercial or corporation tax purposes.
The transaction value principle states that the price for the goods when sold for
export to the country of importation should represent the customs value of those
goods. Provided, therefore, that the price paid or agreed to be paid at that time was
not in any way provisional or subject to review or adjustment in the light of future
events, specifed or otherwise, that price must be the customs value of the goods. If,
subsequently, that price is adjusted as a result of circumstances that were not foreseen
at the time of the sale for export or that, if they had been foreseen, were not expected
or intended to lead to a price adjustment there appears to be no provision under the
WTO Valuation Agreement that would either:
In the event of a downward adjustment, allow the importer to recover duty
overpaid; and
In the event of an upward adjustment, allow the customs authority to recover
dutyunderpaid.
However, it is likely that, so far as customs authorities are concerned, the above is true
only of occasional and non-recurring adjustments. If, for example, a company were
to make a practice of reviewing its results at the end of each fscal year and decided
to reallocate proft between itself and its affliates, it is probable that customs would
take the view that such adjustments were effectively part of the companys transfer
pricing policy, even if no reference to it appeared in any written description of that
policy. In those circumstances, subject to any statute of limitations, they would be
likely to seek arrears of duty and possibly also penalties for all previous years in which
upward adjustments had been made. While some customs jurisdictions may give credit
for any downward adjustments in assessing the amount of duty due, it is unlikely that
they would accept a claim for repayment where a net overdeclaration of value could
besubstantial.
Where a companys transfer pricing policy specifcally provides for periodic review and
retrospective price adjustment for example, to meet the requirements of the IRS and
other revenue authorities customs will certainly regard any adjustments as directly
applicable to the values declared at the time of importation. Any upward adjustments
will therefore have to be declared and the additional duty paid. Downward adjustment,
in some countries, may be considered post-importation rebates and consequently
claims for overpaid duties will not be accepted. However, in the US, importers may take
advantage of the Customs Reconciliation Program, which provides the opportunity to
routinely adjust the value of imported goods and either collect or pay duties.
In addition, in the US, a specifc IRS provision (1059A) requires that the inventory
basis for tax purposes does not exceed the customs value (plus certain allowable
adjustments). Therefore, the possibility exists that the IRS authorities could
disallow any upward price adjustment in the event it causes the inventory taxable
basis to exceed the customs value. To avoid penalties for failing to declare the full
value of imported goods and to ensure that duty can be recovered in the event of
price reductions, it is recommended that any transfer pricing policy that involves
retrospective price adjustments should be notifed to customs in advance. Some
authorities are amenable to arrangements whereby provisional values are declared
at the time of importation and subsequent adjustments are reported on a periodic
basis, provided they are accompanied by the appropriate additional duties or claims
forrepayment.
As an alternative to the above, it may in some cases be in the importers interests to
take the position that, at the time of importation, there is no transaction value because
the eventual price for the goods cannot then be determined. In that event, the importer
could seek valuation under one of the alternative methods described above.
924. The impact of international structure
The structure of a transaction chain that involves at least one cross-border movement
between different customs jurisdictions can have a signifcant impact on duty
liabilities. Transaction values exist only where there is a price for imported goods
between two separate legal entities in a sale whereby ownership of the goods and the
attendant risks pass from the seller to the buyer. In the absence of such a sales price
between the exporter and importer, the customs value must be based on another sales
transaction, if there is one, or on one of the alternative methods of valuation described
above. The following examples illustrate the impact of various structures on the value
of imported goods for duty purposes:
Where an exporter uses a subsidiary company in the country of importation as its
distributor, and the latter buys imported goods as a principal and resells them to
end-customers, the price between the two companies is, in principle, acceptable
for customs purposes. However, this is not the case where the distributor is merely
a branch of the exporter and part of the same legal entity. In that event, unless
there is another transaction value, duty is payable on the selling price to the end-
customer, including the gross margin of the branch;
Similarly, there is no transaction value if the subsidiary merely acts as a selling
agent or commissionaire for the exporter and does not own the imported goods.
Again, duty is payable on the selling price to the end-customer, including, in this
case, the subsidiarys commission; and
Transactions involving reinvoicing operations that merely issue a new invoice in a
different currency and do not take title or risk in respect of the imported goods are
ignored for customs purposes, as are those involving foreign sales corporations
(FSCs), which are remunerated by way of commission. However, transactions
involving FSCs that act as principals may provide a basis of valuation.
The customs laws of the EU and the US (but not, at present, any other jurisdiction)
recognise a transaction value, based on a sale for export to the country of import
even when there are subsequent sales in the supply chain (successive or frst sale
concept). This means, for example, that if a manufacturer in the US sells goods for
USD80 to a US exporter who, in turn, sells them to an importer in the EU for USD100,
the latter can declare a value of USD80 for duty purposes, even though USD100 was
paid for the goods. Acceptance of the price in the earlier sale is conditional upon the
followingfactors:
The goods being clearly intended for export to the country of importation at the
time of the earlier sale;
The price being the total consideration for the goods in the earlier sale and not
being infuenced by any relationship between the buyer and seller; and
The goods being in the same physical condition at the time of the earlier sale and
atimportation.
Apart from allowing duty legitimately to be paid on what is, in most cases, a lower
value, the successive sales concept in the EU and frst sale approach in the US also
have the beneft of decoupling the value of imported goods for duty purposes from
the values of those goods for the purposes of determining the taxable profts of the
importer and exporter. Japan also provides for duty reduction based on a principle very
similar to that which underlies the frst sale programmes in the US and EU, albeit in a
more complex manner.
925. Dealing with an audit of pricing by an indirect tax
authority
For similar reasons to those advanced by the tax authorities, customs authorities are
taking an increasing interest in the validity of values declared by importers on the basis
of transfer prices between related parties. The principal areas on which they focus their
inquiries are:
Whether the transfer price allows full recovery of all relevant costs, including
general and administrative overheads and relevant R&D;
Whether the addition for proft occurs on an arms-length basis; and
Whether all appropriate additions have been made for royalties, R&D payments
and assists.
Traditionally, customs authorities have tended to operate in a vacuum, with no
consideration for the commercial or tax environments within which transfer pricing
policies are developed and implemented. This has led to considerable frustration
as companies have tried to defend to customs offcers prices that are not only
commercially justifable but have already been accepted by the revenue authorities.
However, this situation is changing in some jurisdictions where customs authorities
are making efforts to understand the OECD Guidelines and are increasingly interfacing
and cooperating with their direct-tax revenue colleagues. It is unlikely that greater
knowledge and understanding will lead to fewer customs valuation audits indeed,
the opposite is more likely to be the case but it should mean that they are less
troublesome for importers.
As for tax purposes, the availability of documentation that describes the companys
overall transfer pricing policy and demonstrates how individual transaction values
have been calculated is essential. In addition, a similar approach to customs value
documentation should also be undertaken. This can start with the transfer pricing
documentation and include the appropriate additional analysis required by customs.
In addition, where the position is complex and there is likely to be any contention as
to the correct values, it is strongly recommended that the facts and legal arguments
be presented to the customs authority before the relevant imports commence and,
as advisable, a formal ruling or opinion obtained. Although these will not preclude
subsequent audit, the latter should then be confned to verifcation of the relevant facts
rather than involve arguments about issues of principle.
926. Strategy based on balance and leverage
A prudent company will take the same care and documentation approach for customs
as it does for transfer pricing. Considering the above, it can be argued that an
importers sole reliance on a transfer pricing analysis would likely not be suffcient
to support the proper appraisement of merchandise for customs valuation purposes.
To believe and act otherwise runs the risk of being subjected to fnes, penalties or a
mandated application of an alternative customs valuation method that may be diffcult
and costly to implement and sustain. Indeed, the belief that if a taxpayer has done a
transfer pricing study then its customs value must be correct has been proven wrong
time and time again.
Still, a transfer pricing analysis and related documentation can be leveraged to provide
a basis from which a customs value may be derived and supported. This assumes,
of course, that all required statutory adjustments are applied and other relevant
considerations are factored in. The potential benefts to global traders from fnding an
appropriate balance in the transfer pricing and customs valuation nexus are many and
A foundation for establishing inter-company pricing policies for customs purposes
that help to decrease accounting issues that are created by gaps, lack of coverage, or
contradictions among inter-company pricing initiatives;
The ability to signifcantly reduce the potential of a customs audit as well as
the fnancial exposure related to penalties associated with non-compliance of
customsregulations;
A global (or at least multijurisdictional), long-term coordinated inter-company
customs valuation documentation compliance solution that considers products/
product line, market conditions, and other key economic factors;
A basis for proactively managing value adjustments to achieve arms-length results
required under tax and customs regulations;
A foundation for pursuit of advanced pricing agreements that may also be
considered by customs authorities as evidence of an appropriate arms-
lengthresult;
The ability to identify planning opportunities related to the valuation of
merchandise and intangibles (e.g. royalties, licence fees, research and
development, warranties, marketing and advertising, cost-sharing arrangement)
via alternative methods of appraisement;
The development of limits to customs authorities ability to interpret Art. 1.2(a)
and (b) of the WTO Customs Valuation Agreement relating to the acceptability
of using the transfer price as an initial basis for the customs value of imported
merchandise;and
Enhanced fnancial reporting compliance related to inter-company cross-border
transactions to satisfy obligations under Sarbanes-Oxley reporting requirements.
Procedures for achieving an
offsettingadjustment
10.
158 www.pwc.com/internationaltp Procedures for achieving an offsetting adjustment
1001. Introduction
Early consideration should be given to the procedures that might be followed to obtain
compensating adjustments in other jurisdictions should a transfer pricing audit lead to
additional tax liabilities in a particular jurisdiction. The attitudes of revenue authorities
vary and will depend upon the overall circumstances (such as whether they consider
that the taxpayer has deliberately sought to reduce their taxes by what they perceive to
be abusive transfer pricing).
Generally, no scope is available with which to make adjustments in the absence of
a double tax treaty or multi-country convention. However, it might be possible to
render further invoices in later years refecting pricing adjustments, although these
types of adjustments are frowned upon and attract scrutiny from the tax authority of
the receiving jurisdiction. Very careful attention needs to be paid to the legal position
of the company accepting retroactive charges and to other possible consequences,
particularly to indirect taxes. Nevertheless, in a few cases this may afford relief.
The ability to seek relief under the mutual agreement procedure process and, more
particularly, under the European Union Convention, which is discussed in this chapter,
is sometimes cited by taxpayers as if it is an easy solution to transfer pricing problems.
This is not the case and should certainly not be viewed as allowing taxpayers to avoid
paying careful attention to the implementation of a coherent transfer pricing policy
and to its defence on audit.
1002. Competent authority
Competent authority procedures for the relief of double taxation are typically
established in bilateral tax treaties and must always be considered when a tax authority
proposes an adjustment to prices. For instance, where a US subsidiary accepts that the
price of each widget sold to it by its UK parent should be reduced by, say, 10, to satisfy
the US Internal Revenue Service, will the UK Inland Revenue accept a corresponding
reduction in UK taxable income? This type of question involves consultation with
the competent authorities. Virtually all double tax treaties contain provisions similar
to those set out in Article 25 of the OECD Model. These provide that a taxpayer may
petition the competent authority of the state in which he/she is resident where the
actions of one or both of the treaty partners result or will result for him/her in
taxation not in accordance with the provisions of [the double tax treaty].
International Transfer Pricing 2011 Procedures for achieving an offsetting adjustment 159
Procedures for achieving an offsetting adjustment
In the course of an audit, a taxpayer needs to consider whether reference should
be made to the competent authority procedures and at what stage. It is necessary
to pay attention to the required procedures and, more particularly, to the statute of
limitations under each treaty. Adjustments may not be possible after a tax liability has
become fnal, and only if the other revenue authority is prepared to give relief will
double taxation then be avoided. While in general, revenue authorities consider that
their enquiry should have been concluded before they begin discussions with the other
revenue authority, they may be prepared to delay the fnalisation of any assessment
and, in particularly complex cases, may be willing to operate the procedure in parallel
with the conduct of their audit. However lengthy or uncertain they are, the competent
authority procedures remain the main process through which a taxpayer can hope to
avoid double taxation after paying tax in respect of a transfer pricing adjustment.
It is signifcant to note that the Mutual Agreement Procedure under a double tax
treaty ordinarily provides an alternative process of dispute resolution and is an option
available to the taxpayer in addition to and concurrently with the prevailing appellate
procedures under domestic law. The reference to the competent authority is to be
made by the aggrieved party impacted by taxation not in accordance with the treaty.
Consequently, the reference would be made by the taxpayer, which has or may suffer
double taxation arising from the adjustment to the transfer price of an associated
enterprise, rather than the enterprise itself.
Further, it is important to recognise that the charter of the mutual agreement
procedure process is to mitigate taxation not in accordance with the treaty and not
a means of eliminating the tax impact of a proposed transfer pricing adjustment.
The mutual agreement procedure is a negotiation process between the competent
authorities and ordinarily involves a compromise on both sides, by way of reaching a
consensus on the acceptable transfer prices. During the mutual agreement procedure
process, it is advisable for the taxpayer and its associated enterprise to provide inputs
to respective competent authorities on an ongoing basis so that an effective and
acceptable settlement is expeditiously reached. The taxpayer is at liberty to accept the
agreement reached by the competent authorities or decline the arrangement (and by
consequence revert to remedies under domestic law). The taxpayer may also withdraw
its reference to the competent authorities during the negotiation process.
EUROPEAN UNION ARBITRATION CONVENTION
1003. Background
On 23 July 1990, the representatives of Belgium, Denmark, Germany, Greece, Spain,
France, Ireland, Italy, Luxembourg, the Netherlands, Portugal and the UK jointly
approved a convention on the elimination of double taxation in connection with the
adjustment of profts of associated enterprises (Convention 90/436). This multilateral
convention represented a unique attempt to solve some of the diffculties faced by
multinational enterprises in the transfer pricing area.
There were a number of procedural diffculties that made its use diffcult, due to the
modifcations required to ratify the original treaty, to refect the accession of Finland,
Sweden and Austria, and also to the ratifcations needed to extend the life of the
original treaty beyond 31 December 1999. These procedural diffculties have now been
overcome, thanks to the work of the EU Joint Transfer Pricing Forum. In November
2006, the Council Convention was amended with the accession of the Czech Republic,
Procedures for achieving an offsetting adjustment 160 www.pwc.com/internationaltp
Estonia, Cyprus, Latvia, Lithuania, Hungary, Malta, Poland, Slovenia and the Slovak
Republic in the European Union and entered into force on 1 November 2006.
1004. The scope of the Convention
The Convention is designed to apply in all situations in which profts subject to tax
in one Member State are also subject to tax in another as a result of an adjustment
to correct non-arms-length pricing arrangements. The Convention also provides
that relief is available under its terms where there is a risk of losses being doubly
disallowed. However, the Convention is not applicable in any circumstance in
which the authorities consider that the double taxation arises through deliberate
manipulation of transfer prices. Such a situation arises in any instance where a revenue
authority is permitted to levy a serious penalty on the business concerned. This is
considered in more detail in section 1009 below.
The businesses that can beneft from the Convention are those that constitute an
enterprise of a contracting state; this specifcally includes permanent establishments
of any enterprise of a contracting state. No further defnition of these terms is
included in the Convention, although it is stipulated that, unless the context otherwise
requires, the meanings follow those laid down under the double taxation conventions
between the states concerned. The intention was undoubtedly that all businesses of
any description which have their home base within the European Union (EU should
receive the protection of the Convention, regardless of their legal form. Consequently,
a French branch of a German company selling goods to an Italian affliate would be
covered. However, a French branch of a US company selling goods to an Italian affliate
would not be covered. It is important to note that the Convention is drawn up in terms
that recognise not just corporations but also other forms of business, subject to tax
onprofts.
1005. The required level of control
In drafting the Convention on transfer pricing, the European Commission recognised
that Member States use widely varying defnitions of the level of control required
between affliated businesses before anti-avoidance law on transfer pricing can apply.
The Conventions defnition of control for these purposes is accordingly very widely
drawn indeed. It merely requires that one Member State enterprise participates
directly or indirectly in the management, control or capital of an enterprise of
another contracting state and that conditions are made or imposed between the two
enterprises concerned such that their commercial and fnancial relationships differ
from those that would have been made between independent enterprises. A similar
defnition deals with the situation where two or more Member State businesses are
controlled by the same person.
Regarding the profts to be attributed to a permanent establishment, the Convention
follows the OECD Model Treaty, requiring that the permanent establishment be
taxed on profts that it might be expected to make if it were a distinct and separate
enterprise, engaged in the same or similar activities under the same or similar
conditions and dealing wholly independently with the enterprise of which it is a
permanentestablishment.
1006. Adjustments to profts
The Convention makes no attempt to interfere with the processes by which the tax
authorities of any one Member State seek to make adjustments to the profts declared
by a business operating in their country. However, where a contracting Member State
does intend to make an adjustment on transfer pricing grounds, it is required to notify
the company of its intended actions in order that the other party to the transaction can
give notice to the other contracting state. Unfortunately, there is no barrier to the tax
adjustment being made at that stage. As a result, Member State businesses still face the
cash-fow problems associated with double taxation until such time as the authorities
agree to make offsetting adjustments. If this double taxation cannot be eliminated
by agreement between the two countries concerned, then the remaining provisions
of the Convention may be used to gain relief. To address these issues, the Council of
the European Union adopted a Code of Conduct for the effective implementation of
the Convention wherein it has recommended Member States to take all necessary
measures to ensure that tax collection is suspended during the cross-border dispute
resolution procedures under the Arbitration Convention. As of September 2006,
16 Member States had allowed the suspension of tax collection during the dispute
resolution procedure and other states were preparing revised texts granting
thispossibility.
1007. Mutual agreement and arbitration procedures
The Convention provides for an additional level of protection to Member State
businesses over and above anything available under the domestic laws of the states
concerned or through the existing bilateral treaties. The protection available begins
with the presentation of a case to the competent authority of the contracting state
involved. This presentation must take place within three years of the frst notifcation
of the possible double taxation. The procedures require that all the relevant competent
authorities are notifed without delay and the process is then underway to resolve the
problem, regardless of any statutory time limits prescribed by domestic laws.
If the competent authorities are unable to reach an agreement within two years of the
case frst being referred to them, they are obliged to establish an advisory commission
to examine the issue. The Convention provides that existing national procedures for
judicial proceedings can continue at the same time as the advisory committee meets,
and that if there is any confict between the procedures of the arbitration committee
and the judicial procedures in any particular Member State, then the Convention
procedures apply only after all the others have failed.
1008. Serious penalty proceedings
There is no obligation on Member States to establish an arbitration commission to
consider pricing disputes if legal and administrative proceedings have resulted in a
fnal ruling that by actions giving rise to an adjustment of transfers of profts one of
the enterprises concerned is liable to a serious penalty. Where any proceedings are
currently underway, which might give rise to serious penalties, the normal due date for
the establishment of the arbitration committee is deferred until the other proceedings
are settled.
The term serious penalty is somewhat subjective and has different meanings from
one country to another. However, the Member States have included, as part of the
treaty, unilateral declarations on their view of the meaning of serious penalty for
these purposes.
1009. The advisory commission
When an advisory commission is needed, it is established under the chairmanship of
an individual possessing the qualifcations required for the highest judicial offces of
his/her country. The other members of the commission include a maximum of two
individuals from each of the competent authorities involved and an even number
of independent persons of standing, to be selected from a list of such people drawn
up for the purpose by each contracting state. The task of the advisory commission is
to determine, within six months, whether there has been a manipulation of profts,
and, if so, by how much. The commission makes its decisions by simple majority of its
members, although the competent authorities concerned can agree together to set up
the particular detailed rules of procedure for any one commission. The costs of the
advisory commission procedure are to be divided equally between all the contracting
states involved.
In reaching its decision, the advisory commission may use any information, evidence or
documents received from the associated enterprises concerned in the transactions. The
commission can also ask the competent authorities of the contracting states involved
to provide it with anything else it requires, but there is no obligation on the contracting
states to do anything that is at variance with domestic law or normal administrative
practice. Furthermore, there is no obligation on them to supply information that would
disclose any trade secret, etc., which might be contrary to public policy. There are full
rights of representation for the associated enterprises involved to speak before the
advisory commission.
1010. Resolution of the problem
Once the advisory commission has reported, the competent authorities involved
must take steps to eliminate the double taxation within six months. They retain the
discretion to resolve matters as they see ft, but if they cannot agree on the necessary
steps to be taken, they must abide by the decision of the advisory commission.
1011. Term of the convention
The Convention came into force on 1 January 1995 for an initial period of fve years.
However, it was agreed in May 1998 that the Convention would be extended for at least
a further fve-year period. During this time Austria, Finland and Sweden joined the
EU and became parties to the Convention. The original protocol for accession of new
Member States required that all parties had to satisfy each accession, and consequently
extensions to membership required lengthy procedures to ensure the continued life
of the Convention. As a result of the work with the EU Joint Transfer Pricing Forum,
it is anticipated that as new countries join the EU they will accede to the Arbitration
Convention by a simpler process.
1012. Interaction with non-member states
The Convention recognises that countries other than the Member States of the EU may
be involved in transfer pricing disputes with EU businesses. The Convention simply
notes that Member States may be under wider obligations than those listed in the
Convention and that the Convention in no way restricts these obligations. There is no
comment on the way in which third-country disputes might be resolved.
1013. Experience of the Convention
While the Convention is already perceived by the EU members as being a major step
forward in the development of worldwide tax policies designed to resolve pricing
issues, there is little practical experience of its use (the frst ever advisory commission
set up under the Convention only met on 26 November 2002 to begin looking at a
FrancoItalian matter). It is understood that there is now a backlog of more than 100
cases that might go to arbitration, following the resolution of the procedural problems
faced by the Arbitration Convention. The EU Joint Transfer Pricing Forum will monitor
the work to make sure matters are followed through on a timely basis.
1014. Further EU developments in transfer pricing
Within Europe, the EU Commission struggled for many years to attain agreement
on a common tax base for European businesses or common tax rates across the EU
states. This is politically highly diffcult to achieve and there remains little likelihood of
substantial agreement in this area in the foreseeable future. However, the Commission
convinced Member States that there was no political logic in favour of continuing
the problems experienced by multinationals when they faced double taxation as a
result of transfer pricing adjustments being made by tax authorities. The Arbitration
Convention represents the statement that, from a purely pragmatic point of view, it
must be reasonable to eliminate such double taxation of profts.
The European Commission would like to go much further. Instead of rectifying double
taxation after it has occurred, the Commission would like to see a mechanism for
preventing it in the frst place. A number of Commission offcials have stated their wish
to see possible transfer pricing adjustments being discussed among the competent
authorities before they are made, such that any offsetting adjustment could be
processed at the same time as the originating adjustment. Some Commission offcials
want to go even further than this and create a regime for multilateral advance pricing
agreements on pricing issues within the EU.
It is clear that the European authorities frmly support the use of the arms-length
principle in transfer pricing. They are on record, via the Convention, as stating that
they do not approve of double taxation. Most of the Member State tax authorities have
privately expressed the view that, however desirable, advance pricing agreements
represent an unacceptably high administrative burden. Information on the use of the
Convention within Europe has been lacking. However, this was remedied in October
2001 when a Commission working paper published a summary for 1995 to 1999.
During this period, 127 intra-EU transfer pricing cases were referred to the Arbitration
Convention or to a bilateral treaty mutual agreement procedure (it is interesting
to note the total number of cases rises to 413 when non-EU country counterparties
are brought in). The paper estimated that 85% of the cases had been satisfactorily
resolved, removing double taxation in an average timescale of 20 months. In its recent
communication in February 2007, the European Commission revealed that none of the
24 cases for which the taxpayer had made the request for mutual agreement procedure
prior to January 2000 was sent to arbitration commission.
Recognising that considerable numbers of transfer pricing cases are never referred to
competent authorities for resolution, the Commission identifed transfer pricing as a
major concern for cross-border business. To review the tax position on transfer pricing
in the EU and to consider pragmatic ways in which the burden on business could be
relieved, in early 2002 the Commission proposed the establishment of the EU Joint
Transfer Pricing Forum. This was a radical step, in that membership would include
both government personnel and representatives from business. In addition to the
chairperson, the forum now includes 25 Member State representatives and 10 business
representatives (the author is one of the 10) together with Commission membership
and observers from the OECD and EU accession states.
The forums work resulted in two formal reports. The frst was published on 27 April
2004 and was adopted by the ECOFIN Council on 7 December 2004. The material is
available on the Commission websites and contains detailed guidance on the operation
of the Arbitration Convention, including practical matters relevant to time limits
and the mutual agreement procedures. The Council adopted the Code of Conduct
recommend by the EU Joint Transfer Pricing Forum in full.
The second report of the EU Joint Transfer Pricing Forum was completed in mid-2005
and set out a proposal for documentation standards across all Member States. The
Commission adopted the proposal on 10 November 2005. In June 2006, the Council of
the European Union adopted a Code of Conduct on transfer pricing documentation for
associated enterprises in the European Union. This Code of Conduct standardises the
documentation that multinationals must provide to tax authorities on their pricing of
cross-border, intragroup transactions.
Considering the recent achievements within the EU and the need to ensure a
monitoring of implementation of codes of conduct and guidelines and the examination
of several issues, the EU Joint Transfer Pricing Forum has been renewed for a new
mandate of two years. The Commission has endorsed the Joint Transfer Pricing
Forums suggestions and conclusion on advance pricing agreements and on this basis
released guidelines for advance pricing agreements in the EU. Going forward, the
Joint Transfer Pricing Forum will continue to examine penalties and interest related
to transfer pricing adjustments and focus on the important area of dispute avoidance
andresolution.
1015. International updates in cross-border dispute
resolution
Taking a cue from the EU Arbitration Convention, OECD countries have agreed to
broaden the mechanisms available to taxpayers involved in cross-border disputes over
taxation matters by introducing the possibility of arbitration if other methods to resolve
disagreements fail. The background for this initiative goes back to February 2006,
when the OECD released a public discussion draft entitled Proposals for improving
mechanisms for resolution of tax treaty disputes. This public discussion draft
essentially dealt with the addition of an arbitration process to solve disagreements
arising in the course of a mutual agreement procedure and the development of a
proposed online manual for an effective mutual agreement procedure.
The OECD received numerous comments on the public discussion draft and followed
it up with a public consultation meeting in March 2006. As a result of these comments
and meeting, the Committee of Fiscal Affairs of the OECD approved a proposal to add
to the OECD Model Convention an arbitration process to deal with unresolved issues
that prevent competent authorities from reaching a mutual agreement.
The proposed new paragraph to the Mutual Agreement Procedure Article of the OECD
Model Convention (paragraph 5 of article 25) provides that in the event the competent
authorities are not able to reach agreement in relation to a case presented to the
competent authority for resolution within a period of two years from the presentation
of the case, it may be submitted to arbitration at the request of the taxpayer. It is left to
the discretion of the member countries as to whether the open items may be submitted
for arbitration if a decision on these issues is already rendered under domestic law.
Issues of treaty interpretation would be decided by arbitrators in the light of principles
incorporated in the Vienna Convention on the Law of Treaties, whereas the OECD
Guidelines would apply in respect of transfer pricing matters.
Finally, the OECD has recently developed a Manual on Effective Mutual Agreement
Procedure explaining the various stages of the mutual agreement procedure,
discussing various issues related to that procedure and, where appropriate, bringing
out certain best practices.
Part 2:
Country-specifc
issues
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1101. Introduction
Transfer pricing continues to be a major concern to fscal authorities around the world,
and Africa is no exception. Revenue authorities in the African countries are sceptical
of the tax compliance levels of multinationals operating in the African continent and
more often tend to view inter-company pricing policies as proft-extraction techniques.
In some African countries the revenue authorities have requested assistance from more
developed tax authorities with transfer pricing training. Transfer pricing is therefore
one of the hot topics developing in the African tax arena and is seen by many tax
authorities as a mechanism to protect and increase their tax bases.
Southern and Central Africa
In Southern Africa, South Africa continues to be the most active country in legislating
transfer pricing matters. Section 31(2) of the South African Income Tax Act requires
connected parties to deal at arms length in respect of cross-border transactions. A
detailed Practice Note 7 has been issued that provides guidelines on how companies
should conduct their cross-border related party dealings. Companies that do not
comply with section 31(2) face an adjustment to their taxable income. The adjusted
amount is subject to 28% corporate income tax and 10% secondary tax on companies.
Furthermore, the taxpayers may be liable to interest on the underpayment of taxes and
also penalties of up to 200% of the tax on the adjusted amount. Finally, the assessment
may have a signifcant impact on the companys cash fow as the principle of pay now,
argue later often applies.
Transfer pricing legislation was introduced in Namibia in May 2005, and a Practice
Note on the application of the transfer pricing legislation was issued in September
2006. While Namibias Directorate of Inland Revenue is not yet fully geared to conduct
full-scope transfer pricing compliance investigations, the Directorate has indicated
that it will work closely with the South African Revenue Services and if necessary will
request task teams from the South African Revenue Service to assist in carrying out
transfer pricing audits.
In Zambia, transfer pricing legislation exists. Section 97A of the Income Tax Act
introduces the arms-length principle. The Income Tax (Transfer Pricing) Regulations
2000 also provide further defnitions regarding the extent of application of the transfer
pricing provisions contained in the Income Tax Act. In March 2005, a draft practice
note was issued by the Zambia Revenue Authority (ZRA), which provides detail on how
the ZRA applies the transfer pricing rules. The enforcement of the legislation by the
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ZRA has, however, not been as aggressive as expected. However, it would be diffcult to
mount a defence of nonexistence of transfer pricing legislation when the ZRA begins
to police the legislation actively.
Zimbabwe, at present, does not have specifc transfer pricing legislation in place. The
old-style legislation has not been tested to any great extent. It has been announced
however that the introduction of transfer pricing legislation, based on the South
African law, is being considered.
In Mozambique and Swaziland, transfer pricing does not appear as yet to be a
prominent issue. In Botswana, the Revenue Authority is applying the general anti-
avoidance provision to attack cross-border transactions between connected parties.
We are aware of a number of ongoing audits and assessments issued by the Botswana
Revenue Authority.
In Malawi, the Parliament has passed a law that would introduce transfer pricing
regulations. The Malawi Revenue Authority (MRA) is still working on the transfer
pricing regulations and at this stage, it is uncertain when these regulations will be
fnalised. Prior to introducing specifc transfer pricing rules, the MRA used the tax anti-
avoidance provision to adjust non-arms-length transactions.
In Lesotho, there is a specifc section (section 113 of the Income Tax Order of 1993,
titled Transfer Pricing) that provides the Commissioner with wide discretionary
powers to recharacterise transactions between associates for Lesotho tax purposes. In
practice, this section has, to date, rarely been used by the Lesotho Tax Authority, so
that transfer pricing does not appear to be a prominent issue in Lesotho.
East Africa
In East Africa, the Kenya Revenue Authority (KRA) has been the most active in
policing the transfer pricing practices of multinationals. It has engaged two Kenyan
multinationals in the High Court of Kenya in transfer pricing litigation. Tanzania
tends to follow Kenyas example when it comes to dealing with novel areas of tax
enforcement. In February 2005, the KRA released draft TP regulations for comment
by the industry, and it is expected that Tanzania will adopt the same regulations as
soon as they are adopted as law in Kenya. Although Tanzania has not issued detailed
transfer pricing regulations, the main part of the tax legislation (section 33 of Tanzania
Income Tax Act) contains specifc transfer pricing provisions and, in the past, the
Tanzania Revenue Authority (TRA) has raised transfer pricing audit queries in respect
of multinationals operating in Tanzania.
Although Uganda has no specifc regulations on transfer pricing, section 90 of the
Income Tax Act authorises the Uganda Revenue Authority (URA) to recharacterise
any income, deductions, or credits between related parties, any transaction involving
taxpayers who are associates or who are in an employment relationship, as required
to refect the income that the taxpayers would have realised in an arms-length
transaction. The URA is also working on specifc transfer pricing legislation that will
apply to multinational enterprises in Uganda. The legislation came into effect on 1
July 2010 but the related regulations have not yet been fnalised and these are awaited
without a specifed release date.
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URA considers transfer pricing as a major area of tax leakage and, as a result, they
have generally become more vigilant in respect of transfer pricing issues. They have
also been strengthening their transfer pricing compliance enforcement efforts in
preparation for the impending new transfer pricing regulations. URA is also part of the
Africa Tax Administrators Forum (ATAF), which has identifed transfer pricing as one
of its key issues. Each of the African jurisdictions implementing specifc transfer pricing
regulations is discussed in more detail below.
South Africa, Republic Of
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1102. Introduction
Transfer pricing legislation has been in South African law since 1995; however, it has
only been in recent years that the South African Revenue Service (SARS) has focused
on this area of taxation. The rules require those liable to tax in South Africa to follow
arms-length principles in their dealings with inter alia connected persons who are not
tax residents of South Africa. While exchange control regulations continue to regulate
the fow of funds out of South Africa, the gradual relaxation of the exchange control
rules have provided greater fexibility and freedom for the movement of funds offshore.
As such, the authorities are becoming more reliant on the successful implementation
of transfer pricing rules. In this regard, we have seen increased activity by the specialist
Transfer Pricing unit within SARS, with growing focus on industry sectors, notably
automotive, pharmaceutical and retail.
The years queried by SARS would depend on whether the assessments (in respect of
the years in which the relevant transactions took place) have prescribed (generally
speaking, assessments prescribe three years after the date of assessment) and whether
it would be possible to argue that non-disclosure took place, in which case, earlier years
of assessment can be reopened. In the last year, we have seen SARS raise assessments
in respect of transfer pricing adjustments where the assessments are close to
prescription, or to reopen assessments for earlier years on the basis that non-disclosure
took place. SARS is applying todays knowledge and general practice with hindsight,
which stands in stark contradiction to the provisions of the Practice Note and the OECD
Guidelines. The South African government has indicated that they would want South
Africa to become the gateway into Africa, and they are looking into incentives to
make South Africa more attractive as a central hub for investments into Africa.
1103. Statutory rules
Section 31 of the South African Income Tax Act 58 of 1962 (Income Tax Act) combines
transfer pricing and thin capitalisation measures. Section 31(2) gives the commissioner
the power to adjust the consideration of a transaction to an arms-length price for
the purposes of computing the South African taxable income of a taxpayer. This rule
applies to goods and services, both terms being defned in section 31(1), as well
as to direct and indirect fnancial assistance. Section 31 is a discretionary section,
which means that while the taxpayer can place some comfort on the fact that the
commissioner must have applied due care and reasonableness in raising a transfer
pricing adjustment, the onus of proof for rebutting such an adjustment rests squarely
with the taxpayer.
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In terms of section 64C(2)(e), SARS may, in certain circumstances, also deem an
adjusted amount to be a dividend on which secondary tax on companies (STC) is
payable (currently 10%). This STC is payable even if the company has an assessed
loss. Note, however, that STC will be abolished in favour of a dividend withholding
tax. The deemed dividend legislation will in future also be replaced with a new value
extraction tax. The value extraction tax and the dividend withholding tax will be
implemented from the same date the actual date of implementation is uncertain.
As the new legislation is still in fux, it is not clear what the fnal position will be. An
unresolved contention remains regarding the application of the current STC charge on
adjustments made voluntarily and whether this should attract an STC charge.
Additional taxes include interest and penalties. For instance, in the event of
the underpayment of taxes due to transfer pricing, a taxpayer may in terms of
section 89 also be liable to interest on the underpayment of tax as well as to the
payment of penalties in terms of section 76, which may be as much as 200% of the
underpaidtaxes.
Although the Income Tax Act contains no explicit transfer pricing documentation
requirements, SARS may, in terms of section 74 read with section 74A, require a
taxpayer to furnish information, documents or things as the commissioner may
require for the administration of the Income Tax Act. In practice, SARS may require
detailed transfer pricing information to be supplied within 14 days from the date
ofrequest.
What is of interest is the requirement (introduced in 2004 and clarifed in the
addendum to the practice note) to furnish the transfer pricing documentation with
the tax return if held. It is arguable that this inherently introduces a requirement to
complete documentation, although SARS maintains there is no statutory requirement
to do so. What is critical is that, where such documentation has been prepared it must
adequately refect the current transfer pricing policies being implemented and be up
to date. Otherwise, erroneous, out-of-date or incorrect documentation could, and has
been argued to, represent incomplete disclosure, consequently resulting in prescription
not applying to the years in which the incomplete disclosure was made. This represents
a signifcant risk to taxpayers who could remain open to a transfer pricing review from
SARS for an indefnite period going back as early as 1995. SARS have recently also
started to enter into agreements with taxpayers to extend the period within which an
assessment prescribes if agreed to by the taxpayer, this effectively provides SARS
additional time to raise queries or assessments.
The income-tax return form requires a taxpayer to indicate whether it has cross-border
transactions with connected persons and whether the taxpayer has prepared transfer
pricing documentation. In terms of current SARS practice (specifcally in the event that
a taxpayer makes use of SARS e-fling), the system does not allow for the submission
of transfer pricing documentation with the corporate income-tax return form
rather it must be available upon request from SARS. Uncertainty exists as to how this
will impact the taxpayers obligation to provide full disclosure to SARS. Generally
speaking, in the event that there is non-disclosure in a taxpayers income-tax return,
the assessment in respect of the specifc year does not prescribe (assessments usually
prescribe after three years). Furthermore, bearing in mind the focused questionnaires
that SARS sends to taxpayers, it may not necessarily be advisable to submit the transfer
pricing documentation when the tax return is fled. Given the current uncertainty as
to whether a taxpayer must submit transfer pricing documentation and the possible
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impact of non-disclosure, taxpayers are cautioned to keep abreast of developments
in this regard and seek advice before deciding not to prepare contemporaneous
documentation or fle supporting documentation.
In the event that transfer pricing documentation is available and a taxpayer does not
submit it on request from SARS, failure to submit the documentation could arguably
lead to prosecution under section 75 of the Income Tax Act.
Section 31(3) is more specifcally aimed at thin capitalisation and is discussed in more
detail below.
1104. Controlled foreign companies
The Income Tax Act deems any transaction undertaken between a controlled foreign
company (CFC) and any connected person to such CFC to be a transaction to which
the transfer pricing provisions contained in section 31 apply. CFCs are non-resident
companies of which more than 50% of the total participation rights or voting rights
in the company are held directly or indirectly by one or more South African residents.
The result is that, in effect, the Act is deeming the CFC party to the transaction to be a
resident for transfer pricing purposes.
This is increasingly becoming an area of scrutiny for SARS, as many multinationals
based in South Africa do not identify the potential risk in transactions between CFCs.
One of the stringent anti-diversionary rules requires that the transactions between
CFCs and residents are conducted at arms length before the specifc business
establishment exemption from CFC imputation can apply to these transactions.
1105. Other regulations
SARS issues practice notes that provide guidance on its interpretation and application
of the Income Tax Act. Practice Note 2 was issued in May 1996 and focuses on the
interaction of the thin capitalisation rules and the transfer pricing rules. Practice Note
2 relates to the provision of fnancial assistance given by an overseas connected party to
a South African resident, but not vice versa. The Practice Note helps taxpayers identify
levels of excessive loan debt under the thin capitalisation rules as well as excessive
interest rates under the transfer pricing rules. Thin capitalisation is a current focus area
for SARS.
The Practice Note strictly applies only to inbound fnancial assistance, and taxpayers
need to be wary if relying on this for outbound fnancial assistance, notably as SARS is
aggressively focusing on this area. It is our understanding that SARS is currently in the
process of preparing an updated Practice Note dealing with fnancial assistance and
thin capitalisation the anticipated date of release is not currently known.
Practice Note 7 was issued in 1999 and is aimed at providing more specifc guidance to
the workings of the legislation on transfer pricing. It is a very comprehensive practice
note following a similar approach to the Australian and New Zealand guidance on
implementing transfer pricing rules and documentation requirements.
Under accounting statement IAS 24 (AC126) (and the new IRFS requirements),
companies are required to disclose all transactions with related parties. We understand
that, due to amendments to IAS 24, additional related party information may need to
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be disclosed in future. Due to the rather wide defnition of related parties, the fnancial
statements will now provide information to SARS on cross-border transactions with
connected persons. Also becoming of increasing importance, the requirements under
the accounting standards must be able to support any statement made in the fnancial
statements. Consequently, if the statement is made in the fnancial statements that
all related party transactions are conducted at arms length, the auditor needs to
be confdent that this statement can be supported. In the current climate of risk
averseness, this is placing a greater onus on the auditors and, in turn, greater pressure
on multinationals to ensure the transfer pricing house is in order. If a general statement
is made that the related party transaction takes place at arms length and this is not in
fact the case, SARS could claim that the taxpayer made a fraudulent misrepresentation,
resulting in prescription not applying to the years in which the incorrect disclosure
wasmade.
The introduction of legislation regarding reportable irregularities for auditors and
tax practitioners is also placing strain on transfer pricing compliance. Transfer
pricing in South Africa is discretionary and, therefore, identifying the existence of
a transfer pricing exposure and quantifying this, without undertaking extensive
analysis, is problematic and raises considerable concerns for auditors, tax practitioners
andtaxpayers.
1106. Legal cases
As yet, no court cases have been brought on this issue. As a result of the increased focus
of SARS on transfer pricing, various transfer pricing assessments have been issued in
which adjustments have been made. Some of these adjustments have been appealed
against and are likely to be tested through the courts.
In terms of the South African constitution, the courts are bound to follow international
precedent (i.e. foreign case law) in the event that no local precedent is available.
Currently, SARS is open to entering into settlement agreements rather than going to
court. This is a positive development and does not infringe on the taxpayers right to
object and appeal (if the taxpayer is not satisfed with the SARS stance).
Given the lack of court cases on transfer pricing, few advocates and judges are available
with knowledge of transfer pricing. For this reason, taxpayers sometimes prefer to
settle cases with SARS rather than going to court.
1107. Burden of proof
Section 31 is a discretionary section; therefore, in making any transfer pricing
adjustment, SARS must demonstrate that it has paid due care and attention to the
issue. Notwithstanding, the burden of proof lies with the taxpayer to demonstrate that
the transfer pricing policy complies with the relevant rules and that the transactions
have been conducted in accordance with the arms-length standard.
1108. Tax audit procedures
In the 2010/11 budget speech, the South African Minister of Finance indicated that
transfer pricing is one of SARS key focus areas.
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SARS follows the OECD Guidelines in conducting a transfer pricing investigation
and all multinationals are potential targets, both inbound investors as well as South
African-based. Companies that fall within the provisions of section 31 should take
transfer pricing seriously and develop and maintain properly documented and
defensible transfer pricing policies. Such documentation must be contemporaneous
and regularly updated. Previously, SARS practice generally accepted a document
be updated only every three years and for changes in the operations. Currently, we
recommend that benchmarking for non-core services be updated at least every three
years. Furthermore, on the basis that tax is viewed as an annual event, taxpayers
need to ensure the documentation is reviewed annually. At a minimum, the fnancial
analysis must be completed on an annual basis given that SARS performs their
calculation on an annual basis rather than on a weighted-average basis (as suggested
by the OECD). SARS also prefers the South African taxpayer to be the tested party,
even though it may not be the least complex party to the transaction. The transfer
pricing document must list every cross-border transaction entered into by the taxpayer,
even though the transfer pricing document may not deal with a specifc transaction in
detail this ensures that the taxpayer satisfes the requirement of full disclosure in its
transfer pricing documentation.
SARS is currently aggressively auditing taxpayers on their transfer pricing and has
indicated that it will place greater scrutiny on multinationals that have connected-
party entities situated in low-tax jurisdictions. This line of enquiry tends to combine
a challenge of residence of the low-taxed foreign entity together with transfer
pricing. In the last year, we have also seen the SARS issue focused on transfer
pricing questionnaires to multinationals to obtain information regarding the
taxpayers transfer prices. The focus of these questionnaires is on comparability and
characterisation of a transaction.
SARS, as in South Africa generally, is experiencing a resource issue, which means
many of the audits commenced are taking a long time to conclude. In addition, where
transactions are with African countries that do not have a transfer pricing regime,
solutions through the normal channels of mutual agreement procedures (MAPs) are
unlikely to yield success.
1109. Resources available to the tax authorities
A specialist unit within SARS conducts transfer pricing audits. This unit comprises
highly skilled individuals who have previously been employed by the professional
frms. To help train personnel in the unit, SARS has sought advice and training from
Revenue specialists in the US, the UK and Australia. Over the last year, SARS has also
recruited personnel (on a secondment basis) from other tax authorities (e.g. from
the UK and Australia), and cooperation between SARS and overseas tax authorities
has increased. SARS transfer pricing representatives also regularly attend OECD
conferences and training sessions.
1110. Use and availability of comparable information
Use
The OECD Guidelines on transfer pricing are the basis for determining an acceptable
transfer pricing methodology. Within the context of these guidelines, therefore, any
information gained on the performance of similar companies would be acceptable in
defending a transfer pricing policy.
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Availability
Information on the performance of public companies in South Africa is readily
available only in the form of published interim and annual fnancial statements.
More detailed information on public companies and information concerning private
companies is generally not available publicly, which makes the search for comparables
in South Africa diffcult.
SARS has indicated that it will accept the use of fnancial databases used elsewhere
in the world, but all comparables must be adjusted for the South African market. Our
understanding is that SARS uses Amadeus to conduct comparable studies, relying
largely on European companies for comparability.
We have seen limited evidence of SARS relying on secret comparable information (i.e.
information of competitors) they have access to when determining adjustments under
audit. Although such supporting evidence could never be used in a court of law and
this practice would not be confrmed publically, it nevertheless places greater emphasis
on the need for multinationals to have robust benchmarking to support the related
party transaction in order to be able to rebut such proposed adjustments.
1111. Risk transactions or industries
SARS is becoming much more aggressive in its audit activity and is focusing on
industry areas. SARS has demonstrated its ability to research an industry and is
being selective in targeting audits. We have seen increased activity in the automotive,
pharmaceutical and retail sectors. In addition, SARS stated in its 2007 budget that
intellectual property (IP) is a focus area, and since then a number of IP-related queries
have been issued, which we expect to increase.
South African companies that have related companies situated in lower tax
jurisdictions remain at a high risk of investigation. Such investigation is often two-
pronged, testing residency together with transfer pricing. SARS arguably has a stricter
requirement for documentation and supporting evidence than many other countries.
For instance global documentation prepared by a group and rolled out throughout that
group is not acceptable without a suffcient level of localisation. SARS focus is very
much on the transactional level and it does not readily accept analyses undertaken on
a whole of entity basis, commonly adopted in the US and Australia. Further, SARS is at
odds with the OECD in some respect, notably on the use of multiple-year data. SARS
views tax as an annual event and adjustments for transfer pricing are viewed on a year-
by-year basis, irrespective of the longer term picture.
SARS does not look favourably upon transfer pricing adjustments (i.e. year-end
adjustments, targeted returns or situations where a payment is made in respect
of the indirect assumption of risk by a non-resident connected person without the
corresponding transfer of or change in functions performed by the South African
entity). SARS often views such adjustments as a proft-stripping mechanism and, as
such, any TP adjustments by offshore holding companies are deemed to raise a red
fag for SARS to raise queries or perform an audit. It is therefore important that
appropriate legal agreements are in place to support the pricing adjustment. SARS
also states that the taxpayer cannot use hindsight and that year-end transfer pricing
adjustments are arguably based on hindsight. This is a question of fact, depending on
the legal agreements and related obligations in place.
A
Little information is available on the process for competent authority claims.
Experience suggests that competent authority has not been widely used in South
Africa. The lack of experience coupled with potentially diffcult administrations in
wider Africa means that reliance on MAP to resolve disputes will be problematic.
However, for transactions involving countries with a well-established MAP, its use
provides a valuable defence mechanism against double taxation.
1113. Advance pricing agreements
No procedures are in place by which a taxpayer might achieve an advance agreement
to its transfer pricing policy, and none are expected for some time. In Practice Note 7,
SARS specifcally states that it is not in favour of adopting advance pricing agreements
(APAs). Although it is understood that this initial view is starting to change at SARS,
there are few available resources and therefore the introduction of an APA process in
South Africa is likely to be some way off. SARS will not be bound by unilateral APAs
that a taxpayers connected parties may have agreed with other tax authorities.
1114. Anticipated developments in law and practice
Law
The current requirements regarding the fling of transfer pricing documentation are
not clear. Taxpayers are advised to submit the information requested in the brochure to
the income-tax return form. If this cannot be done via e-fling, taxpayers are advised to
make a separate manual submission to SARS.
No further practice notes concerning transfer pricing have been issued since 1999,
although there is speculation that Practice Notes 2 and 7 will be updated in the
nearfuture.
Practice
SARS has continued its drive to implement the transfer pricing legislation, and all
multinational companies remain the focus of the authorities attention. Note that SARS
is not restricting its focus to the larger groups, but is taking a much wider view. For
this reason, it is important for multinational companies to formulate and document
transfer pricing policies in line with OECD Guidelines and the practice notes as soon
aspossible.
In the 2007 budget, SARS acknowledged the potential economic value locked in
intellectual property and the tendency of multinationals to shift the value offshore.
In response to this, SARS intends to impose measures to correct this. In the 2010/11
budget speech, the Minister of Finance specifcally stated that transfer pricing is one of
SARS areas of key focus.
While South Africa is not a member of the OECD, it is an enhanced engagement
country. SARS plays an active role at the OECD and has been involved signifcantly
with the new releases on the attribution of profts to permanent establishments and
conversion matters. While strictly speaking, the transfer pricing rules do not capture
Africa Regional
transactions between a branch and its head offce, without doubt SARS is focusing on
this area and using transfer pricing principles to review such transactions.
1115. Liaison with other authorities
Although customs and income tax authorities are under the same authoritative body,
and generally speaking, no information was shared between the two authorities, there
is clear evidence of more cooperation between the two tax departments, particularly
in terms of the SARS integrated audit, which seeks to apply a more holistic approach
to tax compliance. Recent questionnaires circulated by the customs authorities include
specifc questions regarding transfer pricing. As a general point, SARS is on a drive to
improve its systems, and better cooperation between the various authorities is to be
expected in the near future.
Recently, we have observed increased cooperation between SARS and the Reserve
Bank. Generally, a South African resident needs Reserve Bank approval to remit
monies outside of South Africa. The extent of the approval and vigilance of the banks
depends largely on the nature of the payments. Generally speaking, cross-border
payments to connected parties will frst be reviewed and cleared by the Reserve Bank.
A marked increase in Reserve Bank requests to review the applicants transfer pricing
documentation in support of the request to settle a controlled transaction before
approval is granted. In this regard, SARS has provided a working handbook to the
Reserve Bank to assist them with transfer-pricing-related matters. The Reserve Bank
has also set up a working committee (the frm is represented on this committee) to
discuss transfer-pricing-related matters in the exchange control context. Note that
the Reserve Bank generally follows a more commercial approach when approving
payments. Where approval is required from the Reserve Bank, it is given on a case-by-
case basis.
Payment for the use of intellectual property and inbound services has always been
a focus of the Reserve Bank. And the Reserve Bank is now effectively requesting a
transfer pricing review by the auditors to ensure any payments are in accordance with
the arms-length principle. In recent years, two notable changes have been: (1) the
requirement to demonstrate a beneft not only to the recipient of an inbound service,
but also to South Africa as a whole; and (2) the recent move towards ensuring the
inbound as well as outbound licence fees for intellectual property are arms length.
As a general point, it is important that exchange controls are considered together
with transfer pricing considerations given that, in a South African context, these two
matters effectively go hand in hand.
1116. OECD issues
South Africa is not a member of the OECD, but it is an enhanced engagement country.
South Africa actively participates in and provides input to OECD discussions and
discussion papers. South Africa does follow the OECD Guidelines and the recent
changes to the draft guidelines issued by the OECD are already being applied by SARS
in their transfer pricing audits.
A
1117. Joint investigations
It is possible for the South African tax authorities to join with the authorities of another
country to jointly investigate a multinational group. Practically, we have started to see
closer cooperation between SARS and other overseas revenue authorities.
1118. Thin capitalisation
Thin capitalisation is dealt with primarily by section 31(3). Guidance on thin
capitalisation and the charging of excessive interest is provided in Practice Note 2
issued 14 May 1996.
Thin capitalisation rules apply where fnancial assistance is granted, directly or
indirectly, by a non-resident to one of the following:
Any connected person who is a resident; and
Any person (in whom the non-resident has a direct or indirect interest) other than a
natural person who is a resident, where the non-resident is entitled to 25% or more
of the companys profts, dividends or capital, or is entitled to exercise, directly or
indirectly, 25% or more of the voting rights of the recipient.
Back-to-back loans are included in the fnancial assistance provisions.
In the 2010/11 budget speech, the Minister of Finance confrmed that, going forward,
the ministry proposes to extend the thin capitalisation provisions to branches. The
draft legislation has, however, not yet been released.
Practice Note 2 of 1996 provides for an acceptable debt-to-equity ratio of 3:1, within
which the commissioner does not generally apply thin capitalisation restrictions.
This 3:1 safe harbour ratio refects the previous approach adopted by the Exchange
Control Authorities. Note that this is a safe harbour and not a statutory ratio, and
taxpayers are free to apply to the commissioner for a relaxation (preferable in the year
when the company becomes thinly capitalised) in this ratio where sound commercial
reasons for the variance exist.
Taxpayers who comply with the safe harbour ratio are not required to justify
shareholder loans, but are still required to supply information as requested on the
annual tax return. Furthermore, in determining the interest rates applicable for rand
denominated loans, an interest rate of the weighted average of South African prime
rate plus 2% is accepted as arms length. For foreign-denominated loans, an interest
rate of the weighted average of the relevant interbank rate plus 2% is considered as
arms length. This provides a safe harbour for determining arms-length interest rates
to be applied to inbound cross-border loans.
Subject to clearance (see below), interest charged on that part of the loan which
exceeds the permissible ratio of 3:1 is not deductible for tax purposes. It is also deemed
to be a dividend under section 64C(2)(e)) of the Income Tax Act, and STC is payable
on the excessive amount.
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These safe harbour provisions apply only to inbound fnancial assistance and not
fnancial assistance provided by a South African entity. Reliance on these provisions for
outbound fnancial assistance is dangerous for this reason.
A literal interpretation of section 31 would lead to the conclusion that the concept of
fnancial assistance would extend beyond interest-bearing loans to interest-free loans.
However, the purpose of section 31(3) is to enable the commissioner to determine an
acceptable debt-to-equity ratio in order to disallow a tax deduction for interest paid
in relation to any excessive part of the debt. Consequently, the application of section
31(3) is limited, in practice, to interest-bearing debt only.
SARS is currently more active in querying thin capitalisation.
Kenya
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1119. Introduction
Kenya has always had a general provision within its tax legislation requiring
transactions between non-resident and resident-related parties to be at arms length.
However, until 2006, no guidance had been provided by the revenue authorities on
how the arms-length standard was to be achieved. This failure to provide guidance
led to protracted disputes between taxpayers and the Kenya Revenue Authority
(KRA), culminating in a landmark case involving the Commissioner of Income Tax
and Unilever Kenya Limited (the Unilever case). The judgment of the High Court in
the Unilever case led to the introduction of transfer pricing rules in July 2006, which
provide guidance on the application of the arms-length principle.
Section 18 (3) of the Income Tax Act, Chapter 470 of the Laws of Kenya (the Act)
requires business carried on between a non-resident and a related Kenya resident to be
conducted at arms length and gives the commissioner the power to adjust the profts
of the Kenya resident from that business to the profts that would be expected to have
accrued to it had the business been conducted between independent persons dealing
at arms length. The Income Tax (Transfer Pricing) Rules, 2006, Legal Notice No. 67 of
2006 (TP rules) published under section 18 (8) of the Income Tax Act (the Act) with
an effective date of 1 July 2006, provide guidance on the determination of arms-
lengthprices.
Under section 18 (3) of the Act and the TP rules, persons or enterprises are related if
either of them participates directly or indirectly in the management, control or capital
of the other or if a third person participates directly or indirectly in the management,
control or capital of both. No minimum threshold for participation in control or capital
is prescribed. However, as Kenya follows IFRS, it is expected that similar considerations
to those in the defnition of a related party in IAS 24 would apply.
The TP rules state that they apply to transactions between branches and their head
offce or other related branches. Doubts as to the legitimacy of this provision have
arisen in light of the restrictive application of section 18 (3) to resident persons,
which excludes branches. This notwithstanding, the widely held view is that it
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Updated by Rajesh Shah and Titus Mukora (PwC Kenya)
A
would be prudent for branches to apply the TP rules in their dealings with their head
offces and other branches for two reasons. Firstly, the intention that, at the local
level and at the international level in the OECD, the arms-length principle should
be extended to branches is clear. Secondly, the arms-length principle is an implicit
requirement in other sections of the Act, for instance with respect to the requirement of
reasonableness of head-offce costs incurred by branches.
Transactions subject to adjustment include: the sale or purchase of goods; sale,
transfer, purchase, lease or use of tangible and intangible assets; provision of services;
lending or borrowing of money; and any other transactions that affect the proft or loss
of the enterprise involved.
The TP rules do not make it an express statutory requirement for taxpayers to
complete supporting transfer pricing documentation. However, Rule 9 (1) gives the
commissioner permission to request information, including documents relating to
the transactions where the transfer pricing issues arise and a non-comprehensive list
of the documents that the commissioner may request is provided in Rule 9 (2). Rule
10 similarly requires a taxpayer who asserts the application of arms-length pricing to
provide supporting documentation evidencing the taxpayers analysis upon request by
the commissioner. The KRA has interpreted these provisions to mean that a taxpayer
is required to have documentation in place in readiness for any such request from the
commissioner.
The documents which the commissioner may request are required to be prepared in or
to be translated into English and include documents relating to:
The selection of the transfer pricing method and the reasons for the selection;
The application of the method, including the calculations made and price
adjustment factors considered;
The global organisation structure of the enterprise;
The details of the transactions under consideration; and
The assumptions, strategies and policies applied in selecting the method; and such
other background information as may be necessary regarding the transaction.
In providing guidance on the nature of documentation required, Rule 9 (2) does not
include any hard and fast rules for compiling documentation or for the process that
taxpayers should follow.
The rules specify that the fve primary methods specifed in the OECD Guidelines may
be used to determine the arms-length nature for goods and services in transaction
between related parties. In circumstances in which the fve methods cannot be used,
another method approved by the commissioner of the KRA can be applied.
No special penalties apply in respect of additional tax arising from a transfer pricing
adjustment. However, the usual penalty applies currently 20% of the principal tax
and late payment interest of 2% per month.
The KRA has seven years from the year in which the income in question was earned in
which to make an assessment. For years in which fraud, intentional negligence or gross
negligence on the part of the taxpayer is suspected, there is no time limit in which the
KRA must make an assessment in respect of transfer pricing.
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The concept of controlled foreign companies (CFCs) is not a feature of Kenyan tax law,
and Kenya does not have any rules that would deem a foreign company controlled by
Kenya residents to be resident for transfer pricing purposes.
For fnancial years ending on or after 31 December 1999, companies are required
to disclose all transactions with related parties under IAS 24. The wide defnition of
related parties in IAS 24 ensures that fnancial statements prepared in accordance
with IFRS will provide the KRA with information concerning related party transactions,
and this will likely be the starting point for KRA enquiries into transfer pricing.
1123. Legal cases
Of the two transfer pricing cases instituted before the courts in Kenya, the Unilever
case is the only one on which a judgment was delivered. In this case, the High Court of
Kenya endorsed the use of OECD Guidelines in the absence of detailed guidance from
the KRA. The governments response to this judgment was the introduction of the TP
rules, which are largely based on the OECD Guidelines. There have been no court cases
since the introduction of the TP rules.
In Kenya, the burden of proof is on the taxpayer to demonstrate that the controlled
transactions have been conducted in accordance with the arms-length standard.
Beyond the requirement to produce documentation in support of the asserted
application of the arms-length principle, the TP rules do not contain any guidance
to taxpayers as to what they may expect in connection with a transfer pricing
investigation, and nothing is known of such guidance communicated internally within
the KRA. However, the KRA appears to be taking guidance on transfer pricing from the
OECD Guidelines, and the expectation is that KRA offcers will be guided by the OECD
Guidelines in conducting a transfer pricing investigation.
The indications are that the KRA regards transfer pricing as a potentially major
revenue earner and that it will be taking an aggressive approach. The KRA is currently
requesting transfer pricing documentation from all taxpayers with cross-border-
related party transactions with the intention of risk profling taxpayers for the purpose
of conducting transfer pricing audits. All multinationals are potential targets for a
transfer pricing audit. And those multinationals with transactions which fall within
the provisions of section 18 (3) and the TP rules should take transfer pricing seriously
and develop and maintain properly documented and defensible transfer pricing
policies. The present recommendation is that documentation should, where possible,
be contemporaneous and regularly updated. Until KRA practice in this respect is clearly
established, taxpayers are advised to regularly update their transfer pricing documents,
especially where there are changes in the operations.
A
A specialist transfer pricing unit has been established within the Domestic Taxes
Department of the KRA and is responsible for conducting transfer pricing audits.
Investment has been made in developing specialist expertise within the KRA through
training locally and abroad. Additionally, the KRA is a member of the African Tax
Administrators Forum, a technical body supported by the OECD.
Use
The TP rules, which are based on the OECD Guidelines, are the basis for determining
an acceptable transfer pricing methodology. Within the context of these rules and
guidelines, therefore, any information gained on the performance of similar companies
would be acceptable in defending a transfer pricing policy.
Availability
Information on the performance of public companies in Kenya is readily available
only in the form of published interim and annual fnancial statements. More detailed
information on public companies and information concerning private companies
is generally not available publicly. Although the KRA has in the past confrmed
that, under certain circumstances, it would accept the use of fnancial databases
used elsewhere in the world, and specifcally Amadeus/Orbis, the KRA has recently
advocated for the use of local comparables or for applying geographic adjustments to
overseas comparables.
There is no indication at present that certain types of transactions or that
multinationals operating in particular industries are at higher risk of investigation than
others. All multinationals are considered to be at a high risk of investigation.
Little information is available on the process for competent authority claims.
Experience suggests that competent authority has not been widely used in Kenya.
The lack of experience means that competent authority claims or reliance on MAP to
resolve disputes will be problematic.
Kenya has no procedures in place by which a taxpayer might achieve an advance
agreement to its transfer pricing policy. In general terms, the KRA is reluctant to
give binding rulings regarding practices or policies adopted by a particular taxpayer
or group of taxpayers. This same reluctance is to be expected in connection with
agreements or rulings on transfer pricing matters.
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The KRA intends to introduce practice notes to assist taxpayers in their review of their
transfer pricing policies. It is also understood that the KRA intends to introduce greater
disclosure requirements in respect of related party dealings in the annual tax return.
Although customs and income tax are under the same authoritative body, they are
administered by distinct and separate departments within the KRA, and there is
very little sharing of information between the two departments. However, KRA is on
a general drive to improve its systems, and better cooperation between the various
authorities is expected in the near future.
1133. OECD issues
Kenya is not a member of the OECD, but does follow the OECD Guidelines and models.
The KRA has not teamed with any other tax authorities for the purposes of undertaking
a joint investigation into transfer pricing. However, the KRA is part of the African Tax
Administrators Forum, a body that is partly responsible for enhancing the technical
expertise of African tax authorities.
The relevant sections of the Income Tax Act which deal with thin capitalisation are
sections 4A (a),16(2)(j) and 16(3).
Thin capitalisation rules apply where fnancial assistance is granted to a resident
company by a related non-resident company, which alone or together with no more
than four other persons, controls the resident company, and the loan exceeds the
greater of:
Three times the sum of the revenue reserves and the issued and paid-up capital of
all classes of shares of the company; or
The sum of all loans acquired by the company prior to 16 June 1988, and still
outstanding at the time of determining the thin capitalisation status of a company.
An interest payment on that part of the loan that exceeds the permissible ratio of 3:1 is
not deductible for tax purposes.
Thin capitalisation rules are typically designed to prevent erosion of the tax base
through excessive interest deductions in the hands of companies that obtain fnancial
assistance from non-resident affliates.
A
Namibia
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1136. Introduction
Namibia introduced transfer pricing legislation on 14 May 2005 in the form of
section 95A to the Namibian Income Tax Act. The legislation is aimed at enforcing the
arms-length principle in cross-border transactions carried out between connected
persons. During September 2006, the Directorate of Inland Revenue issued Practice
Note 2 of 2006 (PN 2/2006) containing guidance on the application of the transfer
pricinglegislation.
Section 95A of the Namibian Income Tax Act (Income Tax Act) is essentially aimed
at ensuring that cross-border transactions by companies operating in a multinational
group are fairly priced and that profts are not stripped out of Namibia and taxed in
lower tax jurisdictions. Section 95A achieves this objective by giving the Minister of
Finance (who essentially delegates to the Directorate of Inland Revenue) the power to
adjust any non-market-related prices charged or paid by Namibian entities in cross-
border transactions with related parties to arms-length prices and to tax the Namibian
entity as if the transactions had been carried out at market-related prices.
While section 95A requires that international transactions between connected persons
must be fairly priced, the section is silent on the mechanisms that may be used for the
determining arms-length prices. Further, the section also does not provide a defnition
for connected persons, nor does it prescribe any acceptable thin capitalisation ratios.
The former two matters were satisfactorily addressed in PN 2/2006, but no guidance in
respect of an acceptable thin capitalisation ratio has been provided by the Directorate
of Inland Revenue to date.
In terms of the normal penal provisions of the Income Tax Act, the Directorate of
Inland Revenue may levy penalties of up to 200% on any amount of tax underpaid.
Consequently, the Inland Revenue may invoke such provisions in the event where a
taxpayers taxable income is understated as a result of the fact that prices charged in
affected transactions were not carried out at arms length. Further, interest will be
charged on the unpaid amounts at 20% per annum.
Namibia does not currently have controlled foreign company legislation.
1139. Other regulations: Practice Note 2 of 2006
The objective of PN 2/2006, issued in September 2006, is to provide taxpayers
with guidelines about how to determine arms-length prices in the Namibian
business environment. It also sets out the Ministers views on documentation and
other practical issues that are relevant in setting and reviewing transfer pricing in
internationalagreements.
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Updated by Nerma Hartman and Stefan Hugo (PwC Namibia)
Africa Regional
The practice note includes defnitions for the following terms, which were not initially
defned in section 95A of the Income Tax Act:
Advance pricing arrangement;
Connected person;
Controlled transaction;
Uncontrolled transaction;
Multinational;
OECD Guidelines; and
Transfer prices.
The practice note is based on and acknowledges the principles of the OECD Guidelines.
Nothing in the practice note is intended to be contradictory to the OECD Guidelines,
and in cases where there is confict, the provisions of the OECD Guidelines prevail in
resolving any dispute. Amendments made to the OECD Guidelines are deemed to be
incorporated into the practice note.
A connected person is defned in PN2/2006. In relation to a company, the following
are regarded as connected persons:
Its holding company;
Its subsidiary;
Any other company where both such companies are subsidiaries of the same
holding company;
Any person who, individually or jointly with any connected person in relation to
such person, holds (directly or indirectly) at least 20% of the companys equity
share capital or voting rights;
Any other company if at least 20% of the equity share capital of such company is
held by such other company, and no shareholder holds the majority voting rights
of such company. This will be the case where companies B and C each hold 50% of
the equity share capital of company A; both companies, B and C, will be connected
persons in relation to company A; and
Any other company, if such other company is managed or controlled by:
a. Any person (A) who or which is a connected person in relation to such
company; or
b. Any person who or which is a connected person in relation to A.
Although it is accepted that Section 95A, by defnition, can apply only between
separate legal entities, the contents of the practice note also applies to transactions
between a persons head offce with the branch of such person or a persons branch
with another branch of such person. The OECD Guidelines interpretation of arms
length is followed in the application of the practice note.
In terms of the practice note, a taxpayer is required to be in possession of transfer
pricing documentation. If the Minister, as a result of this examination, substitutes
an alternative arms-length amount for the one adopted by the taxpayer, the lack
of adequate documentation will make it diffcult for the taxpayer to rebut that
substitution, either directly to the Minister or in the courts.
The practice note expressly states that a taxpayer must demonstrate that it has
developed a sound transfer pricing policy in terms of which transfer prices are
A
determined in accordance with the arms-length principle by documenting the
policies and procedures for determining those prices.
Currently, no statutory rule requires that the transfer pricing policy be submitted to the
Directorate of Inland Revenue as part of the annual income tax return. Taxpayers are,
consequently, required merely to prepare and maintain a transfer pricing policy and
present it as a motivation for the prices adopted under international transactions in the
event that the Inland Revenue conducts a transfer pricing audit. However, PN 2/2006
clearly states that in the event that the taxpayer cannot present a transfer pricing
policy, it will be very diffcult for the taxpayer to successfully object against any transfer
pricing adjustments made and corresponding assessments issued by the Directorate of
Inland Revenue.
1140. Legal cases
No court cases have judged this issue as yet.
The burden of proof is on the taxpayer. However, in accordance with PN 2/2006, the
taxpayer may be assured that the Directorate of Inland Revenue will not misuse the
burden of proof through groundless or unverifable assertions about transfer pricing.
1142. Tax audit procedures and resources available to the
tax authorities
The Ministry of Finance is aware that transfer pricing cases can present special
challenges to the normal audit or examination practices. Transfer pricing cases are
fact-sensitive and may involve diffcult evaluations of comparability, markets, and
fnancial or other industry information. The Ministry of Finance is still in the process
of setting up a special unit to specifcally deal with transfer pricing. The OECD and
the South African Revenue Services will provide technical assistance to the Ministry
ofFinance.
Use
transfer pricing methodology. Within the context of these guidelines, therefore, any
information gained on the performance of similar companies would be acceptable in
defending a transfer pricing policy.
Availability
Information on the performance of public companies in Namibia is readily available
information on public companies and information concerning private companies is
generally not available publicly. Consequently, a search for comparables in Namibia is
more often than not a futile exercise.
South African Revenue Services (SARS) uses the Amadeus database to conduct
comparable studies relying largely on European companies for comparability.
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It is envisaged that the Directorate of Inland Revenue in Namibia will also follow
thisapproach.
Apart from the primary sector, Namibias economy is largely import driven, and major
players in the Namibian private sector economy are subsidiaries of multinational
companies. These Namibian subsidiaries often have limited capacity in terms of
fnancial administration, product development and administration, and strategic
management and, consequently, import these services from head offces or shared
service centres situated elsewhere in the world. The remuneration for these imported
services is often refected as management fees in the fnancial statements of the
Namibian subsidiary.
It is envisaged that the Directorate of Inland Revenue in their transfer pricing
investigations (once the transfer pricing unit is operative) will initially focus on the
arms-length nature of these management fees. It is consequently imperative that
taxpayers prepare and maintain suffcient contemporaneous documentation in order to
be able to justify the arms-length nature of management fees.
1145. Advance pricing agreements (APA)
The Directorate of Inland Revenue has indicated in PN 2/2006 that due to various
factors, the APA process will not in the foreseeable future, be made available to
Namibian taxpayers.
Law
Because Namibia only recently introduced transfer pricing legislation, further laws
or amendments are not expected to be introduced in the near future. It is however
important to note that, in terms of PN/2/2006, Namibia fully adopts the principles
laid in the OECD Guidelines and that the OECD Guidelines take precedence over the
practice note. As a consequence, any changes to the OECD Guidelines are relevant to
and are adopted in Namibia as part of the practice note.
Practice
The Directorate of Inland Revenue will likely establish its own transfer pricing unit and
will commence with transfer pricing audits.
The Namibian Directorate of Inland Revenue will work closely with SARS and the
OECD. It is also envisaged that SARS will assist the Namibian Revenue authorities in
the performance of transfer pricing audits, especially in situations where the audited
multinational entity has affliates or establishments in both countries.
1148. OECD issues
Namibia is not a member of the OECD, but enjoys observer status and does follow the
OECD Guidelines and models.
A
It is possible for the Namibian Inland Revenue authorities to join with the authorities
of South Africa or any other country to jointly investigate a multinational group.
Section 95A deals with thin capitalisation and prescribes that the Minister may, if any
amount of fnancial assistance provided by a foreign connected person is excessive in
relation to a companys fxed capital, disallow the deduction for income-tax purposes of
any interest or other charges payable by the Namibian person on the excessive portion
of the fnancial assistance provided by the foreigner. No guidance is provided by section
95A or PN2/2006 as to what excessive would mean. Therefore, each case should be
considered on the basis of the facts provided.
Tanzania
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1151. Introduction
The Income Tax Act 2004 contains transfer pricing rules that apply to transactions
with resident and non-resident associates. The rules are still largely untested, and no
guidance has been issued by the Tanzania Revenue Authority (TRA) on how the rules
will be applied in practice.
Section 33 of the Income Tax Act 2004 requires that any arrangement between
associates must be conducted at arms length. And where a taxpayer has failed to
meet this standard, the Commissioner has wide powers to make adjustments or
recharacterise any amount. The Act does not specify a methodology for determining
what constitutes an arms-length price.
The legislation contains no explicit requirement for the taxpayer to prepare transfer
pricing documentation, although section 33 does require that the persons who are
involved in the relevant transaction should quantify, apportion and allocate amounts
to be included or deducted in calculating income between the persons as is necessary
to refect the total income or tax payable that would have arisen for them if the
arrangement has been conducted at arms length.. This could be taken to imply that
adequate documentation must be available to support the pricing of transactions
between associates.
Regulation 6 of the Income Tax Regulations 2004 provides that section 33 shall
be construed in such a manner as best secures consistency with the transfer pricing
guidelines in the practice notes issued by the Commissioner pursuant to section 130 of
the Act.
To date, the TRA has not issued a practice note to clarify what approach it will follow to
give effect to the transfer pricing provisions (although it has indicated that a practice
note will be issued in due course).
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Updated by Richard Marshall (PwC Tanzania)
Africa Regional
In the meantime, the TRA has stated that it will apply internationally agreed
arms-length principles as set out in the UN and OECD Transfer Pricing Guidelines.
Furthermore, the TRA has indicated that it will follow the ruling in the Kenyan tax case
on transfer pricing (Unilever Kenya Limited see Kenya section), which applied the
OECD transfer pricing principles.
In addition to section 33, the general deductibility section within the Act, section 11,
provides that expenditure must be incurred wholly and exclusively in the production
of income from the business. It would also be possible for the TRA to challenge the
deductibility of an expense under this section if, for example, it considered the amount
to be excessive or unsupported by suitable evidence.
In terms of Tanzanias controlled foreign company (CFC) legislation, a CFC may trigger
the Tanzanian transfer pricing rules if it is deemed to be an associate of the local entity,
according to the defnition of associate. However, a controlled foreign corporation is
not itself deemed to be a resident of Tanzania for tax or transfer pricing purposes.
The TRA has indicated that it will issue a practice note to provide guidance on the
application of the transfer pricing legislation, but no such guidance has yet been issued.
The tax return form does require a taxpayer to disclose transactions with related
parties, although this information tends to mirror the details already provided in a
companys fnancial statements.
1155. Legal cases
No legal cases have been argued based on the current legislation. A number of TRA
challenges are currently under objection, which may be tested through the courts.
Under the provisions of section 33 and the self-assessment regime, the burden of proof
is on the taxpayer to ensure that transactions are carried out on an arms-length basis.
No specifc procedures have been laid down by the TRA in relation to transfer pricing
investigations and, currently, queries on transfer pricing issues form part of the normal
TRA audit process.
The TRA has no dedicated transfer pricing unit, and queries are handled by the Large
Taxpayers Department or Domestic Revenue Department as part of the normal process
of reviewing a taxpayers income tax affairs.
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Use
The transfer pricing rules are the basis for determining an acceptable transfer pricing
methodology (although no specifc methodologies are prescribed). The TRA has
indicated that it will apply internationally agreed arms-length principles as set out in
the UN and OECD Transfer Pricing Guidelines.
Availability
Information on the performance of companies in Tanzania is readily available only
in the form of published or fled fnancial statements, with practical observance
being more consistently followed by public companies and fnancial institutions.
More detailed information is not generally available publicly. As a result, the use of
Tanzanian comparables is not possible.
The TRA has not indicated whether it will accept the use of fnancial databases used
elsewhere in the world; and given the lack of practice in this area, it is possible that this
issue has not yet been considered.
There is no indication at present that certain types of transactions or industries are at
higher risk of investigation than others. However, to date, the key area of focus by the
TRA has been intragroup management fees (basis of calculation of the fee and evidence
of services actually being provided), export sales of goods and interest-freefunding.
The lack of experience coupled with potentially diffcult administrations in wider
Africa means that competent authority claims and/or reliance on MAP to resolve
disputes will be problematic.
Regulation 33 of the Income Tax Regulations 2004 provides for the Commissioner
to enter into a binding agreement on the manner in which an arms-length price is
determined. However, in practice, the TRA is reluctant to issue binding rulings, and
this reluctance is likely to also apply to transfer pricing matters. We are not aware that
any advance pricing agreements (APAs) have been made to date.
Given that the transfer pricing legislation in Tanzania is still relatively new and
untested, it is likely that over time the TRAs policy on how the law will be applied and
what evidence is required will become clearer, and it is hoped that a practice note will
be issued to give guidance to taxpayers.
Although customs and income tax are under the same authoritative body, they are
administered by separate departments within the TRA and there is limited direct
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sharing of information between the two. However, it is likely that this practice of
limited information sharing will change in the future.
1165. OECD issues
The TRA has indicated that it will follow OECD and UN transfer pricing guidelines.
The TRA has not teamed up with any other tax authorities for the purpose of
undertaking a joint investigation into transfer pricing. On rare occasions, they have
taken advantage of the information-sharing provisions in double tax treaties.
Tanzania has enacted no specifc legislation relating to thin capitalisation.
However, section 12 of the Act provides for a deferral of interest deductions in certain
cases, including where a resident entity is held at least 25% by a non-resident. In such
circumstances, the total amount that may be deducted in respect of interest incurred
during the year is limited to the sum of:
Interest income derived during the year and included in taxable income; and
70% of the entitys total taxable income for the year, excluding interest income
andexpense.
Any interest for which a deduction is denied is carried forward and treated as incurred
during the next year of income, subject to the same rules again.
Zambia
6

1168. Introduction
Transfer pricing legislation was frst introduced in Zambia in 1999 and was
subsequently amended in 2001 and 2002, respectively. The scope of the transfer
pricing provisions for Zambia is contained in sections 97A to 97D of the Zambia
Income Tax Act 1966 (Zambia Income Tax Act) read together with the Transfer Pricing
Regulations, 2000 (the Regulations) as well as the fnal draft practice note (Zambia
draft practice note) issued by the Zambia Revenue Authorities (ZRA). The enforcement
of the legislation by the ZRA has, however, not been as aggressive as expected.
Conversely, it would be diffcult to mount a defence of nonexistence of transfer pricing
legislation when the ZRA begins to actively police the legislation.
Section 97A of the Zambia Income Tax Act introduces the arms-length principle.
The Income Tax (Transfer Pricing) Regulations 2000 also provide further defnitions
regarding the extent of application of the transfer pricing provisions contained in the
Income Tax Act. In March 2005, a draft practice note was issued by the ZRA, which
6
Updated by Jyoti Mistry and George Chitwa (PwC Zambia)
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provides detail on how the ZRA would apply the transfer pricing rules. As Zambia does
not tax on a worldwide basis, the legislation aims to counter tax losses brought about
by non-arms-length pricing. Furthermore, the transfer pricing legislation applies only
in situations where the effect of the associated-party pricing is to understate Zambian
proft or overstate Zambian losses.
Zambias transfer pricing policy does not only apply to cross-border transactions but
also to transactions between Zambian taxpayer residents who are wholly and solely
within the Zambian tax jurisdiction, i.e. domestic transactions). This is to ensure losses
are not effectively shifted between taxpayers or between sources by applying non-
arms-length pricing. In addition, the transfer pricing legislation applies to companies
as well as partnerships and individuals.
Section 97A (2) of the Zambia Income Tax Act states that the provisions relating to
transfer pricing apply:
where actual conditions having being imposed instead of the arms-length
conditions there is, except for this section, a reduction in the amount of income
taken into account in computing the income of one of the associated persons
referred to in subsection (1), in this section referred to as the frst taxpayer,
chargeable to tax for a charge year, in this section referred to as the income year.
The phrase actual conditions is defned in section 97A(1) of the Zambia Income
Tax Act as conditions made or imposed between any two associated persons in their
commercial or fnancial relations.
Associated persons is defned as in section 97 (C) of the Zambia Income Tax Act. The
section states that one person associates with another if one of the following applies:
One participates directly or indirectly in the management, control or capital of the
other; and
The same persons participate directly or indirectly in the management, control or
capital of both of them.
Amendments to the transfer pricing provisions of the Income Tax Act
The 2008 amendments to the transfer pricing provisions of the Income Tax Act
introduced specifc provisions applicable to the mining sector.
The new subsections 97A (13) to (17) deal with transactions for the sale of base metals
and precious metals or substance containing base metals or precious metals between
associated parties. The subsections state that the price applicable should be the
reference price that is aligned with prices on the London Metal Exchange or any other
metal exchanges approved by the Commissioner-General or to the Metal Bulletin.
New provisions under the Mines and Minerals Development Act
The provisions of section 97A have also been cross-referenced with the new Mines
and Minerals Development Act in determining arms-length gross value and the norm
value of minerals for the purposes of determining the mineral royalty payable to the
government by mining companies.
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Amendments to the Property Transfer Act
The Property Transfer Tax Act has also been amended and makes a direct reference to
section 97A for the purposes of determining the realised value for shares transferred.
Final draft practice note
The Zambia draft practice note states that in relation to a body corporate, one
participates directly in the management, control or capital of the body corporate if
they have control over the body corporate. Control means the power of a person
to secure that the affairs of the body corporate are conducted in accordance with
the wishes of that person. Such power would be derived from shareholding or other
powers conferred by the constitutional documents of the body corporate.
The Zambia draft practice note states that a person indirectly participates in a second-
person corporate if the frst person would be a direct participant (hereinafter referred
to as the potential participant) due to:
Rights and powers that the potential participant, at a future date, is entitled to
acquire or will become entitled to acquire;
Rights and powers that are, or may be required, to be exercised on behalf of, under
the direction of, or for the beneft of the potential participant;
Where a loan has been made by one person to another, not confned to rights and
powers conferred in relation to the property of the borrower by the terms of any
security relating to the loan;
Rights and powers of any person with whom the potential participant is
connected;and
Rights and powers that would be attributed to another person with whom
the potential participant is connected if that person were himself the
potentialparticipant.
The draft practice note further includes in its defnition of indirect participation joint
ventures that are able to use non-arms-length prices to shift profts overseas for their
mutual beneft. The rules apply only to transactions between at least one of the joint-
venture parties (referred to as the major participant) and the joint venture itself and
not between two joint ventures themselves unless they are under common control.
The Zambia draft practice note states that although section 97A97D of the Zambian
Income Tax Act are inapplicable to transactions between branches and their head
offces, the provisions are applicable to transactions between a Zambian branch of an
overseas head offce and associated companies of the overseas head offce (wherever
resident) or overseas branches of a Zambian head offce and a person associated to
the Zambian head offce wherever located. Section 97 C (3) of the Zambian Income
Tax Act states that conditions are taken to be imposed by an arrangement or series
of arrangements, or agreement or series of agreements. The defnition is wide
andincludes:
Transactions; understandings and mutual practices; and
An arrangement or agreement whether it is intended to be legally enforceable.
Further, the arrangement or agreement or series of arrangements or agreements may
not have to take place between two related parties (e.g. thinly capitalised taxpayers
paying interest to third parties under fnance arrangements guaranteed by associates).
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Section 97AA of the Zambia Income Tax Act is more specifcally aimed at thin
capitalisation and is discussed in more detail below.
Financial arrangements extend to interest, discount and other payments for the use of
money, whether these are receivable or payable by the person under review.
Zambia does not currently have controlled foreign company legislation.
Penalties and interest
If the ZRA makes a legitimate and reasonable request in relation to a tax return that
has been submitted, or should have been submitted, a taxpayer may be exposed to
the risk of penalties if the primary records, tax adjustment records, or records of
transactions with associated entities are not made available. In addition, the taxpayer
may be exposed to further risk if no evidence is made available within a reasonable
time to demonstrate appropriate arms-length results of transactions to which transfer
pricing rules apply or if the evidence made available by the taxpayer is not a reasonable
attempt to demonstrate an arms-length result.
When considering whether a reasonable attempt has been made to demonstrate an
arms-length result, the ZRA observes the same principles of risk assessment that
it observes when considering whether to initiate a transfer pricing enquiry (i.e. the
ZRA would expect a taxpayer acting reasonably to go to greater lengths in relation to
making records and evidence available where risks are higher than it would where the
risks are lower).
In terms of the general penal provisions, section 98 of the Zambia Income Tax Act, the
Commissioner-General of the Zambia Revenue Authority may levy a fne not exceeding
10,000 penalty units or subject the taxpayer to imprisonment for a term not exceeding
12 months, or may levy and subject the taxpayer to both the fne and imprisonment.
Further, under section 100 of the Zambia Income Tax Act, a penalty for an incorrect
return may be levied on the amount of income understated or expenses overstated. The
penalty charged on the amount of income understated or expenses overstated may be
levied at 17.5% in the event of negligence, 35% in the event of wilful default and 52.5%
in the event of fraud. In addition, the late payment of tax is penalised 5% per month
or part thereof from payment due date, plus interest is levied on the outstanding tax
payable amount at the Bank of Zambia discount rate plus 2% (currently approximately
15% per annum).
Documentation
The Zambia draft practice note states that the following records should be kept to avoid
exposure to penalties:
Primary accounting records;
Tax adjustment records; and
Records of transactions with associated businesses.
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1172. Legal cases
PwC is not aware of any court cases on this issue as yet.
In accordance with section 97C of the Zambia Income Tax Act, the burden of proof lies
with the taxpayer to demonstrate that the transfer pricing policy complies with the
relevant rules and that the transactions have been conducted in accordance with the
arms-length standard.
Furthermore, as per the Zambia draft practice note, the ZRA considers that as a step
towards discharging the burden of proof, it is in the taxpayers best interests to:
Develop and apply an appropriate transfer pricing policy;
Determine the arms-length conditions as required by section 97A of the Zambia
Income Tax Act;
Maintain contemporaneous documentation to support the policy and the arms-
length conditions in points (a) and (b) above; and
Voluntarily produce the documentation when asked.
As per the Zambia draft practice note, the ZRA has adopted the arms-length principle
and refers to the OECD Transfer Pricing Guidelines for Multinational Enterprises and
Tax Administrations in conducting a transfer pricing investigation.
The ZRA follows OECD Guidelines, and all multinational enterprises are potential
targets. The ZRA follows no specifc procedure when conducting a tax audit; generally,
the company is notifed and requested to provide supporting documentation. The ZRA
prefers that the company under enquiry also provide the comparables. The ZRA then
looks at the information provided and the comparables and negotiates accordingly.
The Domestic Taxes Department within the ZRA is responsible for conducting
corporate tax enquiries. There has been no move yet towards the establishment of a
specialist unit for conducting transfer pricing audits. However, investment has been
made in developing specialist expertise within the ZRA through training locally and
abroad (i.e. the UK, Australia and South Africa).
Use
transfer pricing methodology. Therefore (within the context of the OECD Guidelines),
any information gained on the performance of similar companies would be acceptable
in defending a transfer pricing policy.
Note, however, that the ZRA does prefer comparable information to be in respect of
Zambian companies with the view that inter alia the companies will be operating
under the same economic circumstances.
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Availability
Information on the performance of public companies in Zambia is readily available,
information on public companies and information concerning private companies is
generally not available publicly. Consequently, a search for comparables in Zambia is
more often than not a futile exercise.
As per the Zambia draft practice note, the ZRA accepts the use of foreign comparables,
such as data from the UK, the US and Australian markets. However, taxpayers using
this approach are required to adjust for the expected effect on the price due to
geographic and other differences in the Zambian market.
The South African Revenue Services (SARS) uses the database Amadeus to conduct
comparable studies, relying largely on European companies for comparability. It is
envisaged that the Commissioner-General of the Zambia Revenue Authority will also
follow this approach.
The ZRA does not have access to the Amadeus database nor does it have access to
any similar database. The ZRA prefers for the company under enquiry to provide
comparables and, if possible, those comparables should be with other similar
companies in Zambia. It is not clear at this time whether, in the absence of suitably
local comparables, the ZRA will accept foreign comparables.
There is no indication at present that certain types of transactions or that
multinationals operating in particular industries are at higher risk of investigation than
others. All multinationals are considered to be at a high risk of investigation.
Note that the particular transactions that the ZRA may examine are management and
technical assistance fees, royalties and purchases of trading goods.
The lack of experience coupled with potentially diffcult administrations in wider
Africa means that competent authority claims or reliance on MAP to resolve disputes
will be problematic.
As per the Zambia draft practice note, the ZRA does not currently intend to adopt an
APA procedure, but will keep this decision under review as taxpayers and the ZRA gain
transfer pricing experience.
It is not foreseen that signifcant further laws or amendments will be introduced to
transfer pricing legislation in the near future. It is however important to note that in
terms of the Zambia draft practice note, Zambia fully adopts the principles laid in the
OECD Guidelines. Consequently, any changes to the OECD Guidelines will be relevant
to, and be adopted in, Zambia, as part of the Zambia draft practice note.
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As the ZRA applies the OECD Guidelines on transfer pricing as the basis for
determining acceptable transfer pricing methodology, it is envisaged that the ZRA will
work closely with the OECD.
In addition, when conducting an investigation, the ZRA may liaise with the foreign
revenue authority of the foreign company involved in the related party transaction.
The ZRA may further seek advice and guidance from the revenue authorities in the UK
andAustralia.
1182. OECD issues
Zambia is not a member of the OECD, but enjoys observer status and does follow the
OECD Guidelines and models.
It is possible for the ZRA to join with the authorities of South African or any other
country to jointly investigate a multinational group.
Thin capitalisation is dealt with primarily by section 97A and 97AA of the Zambia
Income Tax Act. Guidance on thin capitalisation and the charging of excessive interest
is provided in the Zambia draft practice note.
Thin capitalisation commonly arises where a company is funded by another company
in the same group or by a third party, such as a bank, but with guarantees or other
forms of comfort provided to the lender by another group company or companies
(typically the foreign parent company).
The ZRA seeks to establish the terms and conditions that a third-party lender would
have required if it had been asked to lend funds to the borrower. This involves the
consideration of, for example: the type of business; the purpose of the loan; the debt-
to-equity ratio of the borrower; the income cover, profts cover or cash-fow cover; and
any additional security available. This list is not exhaustive; the governing factor is
what would have been considered arms length.
If the borrowing under consideration would not have been made at arms length on
the terms that were actually applied, the ZRA may seek to adjust those terms to those
that would have been applied at arms length. This may involve the adjustment of the
rate of interest payable, the amount of the loan and any other terms of the loan that
would not be found in an arms-length borrowing. Furthermore, the ZRA may limit
the interest deduction on interest actually incurred to that which a Zambian borrower
would have incurred at arms length.
Section 97AA of the Zambia Income Tax Act makes provision for determining the
arms-length conditions when the actual conditions include the issue of a security.
Argentina
12.
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Argentina
1201. Introduction
Argentine transfer pricing regulations have existed, in some form, since 1932. Prior to
1998, the rules focused on the export and import of goods through application of the
wholesale price method, comparing the price of imports and exports to the wholesale
price of comparable products in the markets of origin or destination. This methodology
was applied unless the parties to the transaction could demonstrate that they were not
related parties (article eight of the Income Tax Law).
Article 14 of the Income Tax law refected the need for all transactions to comply with
the arms-length standard:
Transactions between a local enterprise of foreign capital and the individual
or legal entity domiciled abroad that either directly or indirectly control such
enterprise shall, for all purposes, be deemed to have been entered into by
independent parties, provided that the terms and conditions of such transactions
are consistent with normal market practices between independent entities, with
limits to loans and technical assistance.
However, the rules did not include any methodologies for supporting inter-company
transactions or outline any documentation requirements.
On 30 December 1998, pursuant to Law 25,063, Argentina adopted general guidelines
and standards set forth by the OECD, including the arms-length standard, and applied
it to tax years ending on or after 31 December 1998. With the adoption of the OECD
standards, the computation of a taxpayers income-tax liability, including provisions
governing the selection of appropriate transfer pricing methodologies for transactions
between related parties, could be impacted.
On 31 December 1999, Law 25,063 was updated with Law 25,239, which introduced
the special tax return and documentation requirements in relation to inter-company
transactions. Under the transfer pricing reform process, the old wholesale price
method was only applicable to transactions involving imports or exports of goods
between unrelated parties.
On 22 October 2003, Law 25,784 introduced certain amendments to the Income Tax
Law that affected transfer pricing regulations. One of the amendments related to one
of the points of an anti-evasion programme, with one of its objectives being to control
evasion and avoidance in international operations resulting from globalisation. On
the one hand, Law 25,784 replaces regulations on the import and export of goods
International Transfer Pricing 2011 Argentina 201
Argentina
with related and unrelated parties (replacement of article eight of the Income Tax
Law), eliminating the concept of wholesale price at the point of destination or origin
as a parameter for comparison. Now, in the case of imports or exports of goods with
International Prices known through commonly traded markets, stock exchanges
or similar markets, the new parameter establishes that those prices will be used to
determine net income. On the other hand, a new transfer pricing method is introduced
for the analysis of exports of commodities (amendments to Article 15 of the Income
Tax Law).
Taxpayers currently have two important transfer pricing-related obligations: to
prepare, maintain and fle transfer pricing documentation; and to fle an information
return (special tax return) on transactions with non-resident-related parties. In
addition, taxpayers are required to maintain some documentation on import or export
of goods between unrelated parties.
On 14 November 2003, Law 25,795 was published in the Offcial Gazette (modifying
Procedural Law 11,683), establishing signifcant penalties for failure to comply with
transfer pricing requirements.
It is important to note that tax authorities are currently conducting a very
aggressive audit programme, including a number of transfer pricing audits that are
alreadyunderway.
Effective 31 December 1998, Argentine taxpayers must be able to demonstrate that
their transactions with related parties outside of Argentina are conducted at arms
length. Transfer pricing rules are applicable to all types of transactions (covering,
among others, transfers of tangible and intangible property, services, fnancial
transactions and licensing of intangible property). Under Argentine legislation,
there is no materiality factor applicable and all transactions must be supported and
documented.
Transfer pricing rules apply to:
Taxpayers who carry out transactions with related parties organised, domiciled,
located or placed abroad and who are encompassed by the provisions of Article 69
of the Income Tax Law, 1997 revised text, as amended (mainly local corporations
and local branches, other types of companies, associations or partnership) or
the addendum to clause d) of Article 49 of the Income Tax Law (trusts or similar
entities);
Taxpayers who carry out transactions with individuals or legal entities domiciled,
organised or located in countries with low or no taxation, whether related or not;
Taxpayers resident in Argentina, who carry out transactions with permanent
establishments abroad that they own; and
Taxpayers resident in Argentina who are owners of permanent establishments
located abroad, for transactions carried out by the latter with related parties
domiciled, organised or located abroad, under the provisions of Articles 129 and
130 of the Income Tax Law.
Argentina 202 www.pwc.com/internationaltp
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Related parties
The defnition of related party under Argentine transfer pricing rules is rather broad.
The following forms of economic relationship are covered:
One party that owns all or a majority of the capital of another;
Two or more parties that share: (a) one common party that possesses all or a
majority of the capital of each, (b) one common party that possesses all or a
majority of the capital of one or more parties, and possesses signifcant infuence
over the other or others, and (c) one common party that possesses signifcant
infuence over the other parties;
One party that possesses the votes necessary to control another;
One or more parties that maintain common directors, offcers, or managers/
administrators;
One party that enjoys exclusivity as agent, distributor or licensee with respect to
the purchase and sale of goods, services and intangible rights of another;
One party that provides the technological/intangible property or technical know-
how that constitutes the primary basis of another partys business;
One party that participates with another in associations without a separate legal
existence pursuant to which such party maintains signifcant infuence over the
determination of prices;
One party that agrees to preferential contractual terms with another that differ
from those that would have been agreed to between third parties in similar
circumstances, including (but not limited to) volume discounts, fnancing terms
and consignment delivery;
One party that participates signifcantly in the establishment of the policies of
another relating to general business activities, raw materials acquisition and
production/marketing of products;
One party that develops an activity of importance solely in relationship to another
party, or the existence of which is justifed solely in relationship to such other party
(e.g. sole supplier or customer);
One party that provides a substantial portion of the fnancing necessary for the
development of the commercial activities of another, including the granting of
guarantees of whatever type in the case of third-party fnancing;
One party that assumes responsibility for the losses or expenses of another;
The directors, offcers, or managers/administrators of one party who receive
instructions from or act in the interest of another party; and
The management of a company is granted to a subject (via contract, circumstances,
or situations) who maintains a minority interest in the capital of such company.
Methodology
For the export and import of goods between unrelated parties, the international
price is applicable. In the event the international price cannot be determined or is
not available, the taxpayer (the exporter or importer of the goods) must provide the
tax authorities with any information available to them to confrm if such transactions
between unrelated entities have been carried out applying reasonable market prices
(article eight of the Income Tax Law).
For related party transactions, both transactional and proft-based methods are
acceptable in Argentina. Article 15 of the Income Tax Law specifes fve transfer
pricing methods. An additional method has been established dealing with
specifctransactions.
Argentina
1. Comparable uncontrolled price method (CUP);
2. Resale price method (RPM);
3. Cost plus method (CP);
4. Proft split method (PSM);
5. Transactional net margin method (TNMM); and
6. Specifc method for export transactions involving grain, oilseed and other crops,
petroleum and their derivatives and, in general, goods with a known price in
transparent markets.
This last method will only be applied when: (1) the export is made to a related party;
(2) the goods are publicly quoted on transparent markets; and (3) there is participation
by an international intermediary that is not the actual receiver of the goods being sold.
It should be noted that this method will not be applicable when the international
intermediary complies with all the following conditions:
Actual existence in the place of domicile (possessing a commercial establishment
where its business is administered, complying with legal requirements for
incorporation and registration, as well as for the fling of fnancial statements);
Its main activity should not consist of the obtaining of passive incomes or acting as
an intermediary in the sale of goods to and from Argentina or other members of its
economic group; and
Its foreign trade transactions with other members of the group must not exceed
30% of the annual total of its international trading transactions.
The method consists of the application of the market price for the goods being exported
on the date the goods are loaded. This applies regardless of the type of transport used
for the transaction and the price that may have been agreed with the intermediary,
unless the price agreed with the latter were to be higher than that determined to be the
known price for the good on the date of loading. In such a case, the higher of the two
prices should be used to determine the proft of Argentine source.
Under the above-mentioned circumstances, the Argentine tax authorities disregard
the date of transaction for these types of operations and consider the date of loading,
assuming the date of the transactions could be manipulated by the related parties. In
addition, they apply the same methodology even when the foreign intermediary was
an unrelated party.
Best method rule
There is no specifc priority of methods. Instead, each transaction or group of
transactions must be analysed separately to ascertain the most appropriate of the
fve methods to be applied (i.e. the best method must be selected in each case). The
transfer pricing regulations provide that in determining the best method to apply in a
given circumstance, consideration will be given to:
The method that is most compatible with the business and commercial structure of
the taxpayer;
The method that relies upon the best quality/quantity of information available;
The method that relies upon the highest level of comparability between related-
and unrelated-party transactions; and
The method that requires the least level of adjustments in order to eliminate
differences existing between the transaction at issue and comparable transactions.
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Tested party
The regulations established by the tax authority have stated that the analysis of the
comparability and justifcation of prices when applying the methods of Article 15
must be made based on the situation of the local taxpayer.
Documentation requirements
The Argentine income-tax law requires that the Administracin Federal de Ingresos
Pblicos (AFIP) promulgate regulations requiring the documentation of the arms-
length nature of transactions entered into with related parties outside of Argentina. In
this regard, the transfer pricing regulations require that taxpayers prepare and fle a
special tax return detailing their transactions with related parties. These returns must
be fled along with the taxpayers corporate income-tax return.
In addition to fling the special tax return, the Argentine transfer pricing regulations
require that taxpayers maintain certain contemporaneous supporting documentation
(i.e. such documentation must exist as of the fling date of the special tax return).
This requirement was applicable to fscal years 1999 up to fscal year ended on 30
November2000.
However, on 31 October 2001, the AFIP issued new regulations regarding information
and documentation requirements. This required certain contemporaneous
documentation be fled and submitted together with the special tax return. This applies
to periods ending on or after 31 December 2000.
Information returns
Import and export transactions between unrelated parties:
Requirements have been established for information and documentation regarding
import and export of goods between unrelated parties (article eight of the
Income Tax Law) covering international prices known through commonly traded
markets, stock exchanges or similar markets, which will be used to determine the
net income. A semi-annual tax return must be fled in each half of the fscal year
(Form741).
In the case of import and export transactions of goods between unrelated parties
for which there is no known internationally quoted price, the tax authorities
shall be able to request the information held in relation to cost allocation, proft
margins and other similar data to enable them to control such transactions, if
they, altogether and for the fscal year under analysis, exceed the amount of ARS1
million. A yearly tax return must be fled for those import and export of goods
between unrelated parties for which there is no known internationally quoted price
(Form 867).
In cases of transactions with parties located in countries with low or no taxation,
the methods established in Article 15 of the law must be used and it will be
necessary to comply with the documentation requirements described for the
transactions covered by transfer pricing rules. The obligation to document and
preserve the vouchers and elements that justify the prices agreed with independent
parties is laid down, and minimum documentation requirements are established.
Argentina
Compliance requirements for related party transactions:
Six-month tax return, for the frst half of each fscal period (Form 742); and
Complementary annual tax return covering the entire fscal year (Form 743). The
return and any appendices must be signed by the taxpayer and by an independent
public accountant whose signature must be authenticated by the corresponding
professional body. This tax return must be accompanied by both:
1. A report containing the information detailed below; and
2. A copy of the fnancial statements of the taxpayer for the fscal year
beingreported.
Additionally, fnancial statements for the previous two years must be attached to the
frst tax return presentation.
Contents of the report:
Activities and functions performed by the taxpayer;
Risks borne and assets used by the taxpayer in carrying out such activities
andfunctions;
Detail of elements, documentation, circumstances and events taken into account
for the analysis or transfer price study;
Detail and quantifcation of transactions performed covered by this general
resolution;
Identifcation of the foreign parties with which the transactions being declared are
carried out;
Method used to justify transfer prices, indicating the reasons and grounds for
considering them to be the best method for the transaction involved;
Identifcation of each of the comparables selected for the justifcation of the
transfer prices;
Identifcation of the sources of information used to obtain such comparables;
Detail of the comparables selected that were discarded, with an indication of the
reasons considered;
Detail, quantifcation and methodology used for any necessary adjustments to the
selected comparables;
Determination of the median and the interquartile range;
Transcription of the income statement of the comparable parties corresponding to
the fscal years necessary for the comparability analysis, with an indication as to the
source of the information;
Description of the business activity and features of the business of comparable
companies; and
Conclusions reached.
General due dates:
General due dates:
Form Period Due date
741 First six months of scal year Fifth month following the end of the half-year
741 Second six months of scal year General due date for ling income tax return
867 Full scal year Seventh month following the end of the scal year
742 First six months of scal year Fifth month following the end of the half-year
743 Full scal year eighth month following the end of the scal year
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1204. Legal cases
Since the tax reform introduced in 1998, several cases have been and are currently
being discussed before the courts. It is expected that the tax courts will address several
issues related to transfer pricing in the coming years. Following are summaries of some
of the transfer pricing court cases.
S.A. SIA
The Supreme Court applied article eight for the frst time in the S.A. SIA, decided on
6 September1967. The taxpayer, a corporation resident in Argentina, had exported
horses to Peru, Venezuela and the US. It was stated in the corporations tax return that
these transactions had generated losses because the selling price had been lower than
the costs. The tax authority decided to monitor such transactions under the export
and import clause; that is according to the wholesale price at the place of destination.
The tax authority concluded that, contrary to what had been argued by the taxpayer,
such transactions should generate profts. It based this statement on foreign magazines
on the horse business (that explicitly referred to the horses of the taxpayer and the
transactions involved in this case).
The Supreme Court maintained that since the evidence on which the tax authority
based its argument was not disproved by the taxpayer, it had to be deemed that they
correctly refected the wholesale price of the horses. As a result, the adjustment was
considered valid.
Eduardo Loussinian S.A.
Loussinian S.A. was a company, resident in Argentina, which was engaged in
importing and distributing rubber and latex. It concluded a supply contract with a
non-resident subsidiary of a foreign multinational. Under this contract, the parent
of the multinational group, ACLI International Incorporated (ACLI), would provide
Loussinian such goods from early January 1974 up to the end of 1975.
After the contract was agreed, the international market price of rubber and latex fell
substantially. However, Loussinian kept importing the goods from ACLI despite the
losses. The tax authority argued that there was overcharging under the contract and
that article eight should be applied in this case. As a result, it considered that the
difference between the wholesale price of the goods at the place of origin and the
price agreed on the contract was income sourced in Argentina that Loussinian should
have withheld when it made the payments to ACLI. Both the tax court and the court of
appeals upheld the tax authority decision.
The Supreme Court said that despite the fact that the purchasing price was higher than
the wholesale price, the latter could not be applied to this case to determine the income
sourced in Argentina. This was because it considered that Loussinian had rebutted the
presumption under which both parties had to be deemed associated due to this gap
between prices.
Laboratorios Bag S.A.
On 16 November 2006, the members of Panel B of the National Fiscal Court (NFC)
issued a ruling in the case Laboratorios Bag S.A. on appeal Income Tax. The matter
under appeal was the taxpayers position to an offcial assessment of the income tax for
the fscal years 1997 and 1998.
Argentina
Even though the current transfer pricing legislation was not in force during those
periods (wholesale price method was applicable in 1997 and 1998), the case was
closely related to that legislation. Specifcally, the ruling addressed issues such as (1)
comparability of selected companies, (2) the use of secret comparables (non-public
information) for the assessment of the taxpayers obligation, and (3) the supporting
evidence prepared by the tax authorities.
Laboratorios Bag S.A., a pharmaceutical company based in Argentina, exported
fnished and semi-fnished manufactured products to foreign subsidiaries. The tax
audit was focused on the differences in prices between the different markets involved,
both international and domestic.
In this case, the taxpayer argued that, with regard to its export transactions, it
only performed contract manufacturer activities, focusing its efforts only on
manufacturing. Foreign affliates performed research and development, advertising,
sales and marketing activities, among others.
The tax authorities frst confrmed the lack of publicly known wholesale prices in
the country of destination. Afterwards, they conducted a survey of other similar
companies located in Argentina, requesting segmented fnancial information on export
transactions. The main purpose of that request was to obtain the proftability achieved
by independent companies in the same industry.
Since the taxpayers results were below the proftability average of independent
companies, the tax authority adjusted the taxable basis for income-tax purposes.
The ruling focused on four specifc issues:
Validity of the information obtained by the tax authority;
Use of the so-called secret comparables;
Nature of the adjustment performed by the tax authority; and
Evidence presented by the parties.
Matters such as comparability adjustments, the application of statistical measures like
the interquartile range and, especially, the defnition of functions, assets and risks,
were mentioned in the ruling but were not material to the decision.
The analysis conducted by the tax authority contained conceptual mistakes that
affected the comparability of the transactions (e.g. differences in volume of net sales
as well as of export sales, verifcation of economic relationship or otherwise between
the selected companies and their importers, unifcation of criterion for the different
selected companies allocation of fnancial information, among others).
It is also remarkable that in this case, the tax court accepted the use of secret
comparables, being understood as information obtained by the tax authority through
audits or other information-gathering procedures.
The taxpayer presented several scenarios and other related evidence that supported its
current position.
Eventually, it was the evidence presented by the parties that allowed for the ruling in
this case to be favourable to the taxpayer. Specifcally, the tax court held in this case
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that under domestic law, the tax authority has a signifcant burden of proof when
adjusting transfer prices. Since the tax authority did not offer enough evidence to
support its position, the tax court ruled in favour to the taxpayer.
DaimlerChrysler Argentina
The case dealt with export transactions for the fscal period 1998 (i.e. under the old
transfer pricing methodology). The members of the Argentine tax court unanimously
decided that section 11 of the regulatory decree establishes a different presumption
where once the business relationship has been proved, the tax authorities may apply
the wholesale price of the country of seller. However, the tax court clearly stated that it
is not entitled to issue an opinion on the constitutionality of laws unless the Argentine
Supreme Court of Justice had already issued an opinion. Additionally, from the
decision of the tax court, we understand that there are elements to consider that the
comparability standard is not the most appropriate standard for this case.
Based on that interpretation, the crucial element to be determined is if the business
relationship criteria applies to transactions between Mercedes Benz do Brasil,
Mercedes Benz Argentina and Daimler Benz AG. Quoting traditional case law, and
considering the economic reality principle, the tax court ruled that wholesale prices
effective in Argentina should be applied.
In terms of the price used in the assessment by the tax authorities, the discounts and
rebates granted to local car dealers were important elements. The court adopted a
formal approach in this case, since it stated that the regulatory decree sets forth that
the tax authorities can apply the wholesale price without taking into consideration
the impact of the domestic market expenses. Thus, the tax court has not considered
that prices in the domestic and foreign market can only be compared if an adjustment
is made on the differences in the contractual terms, the business circumstances,
functions, and assets and risks in either case. In this situation, the tax court has applied
a price to a substantially different operation (and therefore, non-comparable).
Volkswagen Argentina SA
The case was conceptually similar to DaimlerChrysler Argentina, with the exception
that an independent third party acquired products of the local company (VWA), then
sold them, once imported, to Volkswagen do Brasil (VWB).
The courts analysis is based on the export contract executed between VWA and the
third party. The court considered that certain clauses evidence the control that VWA
and VWB exerted on the third party (i.e. purchase commitments, audit of the costs
and expenses of the intermediary, assistance in the import process, among others). As
such, the tax court concluded that the operations should be considered as having been
conducted between related parties, even when the relationship was not economic,
based on the principle of economic reality, according to which substance prevails
overform.
The tax court believes that the administrative court ignored section 8 and applied
section 11 of the regulatory decree without giving any reason for not applying the
wholesale prices in the country of destination (Brazil) and applying that of the country
of seller (Argentina). The procedure followed by the tax authorities would have been
appropriate if it had proven why prices informed by the Brazilian tax authorities were
not valid or if it had applied the provisions of section 8 (i.e. the determination of the
Argentina
factors of results obtained by third parties conducting activities similar or identical to
those of the taxpayer).
The general rule is that the taxpayer has the burden of proof, as it is obligated to fle
a report with certain information related to transfer pricing regulations together
with the income-tax return. If the taxpayer has submitted proper documentation, the
AFIP must demonstrate why the taxpayers transfer prices are not arms length and
propose an amount of transfer pricing adjustment in order to challenge the transfer
prices of a taxpayer. Once the AFIP has proposed an alternative transfer pricing
method and adjustment, it is up to the taxpayer to defend the arms-length nature of its
transferprices.
Selection of companies for audit
The AFIP has a specialised group that performs transfer pricing examinations. This
group is part of the Divisin de Grandes Contribuyentes, a division of the AFIP that
deals with the largest taxpayers. At present, the Argentine tax authorities investigate
transfer pricing issues under four main categories:
In the course of a normal tax audit;
Companies that undertake transactions with companies located in tax havens;
Companies that registered any technical assistance agreement or trademark or
brand name licence agreement with the National Industrial Property Institute; and
Specifc industrial sectors such as the automotive, grain traders, oil and
pharmaceutical industries.
Controversial issues include, among others, the use of multiple-year averages for
comparables or, for the tested party, the application of extraordinary economic
adjustments according to the present situation of the country (e.g. extraordinary
excess capacity, extraordinary discounts and accounting recognition of extraordinary
bad debts).
1207. The audit procedure
The audit procedure must follow the general tax procedure governed by Law 11,683.
Transfer pricing may be reviewed or investigated using regular procedures such as on-
site examination or written requests. Written requests are the most likely form of audit.
During the examination, the tax authorities may request information and must
be allowed access to the accounting records of the company. All fndings must
be documented in writing and witnesses might be required. In the course of the
examination, the taxpayer is entitled to request information and the audit cannot
be completed without providing the taxpayer a written statement of fndings. Upon
receipt of this document, the taxpayer is entitled to furnish proofs and reasoning that
must be taken into account for the fnal determination.
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1208. Reassessments and the appeals procedure
Additional assessments or penalties applied by the Direccin General Impositiva (DGI)
may be appealed by the taxpayer within 15 working days of receipt of the notifcation
of assessment. The appeal may be made to either the DGI or the tax tribunal. An
unsuccessful appeal before one of these bodies cannot be followed by an appeal before
the other, but an appeal before the competent courts of justice may be fled against the
fndings of either.
If appeal is made before the DGI or the tax tribunal, neither the amount of tax nor the
penalty appealed against need be paid unless and until an adverse award is given. For
an appeal to be made before the courts of justice, the amount of tax must frst be paid
(although not the penalties under appeal).
Overpayments of tax through mistakes of fact or law in regular tax returns fled by the
taxpayer may be reclaimed through submission of a corrected return within fve years
of the year in which the original return was due. If repayment is contested by the DGI,
the taxpayer may seek redress through either the tax tribunal or the courts of justice,
but not both. Overpayments of tax arising from assessments determined by the DGI
may be reclaimed only by action before the tax tribunal or the courts of justice. Upon
claim for overpayments of tax, interest is accrued from the time when the claim is fled.
1209. Additional tax and penalties
Law 25,795 increases existing penalties and introduces new penalties covering non-
compliance by taxpayers in relation to international transactions, as follows:
Omitted fling of informative tax returns regarding international import and export
operations on an arms-length basis will be penalised with a fne amounting to
ARS1,500 (USD390) or ARS10,000 (USD2,590) in the case of entities owned
by foreign persons. Failure to fle returns for the remaining operations will be
penalised with a fne of ARS10,000 (USD2,590) or ARS20,000 (USD5,180) in the
case of entities belonging to foreign persons.
A fne ranging between ARS150 (USD40) and ARS45,000 (USD11,700) will be
set in the event of failure to fle data required by AFIP for control of international
operations and lack of supporting documentation for prices agreed in
internationaloperations.
A fne ranging between ARS500 (USD 130) and ARS45,000 (USD11,700) has
been established for non-compliance with the requirements of AFIP on fling of
informative returns corresponding to international operations and information
regimes for owner or third-party operations. Taxpayers earning gross annual
income equal to or higher than ARS10 million (USD2.6 million) not observing
the third requirements on control of international operations will be fned up to
ARS450,000 (USD117,000), 10 times the maximum fne.
A fne on tax omission has been established between one and four times the tax
not paid or withheld in connection with international operations. In addition,
the taxpayer will be liable for interest, currently 2% per month of the additional
taxdue.
If the tax authorities consider that a taxpayer has manipulated its results intentionally,
the fne can climb to 10 times the tax amount evaded, in addition to the penalties
Argentina
established by the Penal Tax Law 24,769. The tax authorities have the discretion to
analyse the transfer pricing arrangement(s) by consideration of any relevant facts and
application of any methodology they deem suitable.
Availability of comparables
Comparable information is required in order to determine arms-length prices and
should be included in the taxpayers transfer pricing documentation. Argentine
companies are required to make their annual accounts publicly available by fling
a copy with the local authority (e.g. Inspeccin General de Justicia in Buenos
Aires). However, the accounts would not necessarily provide much information on
potentially comparable transactions or operations since they do not contain much
detailed or segmented fnancial information. Therefore, reliance is often placed on
foreigncomparables.
The tax authorities have the power to use third parties confdential information.
Use of comparables
To date, there have been several cases where the tax authorities have attempted
to reject a taxpayers selection or use of comparables. Any discussion in this
context is focused on the comparability of independent companies, or its condition
as independent. In this connection, the tax authority has requested additional
information related to the fnal set of comparables.
1211. Limitation of double taxation and competent
authority procedure
Most of the tax treaties for the avoidance of double taxation concluded by Argentina
include provisions for a mutual-agreement procedure. In Argentina, a request to
initiate the mutual-agreement procedure should be fled with the Argentine Ministry of
Economy. There are no specifc provisions on the method or format for such a request.
No information is available on the number of requests made to the Ministry of
Economy. It is understood that the competent authority procedure is not well-used in
Argentina, as there is no certainty for the taxpayer that the relevant authorities will
reach an agreement.
1212. Advance pricing agreements (APAs)
There are no provisions enabling taxpayers to agree on APAs with the tax authorities.
Law
New transfer pricing rules are not expected in the near future.
Practice
The tax authorities are expected to become more aggressive and more skilled in the
area of transfer pricing. Transfer pricing knowledge of the average tax inspector is
expected to increase signifcantly, as training improves and inspectors gain experience
in transfer pricing audits.
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As the number of audits increases, some of the main areas being examined include
inter-company debt, technical services fees, commission payments, royalty payments,
transfers of intangible property and management fees.
1214. Liaison with customs authorities
The DGI and the customs authority (Direccin General de Aduanas, or DGA) are
both within the authority of the AFIP. Recent experience suggests that exchange of
information between DGI and DGA does occur. Nevertheless, there is no prescribed
approach for the use of certain information of one area in another area (e.g. transfer
pricing analysis for customs purposes).
Recently, there has been a change in the customs legislation and the information
that must be provided to the DGA, in relation with foreign trade, is now required
in an electronic form. As a result, DGI could have better and easier access to
thatinformation.
1215. OECD issues
Argentina is not a member of the OECD. The tax authorities have generally adopted the
arms-length principle and use as guidance the methodologies endorsed by the OECD
Guidelines for transfer pricing that give effect to the arms-length standard.
Even though there have been some requests for information from other tax authorities
(e.g. Brazil) for specifc transactions or companies, there is no regular procedure for
joint investigations.
The thin capitalisation rules are primarily focused on interest stemming from loans
granted by foreign-related parties (entities having any type of direct or indirect control
of the borrower). Interest will be deductible considering, at the year-end closing
date, the total amount of the liability generating the interest (excluding any liability
corresponding to interest whose deductibility is not conditioned) may not exceed two
times the amount of the net worth at that date.
In such a circumstance, any excess interest that cannot be deducted will be treated as
adividend.
Australia
13.
International Transfer Pricing 2011 213 Australia
1301. Introduction
Australias transfer pricing legislation was introduced with effect from 27 May 1981,
and remains a key focus area for the Australian Taxation Offce (ATO), indicative of the
ongoing globalisation of the Australian economy.
Since the introduction of the transfer pricing legislation, the ATO has issued a series of
rulings providing guidance in applying the legislation. The ATO is vigilant in policing
compliance by taxpayers and continues to work closely with tax authorities in other
jurisdictions and international bodies, such as OECD or the Pacifc Association of Tax
Administrators (PATA), focusing on reducing double taxation and solving transfer
pricing disputes. The views of the ATO are largely consistent with the views expressed
by the OECD.
Division 13 Transfer pricing legislation
Division 13 of Part III of the Income Tax Assessment Act 1936 (ITAA) (SS136AA to
136AF), contains Australias domestic law dealing with transfer pricing. It is an anti-
avoidance division aimed at countering international proft-shifting techniques.
Section 136AD deals with circumstances in which a taxpayer has supplied or
acquired property (all of these terms are widely defned in Section 136AA(1))
under an international agreement, as defned in Sec 136AC. Sec 136AD contains
foursubsections:
Supplies of property for less than arms-length consideration;
Supplies of property for no consideration;
Acquisition of property for excessive consideration; and
Determination of the arms-length consideration in circumstances in which it is
neither possible nor practicable to ascertain.
Section 136AD does not require that the parties to an international agreement be
related; it requires that there be any connection between the two.
In relation to branches of the same enterprise, between which the non-arms-length
international related party transactions take place, Division 13 authorises the
commissioner of taxation to reallocate income and expenditure between the parties
and thereby to redetermine the source of the income or the income to which the
expenditure relates.
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Australia 214 www.pwc.com/internationaltp
Division 13 will notionally apply for the calculation of the income attributable to a
controlled foreign company (CFC). An exemption from attribution should apply to
income that is sourced in a listed country, is otherwise included in the tax base of the
listed country, or if the income passes an active income test. The listed countries are
the US, the UK, New Zealand, Japan, Germany, France and Canada.
The legislation does not impose a time limit for the commissioner to make transfer
pricing adjustments. Therefore, adjustments are technically possible commencing from
27 May 1981, the date of introduction of Division 13 into Australian tax legislation.
Double-tax agreements
The domestic legislation is supplemented by the provisions in Australias double-tax
agreements (DTAs) with a wide range of countries. Applicable articles in the DTAs
include those relating to mutual agreement procedures (MAP), associated enterprises
and business profts. The relevant application of the DTA Articles is to allocate tax
revenue between the two tax jurisdictions in the event a taxpayer experiences double
taxation. In this regard, the DTA Articles generally will prevail over Division 13.
Paragraph 1314 below contains further details on the application of Australias DTAs to
provide relief from double tax.
The ATO traditionally has held the view that the Associated Enterprises Articles of
the DTAs also give the commissioner the ability to impose tax; however, there have
been some recent Australian court decisions that suggest that this might not be
correct. Rather, the commissioner must base any tax assessments on the provisions of
Division13.
In addition to the statutory rules referred to above, the ATO has issued various public
rulings concerning transfer pricing. These both interpret the application of the
statutory rules and provide guidance on other issues not specifcally covered by statute.
There are two types of rulings:
Final public taxation rulings (TR), which represent authoritative statements by the
ATO of its interpretation and administration of the legislation and may be relied on
by taxation offcers, taxpayers and practitioners; and
Draft taxation rulings, which represent the preliminary, though considered views
of the ATO; draft rulings may not be relied on as authoritative statements by
theATO.
A public ruling must be applied by the commissioner, the Administrative Appeals
Tribunal (AAT) and the courts in order to give a taxpayer the beneft of the treatment
provided for in the ruling if that treatment produces less fnal tax under the
assessment. On the other hand, if the law (apart from the public ruling) is found to be
more favourable to a taxpayer in the determination of fnal tax, the law will prevail.
Rulings applicable to transfer pricing include:
Basic concepts underlying the operation of Division 13 Taxation Ruling 94/14;
Arms-length transfer pricing methodologies Taxation Ruling 97/20;
Documentation and practical issues associated with setting and reviewing transfer
pricing Taxation Ruling 98/11;
International Transfer Pricing 2011 Australia 215
Australia
Intragroup services Taxation Ruling 1999/1;
Loan arrangements and credit balances Taxation Ruling 92/11;
Permanent establishments (PE) Taxation Ruling 2001/11;
Penalty tax guidelines Taxation Ruling 98/16;
Procedures for bilateral and unilateral advance pricing agreements (APA)
Taxation Ruling 95/23;
Consequential adjustments Taxation Ruling 1999/8;
Meaning of arms length for the purpose of dividend deeming provisions Taxation
Ruling 2002/2;
International transfer pricing and proft reallocation adjustments, relief from
double taxation and the MAP Taxation Ruling 2000/16;
Addendum: international transfer pricing transfer pricing and proft reallocation
adjustments, relief from double taxation and mutual agreement procedure (MAP
Taxation Ruling 2000/16A;
Thin capitalisation, applying the arms-length debt test Taxation Ruling 2003/1;
Cost contribution arrangements Taxation Ruling 2004/1;
Branch funding for multinational banks Taxation Ruling 2005/11;
Consequential adjustments Taxation Ruling 2007/1 (replaces Taxation Ruling
1999/8); and
Interaction of the thin capitalisation provisions and the transfer pricing provisions
in relation to costs that might become debt deductions, for example interest and
guarantee fees Draft Taxation Ruling TR 2009/D6.
In addition to taxation rulings, the ATO also releases taxation determinations (TD).
While also a type of public ruling, determinations are generally shorter than rulings
and deal with one specifc issue rather than a comprehensive analysis of the overall
operation of taxation provisions. Final taxation determinations may also be relied upon
by taxpayers.
The ATO has issued a suite of publications about international transfer pricing. The
publications in the suite are:
International transfer pricing: introduction to concepts and risk assessment;
International transfer pricing: advance pricing arrangements;
International transfer pricing: applying the arms-length principle;
International transfer pricing: a simplifed approach to documentation and risk
assessment for small to medium businesses;
International transfer pricing: marketing intangibles Examples to show how the
ATO will determine an appropriate reward for marketing activities performed by an
enterprise using trademarks or trade names it doesnt own (see 1320 Marketing &
other intangibles); and
International transfer pricing: attributing profts to a dependent agent
permanentestablishment.
The ATO has indicated that these guides do not replace, alter or affect in any way the
ATO interpretation of the relevant law as discussed in the various taxation rulings.
Finally, in addition to the ATO publications, taxpayers may also be guided by
publications by the PATA, of which the ATO is a member. The other PATA members
are the revenue authorities of the US, Canada and Japan. Recent PATA publications
relevant to transfer pricing are:
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Transfer pricing documentation package: a uniform transfer pricing documentation
package that satisfes the documentation requirements of all member countries;
MAP operational guidance: guidelines intended to facilitate consistent and timely
resolution of MAP cases among PATA members; and
Bilateral advance pricing arrangement (BAPA) operational guidance: guidelines
intended to establish a common, consistent approach to BAPAs among
PATAmembers.
1304 Legal cases
There have been few cases relating to transfer pricing brought before the Australian
courts. In most cases, the courts have found in favour of the ATO, with the exception of
the Roche Products case, which is discussed below. The cases are:
San Remo Macaroni Pty Ltd. 1999 (question of issue of assessments in bad faith);
Daihatsu Australia Pty Ltd. 2001 (challenging transfer pricing adjustments on the
basis of a lack of bona fde attempt by the ATO);
Syngenta Crop Protection Pty Ltd. and American Express International
2006 (requests for the commissioner to provide details of its transfer pricing
assessments); and
WR Carpenter Holdings Pty Ltd. & Anor 2007 (request for commissioner to
provide particulars of matters taken into account in making transfer pricing
determinations).
Importantly, all of these cases involved an administrative law challenge to processes
adopted by the commissioner in issuing transfer pricing-based assessments.
April 2008 saw a preliminary judgment in the frst Australian case dealing
with substantive transfer pricing issues, the case of Roche Products Pty Ltd. See
comments in paragraph 1312 below for a summary of the key implications of the
preliminaryjudgment.
In the event of an audit by the ATO, the burden of proof to satisfy the ATO and the
courts that transfer prices are arms length, lies with the taxpayer. The weight of this
burden has been affrmed by the recent judicial decisions in the Syngenta and WR
Carpenter Holdings cases. In these judgments, the court declined to allow taxpayers
to examine and challenge the commissioners reasons underlying transfer pricing
determinations on the grounds that this was not a relevant consideration to the case.
The court found that the provisions of Division 13 do not require the ATO to establish
the validity of its transfer pricing assessments. Rather, the burden rests entirely on
the taxpayer to establish that its prices were arms length or the commissioners
assessments were excessive.
Tax return Schedule 25A
Taxation in Australia is based on a self-assessment system. Essentially, taxpayers are
responsible for correctly assessing their tax obligations. Filed tax returns are deemed
to be notices of assessment. Taxpayers are expected to take reasonable care in the
Australia
preparation and documentation of their tax returns and are expected to ensure that
arms-length prices are applied to international transactions.
In fling a tax return, every taxpayer that engages in international transactions with
connected parties with an aggregate amount greater than AUD1 million is required to
submit a Schedule 25A with their tax return, detailing the nature and value of these
transactions. The ATO uses information from Schedule 25A to categorise a taxpayer
into risk categories, a factor in determining transfer pricing review targets. If scored
in the high-risk categories as a result of such a review, a transfer pricing review may
takeplace.
The pending release of the ATOs new International Dealings Schedule (IDS) is
expected to replace the current Schedule 25A form for selected fnancial services
taxpayers from 2010 and for taxpayers in all other sectors from 2011.
The IDS will be used in an initial trial in the 2010 Australian Income Tax Return
for fnancial services companies with a turnover in excess of AUD250 million. It is
expected that the IDS will then be rolled out as a replacement for the Schedule 25A
for all relevant taxpayers in 2011. The schedule will require taxpayers to disclose
a signifcantly greater level of detail relating to specifc international related party
transactions including fnancial instruments, asset transfers associated with business
restructures and dealings with tax havens, etc.
Tax return permanent establishment
For the purposes of Schedule 25A, the responses should be provided on a notional
basis that a permanent establishment is a separate but related entity.
Tax return public offcers duties
The public offcers duties in relation to the income-tax return also apply in respect
of the Schedule 25A. The public offcer is required to sign the declaration on the
companys income-tax return, certifying disclosures in the company income-tax return
and Schedule 25A to be true and correct.
Recent ATO activity
Large business
The ATO releases an annual report that details its proposed compliance programme
for the coming year in relation to large businesses (i.e. enterprises with a turnover
of around AUD250 million or more), identifying risk areas and strategies it plans to
implement to deal with those risks.
The compliance programme provides an insight into the key concerns and the strategic
focus of the ATO in dealing with compliance by the large business segment. It also
provides checklists of factors the ATO will take into account in identifying audit cases
and matters taxpayers can expect the ATO to challenge.
During 200809, the ATO completed 29 APAs including 13 renewals, nine new APAs
encouraged by compliance activity and seven unprompted new APAs. Of the 29
completed APAs in 200809, approximately half were with large business taxpayers
and the remainder were in the small to medium enterprise segment.
As part of the Strategic Compliance Initiative (SCI) programme announced in the May
2009 federal budget, the ATO intends to signifcantly increase its focus on transfer
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pricing in the large taxpayer market (i.e. revenue greater than AUD250 million) within
the next four years.
The ATO issued approximately 180 transfer pricing questionnaires during late 2009
and early 2010, with the areas of focus being:
Low proft and/or loss-making entities;
Intragroup fnance, guarantee fees;
Business restructures and transformations;
Inbound and outbound intellectual property transactions; and
Foreign banks.
Following the questionnaires, we understand that the ATO anticipates a sustained
programme of more detailed and/or focused risk reviews and audits. It is also expected
that a large number of APAs may be commenced as taxpayers seek certainty for their
future dealings. Therefore, it is highly likely that the issuance of these questionnaires is
just the start of a sustained campaign that is expected to last for at least four years.
To support this programme the ATO has recruited approximately 60 personnel
members who will focus solely on transfer pricing. Many of these are experienced
transfer pricing practitioners from the profession, industry and from within other areas
of the ATO.
Small to medium enterprises (SMEs)
SMEs are classifed as those taxpayers with a turnover of between AUD2 million and
AUD250 million. This represents an expansion from the 200607 classifcation, which
defned SMEs as taxpayers with a turnover of between AUD2 million and AUD100
million. In recent years, the ATO has heightened its review of the SME sector based on
evidence that the level of transfer pricing documentation and compliance in the sector
has historically been poor. There is a particular focus by the ATO on double zero and
triple zero companies (i.e. those that have not paid tax in two or three of the most
recent years). Additional focus areas of the ATO with respect to SMEs are identifed in
the annual compliance program.
Approximately half of the 29 APAs completed during 200809 were in the small to
medium enterprise segment.
It is likely that the ATO will conduct more income-tax reviews and audits across SMEs
in the short-term. In particular, it has been made known that the ATO has identifed 30
SMEs with an annual turnover between AUD100 and AUD250 million, which it intends
to review as a matter of priority.
The provision of information and duty of the taxpayer to cooperate with the
taxauthorities
A taxpayer must retain documents that are relevant for the purposes of ascertaining
the taxpayers income and expenditure, etc. for at least fve years (calculated from
the date the records were prepared or obtained, or from the date the transactions or
acts to which the records relate were completed, whichever is the later). As the burden
of proof rests with the taxpayer in some circumstances, particularly in relation to
transfer pricing-related matters, retention for a longer time period is prudent (see also
paragraph 1302).
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The commissioner, or any duly authorised taxation offcer, has the right of full and free
access to all buildings, places, books, documents and other papers for the purposes of
the ITAA. The commissioner might also require any person to attend and give evidence
or produce any documents or other evidence relating to a taxpayers assessment.
The provisions of the ITAA also empower the commissioner to require a person to
produce documents held outside Australia. Compliance with this latter requirement
is not mandatory, but where a taxpayer fails to comply with such a requirement, the
taxpayer may not rely on those documents in the event it wishes to challenge the
commissionersassessment.
As mentioned above, when reviewing the tax affairs of a taxpayer, the ATO uses
an approach known as the Client Risk Review (CRR) process to undertake a risk
assessment of material tax issues, including transfer pricing. Material examined by
the ATO includes Schedule 25A, compliance history, latest collections, latest news or
media articles and other publicly available information such as that available on the
internet. The CRR process involves:
Understanding the taxpayers business and the environment in which it operates;
Analysing available information and comparing similar businesses in the market;
Developing hypotheses to build a clear focus on the material risk issues;
Visiting the taxpayer to further understand the business and its environment and to
test the ATO preliminary risk assessment of the material issues; and
Recommending compliance strategies to treat the risks, which can be taxpayer-
specifc or broadly based and include legislative change or other law clarifcation,
such as rulings, maintaining watching briefs, or conducting audits.
When transfer pricing is identifed as a signifcant risk, the CRR may proceed to a
transfer pricing record review (TPRR). Taxpayers subject to a TPRR will receive a risk
rating at the completion of the risk review. A higher risk rating does not necessarily
mean that the company will be selected for audit, but with such a risk rating, the
taxpayer is likely, at a minimum, to be placed on a watching brief.
When a company is selected for audit, the audit process usually commences with an
ATO request for a meeting with the company. At this meeting the ATO will carry out
an inspection of the taxpayers premises and interview key operational personnel. The
approach that the ATO takes broadly follows the frst three steps of the four step
process set out in TR 98/11 as follows:
Step 1: Characterise the international dealings with related parties in the context of
the taxpayers business;
Step 2: Select the most appropriate transfer pricing methodology; and
Step 3: Apply the most appropriate methodology and determine the
arms-lengthoutcome.
At the completion of this process, the ATO would consider all information gathered
(including a review of the taxpayers transfer pricing documentation) and issue a
position paper outlining its fndings and proposed adjustments to taxable income over
the review period.
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While verbal communications between the ATO and the taxpayer generally will
continue throughout the process, the taxpayer is offered an opportunity to respond
in writing to the ATOs position paper, which would involve correcting any factual
errors made by the ATO and, where available, to provide additional information
and arguments to counter the ATOs position. Following a review of the taxpayers
response, the ATO will issue its fnal position paper followed by determinations and
notices of assessment or amended assessments giving effect to the determinations. The
assessments are due and payable at the time of the assessments being issued. Any
delay in paying the assessments incurs additional interest costs.
1308. Revised assessments and the appeals procedure
Australia has a comprehensive objection and appeals procedure for disputing an
amended assessment raised by the commissioner. Under these provisions, the taxpayer
may object to an amended assessment issued by the commissioner to give effect to a
Division 13 determination. A taxpayer who is dissatisfed with such an assessment has
the later of four years from the date of the original assessment (which is shortly after
fling the relevant income tax return) or 60 days from receiving the notice of amended
assessment to lodge an objection in writing, setting out the grounds relied upon
in support of the claim. In practice, most transfer pricing audits are not completed
until more than four years after the original assessment, so in most cases taxpayers
are required to object within 60 days of receiving an amended assessment. The
commissioner is required to consider the objection and may either allow it in full, or
in part, or disallow it. The commissioner is then required to give notice to the taxpayer
of his/her decision on the objection. A taxpayer dissatisfed with such a decision may
either refer it to the AAT for review or refer the matter to the Federal Court of Australia.
Where the notice of assessment includes additional tax for incorrect returns, it
is generally prudent to remit the matter to the AAT, which has the discretion to
reconsider the level of additional tax imposed and may substitute its own decision
for that of the commissioner. In contrast, on appeal to the federal court, that court
can only decide whether the commissioner has made an error in law in imposing
the additional tax. If no error of law has occurred, then the penalties will remain
unadjusted. Decisions of the AAT may be appealed to the federal court, but only on a
question of law.
Penalties for 1992/93 onwards
Penalty rates applying to transfer pricing adjustments under Division 13 and double-
tax agreements are outlined in TR 98/16 issued in November 1998.
The penalties generally range from 10% of the additional tax where the taxpayer
has documented a reasonably arguable position and had no purpose of avoiding
Australian tax, to 50% where there was an intention to avoid Australian tax and a
reasonably arguable position had not been documented. Broadly speaking, a position
will be considered reasonably arguable if it is about as likely as not to be correct. In
order to demonstrate that a position is reasonably arguable, the taxpayer must retain
documentation to support arms-length pricing.
The ATO has the discretion to remit penalties in full if special circumstances exist.
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Penalties may be increased by 20% where:
A taxpayer takes steps to prevent or hinder the ATO from discovering that a transfer
pricing provision should be applied. It is noteworthy that unreasonable time delays
in responding to ATO enquiries or failure to notify the ATO of errors within a
reasonable time could amount to hindrance; and
A taxpayer has been penalised under a scheme section in a prior year of income.
Penalties may be reduced:
By 20% of the penalty if the taxpayer makes a voluntary disclosure to the ATO after
it has been informed of an impending audit; and
By 80% of the penalty if the taxpayer makes a voluntary disclosure to the ATO
before it has been informed of an impending audit.
In addition to penalties the taxpayer is liable to pay a shortfall interest charge (SIC) on
the value of any increase in the tax assessment arising from an ATO adjustment. The
SIC rate is set by reference to a base interest rate plus 3 percentage points. The SIC rate
was 10.15% for the quarter JanuaryMarch 2008.
Penalties for 1991/92 and prior years
Prior to the introduction of the self-assessment regime there was a two-tier structure
for penalties 200% for schemes designed to avoid tax and 25% per annum in other
cases. Where voluntary disclosures are made the penalty may be restricted to 10% per
annum, subject to a maximum of 50% of the tax avoided in any year.
A specialist transfer pricing unit has been established within the ATO comprising of
individuals dedicated to transfer pricing. This group is responsible for providing high-
level technical advice to members of the various business lines (e.g. large business and
international, small business income) in relation to TPRRs, CRRs and audits.
This unit serves as a reference point and is not directly engaged in conducting
record reviews or audits. Actual TPRRs/audits are carried out by members of the
relevant industry segment of the various business lines with assistance provided
by the specialist Transfer Pricing Practice and Field Economist Practice within the
International Strategy and Operations group of the ATO.
The ATO, as a matter of standard practice, engages local economists in transfer pricing
audits. In addition, other international economists have been engaged from time to
time to assist with policy and specifc audits.
As noted earlier, to support its SCI program the ATO recruited approximately 60
personnel who will focus solely on transfer pricing. Many of these are experienced
transfer pricing practitioners from the profession, industry and from within other areas
of the ATO.
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Availability of comparable information
Public companies and large private companies must lodge fnancial statements with
the Australian Securities and Investments Commission (ASIC). This information
is publicly available. However, despite the information lodged with ASIC, reliable
comparable data is diffcult to locate in the Australian market. While databases
are available (for example IBIS World, Business Whos Who, OSIRIS) to identify
organisations on an industry and activity basis, the particularly small Australian
market makes identifcation of reliable comparables diffcult. In addition, some
Australian entities are exempt from lodging full fnancial statements with ASIC, and
many Australian companies are members of multinational groups and consequently
themselves are engaged in controlled transactions such that reliable comparisons
often cannot be made. Given the limitations of Australian data, the ATO is increasingly
turning to overseas markets to identify comparables. It is of note that the ATO has a
strong preference for use of listed companies in comparability analyses, although this
stance has softened within the past year or so.
Australian Bureau of Statistics data
In the conduct of TPRRs, the ATO sometimes uses publicly available data from the
Australian Bureau of Statistics (ABS) in order to form an opinion on the commercial
realism of a taxpayers fnancial performance, relative to the performance of a market
segment as a whole. The ATOs use of ABSs statistics is limited to this situation and
not used in comparability analyses because the data includes details of companies
engaged in controlled transactions, and the categories may be wide enough to include
companies that might be functionally dissimilar.
Use of controlled data
A disturbing aspect of TR 97/20 is the ATOs intention to use controlled data in
circumstances for which there is insuffcient publicly available information on which
to base a comparison. While this contravenes the OECD Guidelines with respect to
the use of controlled data, the ATO does not consider it inappropriate to use the data,
notwithstanding the fact that the taxpayer facing a possible adjustment does not have
access to the same information.
More recent experience indicates that the ATOs use of controlled data has softened
and that where possible, it endeavours to work with methodologies put forward by the
taxpayer and publicly available information.
As mentioned earlier, 2008 saw the determination of two transfer pricing cases: that of
Roche Products Pty Ltd. and an appeal from the case of WR Carpenter Holdings.
Roche Products Pty Ltd.
The fnding in the AAT case of Roche Products Pty Ltd. v The Commissioner is the frst
Australian judgment on substantive transfer pricing issues. While the AAT found that
the commissioners amended assessment was excessive, its judgment still resulted in
uplift of the taxpayers assessable income of almost AUD60 million.
Australia
The case concerned the transfer price of goods acquired by Roche Products (an
Australian company) from its Swiss parent. The AAT found that the transfer prices
of Roches ethical pharmaceutical products were excessive and made adjustments
accordingly. No adjustments were made to the transfer prices of other product lines.
In its judgment the AAT made a number of comments that have implications for all
Australian taxpayers with transfer pricing issues. They include:
The operation of DTAs Although the president of the AAT was not required to
decide on this issue, he commented that there is a lot to be said for the proposition
that Australias DTAs do not give the ATO the ability to impose tax and that
Division 13 must form the base that supports any assessment. This is consistent
with a recent decision in a non-transfer pricing case heard in the Federal Court of
Australia;
Transfer pricing methodologies Although the ruling acknowledges the diffculty
in fnding available comparable data, and uses a uniform gross margin to price the
transfers of all pharmaceutical products, the AATs preference for transactional
methods over proft methods (such as TNMM) is clear;
Loss-making companies In noting the weaknesses of proft methods the judge
pointed out their tendency to attribute any losses to incorrect transfer pricing. The
AAT rejected this inference. The ruling accepted the taxpayers commercial reasons
for the losses in this division, despite their occurring over a number of years, and
ordered no transfer pricing adjustments; and
Separate years The ruling clearly stated that the provisions of Division 13 require
that arms-length prices be determined for each separate year under consideration,
rather than a multiple-year average.
On 23 January 2009 the ATO released its Decision Impact Statement in relation to
the case Roche Products Pty Ltd. v Commissioner of Taxation. Not unexpectedly the
Decision Impact Statement expresses the ATOs view that the decision in Roche is
confned to the facts of the case. In no uncertain terms taxpayers have been told
that all things considered [Roche] is seen as having limited signifcance for the
administration of transfer pricing laws generally. The ATOs message is that the
status quo prevails. As a result, taxpayers have not been provided with any additional
signifcant transfer pricing guidance by the ATO to that which was already in the public
domain. However, in our view, aspects of the AAT decision should not be ignored
bytaxpayers.
WR Carpenter Holdings Pty Ltd.
In July 2007 the Full Court of the Federal Court of Australia upheld an earlier decision
to deny the taxpayer the right to request particulars of how the ATO arrived at its
transfer pricing determination. Affrming the precedent set in the case of Syngenta
Crop Protection, the court found that the provisions of Division 13 do not make the
commissioners reasoning process in making a transfer pricing determining a relevant
consideration. Therefore, the court declined to give the taxpayer an opportunity to
view and challenge these reasons, removing a potential avenue by which the taxpayer
could challenge the ATOs transfer pricing adjustment.
The taxpayer sought, and was granted, leave to appeal to the High Court of Australia.
On 31 July 2008, the High Court of Australia unanimously dismissed the appeal.
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In addition to the developments in law, the ATO was also due to release a number of
rulings and publications in 2008. These include the following:
Division 13 and Australias thin capitalisation provisions
In December 2009, the ATO released a draft tax ruling (TR 2009/D6) intended to
provide guidance on the interaction between Australias transfer pricing rules and thin
capitalisation provisions (Division 820 ITAA1997). The thin capitalisation rules apply
to deny a proportion of the taxpayers deductions for interest payments if the taxpayers
debt exceeds a maximum allowable amount. Generally, the taxpayer may determine its
maximum allowable debt as the safe harbour debt amount (a debt to equity ratio of
3:1) or by reference to an arms-length debt amount.
The arms-length amount of debt generally will mean the level of debt that would
be required for an entity to be regarded as being independent and dealing wholly
independently in respect of its fnancing arrangements.
The ATOs position is that it may use transfer pricing principles to adjust the interest
rate on the taxpayers debt, even when the level of debt falls within the safe harbour
debt amount. However, the ATO will not use transfer pricing principles to adjust the
amount of debt where it falls within the safe harbour amount.
The ATO will take into account the effects of parental affliation when determining
an arms-length interest rate. The ATO has taken this view based on evidence that the
market takes this affliation into account when pricing debt between third parties.
In December 2009, the ATO also issued a draft Practice Statement Law Administration,
PS LA 3187 (draft), which expresses a practical rule of thumb to the effect that
taxpayers will be at low risk if they price inter-company funding transactions at the
parent companys usual rate of interest, and stay within the debt levels allowed by the
thin capitalisation safe harbour. This is intended to be an interim measure until the
ATO resolves its position on various outstanding issues.
The rule of thumb is relevant only to the application of the transfer pricing rules.
It does not apply to related party debt, which is subject to an explicit guarantee.
In essence, the rule of thumb uses the weighted average cost of debt of the group,
adjusted with movements in the weighted average cost of debt going forward. The
weighted average cost of debt is determined on a consolidated accounting basis
in respect of all of the ultimate parents debt funding. The resulting interest rate,
therefore, has no necessary connection with the terms of the taxpayers loan (for
instance, the duration of the loan and the currency it is in), and is the same rate
irrespective of those terms.
Division 13 and Australias debt/equity rules
In July 2008, the ATO released tax determination (TD 2008/20), intended to provide
guidance on the interaction between Australias transfer pricing and debt/equity
provisions (Division 974 ITAA1997).
Division 974 provides tests to determine whether a particular arrangement whereby
property is supplied or acquired gives rise to a debt or an equity interest for specifc
tax purposes, including whether a return on the interest is deductible. The draft
determination considers whether the characterisation of an interest under Division
Australia
974 has any bearing on the characterisation of that interest for the purpose of assessing
whether the arrangement is consistent with the arms-length principle of Division 13.
The ATOs position is that the tests in Division 974 have no bearing on classifying
arrangements for transfer pricing purposes.
In addition to the tax determinations, the ATO has also released the following draft
discussion papers:
Business restructuring
In late 2007 the ATO released a draft discussion paper setting out its preliminary views
on the application of Australias transfer pricing rules to business restructures within
a multinational group. The draft paper also discussed potential for the application of
Australias anti-avoidance tax provisions (Part IVA).
The draft papers focus was on considering the extent to which independent parties
would be likely to engage in such a restructure. Considerations of particular interest to
the ATO included the business objectives behind the restructure, pre-tax and post-tax
proft outcomes, and a possible requirement for exit payments in compensation for the
relocation of functions, assets and risks.
The ATO sought feedback on the paper and has revised the draft accordingly.
Importantly, the revised draft focused entirely on the application of transfer pricing
provisions and excludes any analysis of possible Part IVA implications.
The revised draft is not yet publicly available, and there is no set date for publication.
It is worth noting that the OECD released a discussion paper on this issue on 19
September 2008.
Administrative developments
The ATO is reviewing its approach to public rulings. Due to the cost and process
involved in issuing public rulings, the ATO is looking to set clear guidelines for what
issues should be subject to a public ruling.
A further anticipated development the ATO has foreshadowed is a potential new
general tax compliance programme for large taxpayers, known as Annual Compliance
Arrangements. Under this programme, participating taxpayers will be able to
streamline their tax compliance through ongoing dialogue with the ATO, highlighting
events and issues as they emerge throughout the year. In addition, the commissioner
would remove culpability for penalties in exchange for a commitment to true and full
disclosure from the taxpayer. As at the time of writing, this development is only at the
stage of an internal ATO draft.
There is a likelihood that all related party international dealings may be reviewed
by the ATO in the context of a transfer pricing review. There are no transactions,
situations or industries that are excluded from an ATO transfer pricing review.
The ATO has signalled in its 200910 compliance programme that specifc areas
targeted for closer attention are:
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Low-proft and/or loss-making entities;
Intragroup fnance, guarantee fees;
Business restructures and transformations;
Inbound and outbound intellectual property transactions; and
Foreign banks.
authority proceedings
In the event that a transfer pricing audit results in an adjustment, mechanisms exist
whereby the taxpayer may be able to limit the resulting effective double taxation.
Resident taxpayers
If an Australian taxpayer is likely to suffer double taxation, the following possibilities
are available:
a. Where there is a double-tax treaty:
A resident taxpayer may present his case to the Australian competent authority.
Each of Australias DTAs has a MAP Article that enables competent authorities of
the relevant countries to meet and consult with each other with a view to seeking to
resolve potential double taxation issues. The MAP does not compel an agreement to
be reached and does not relieve the Australian taxpayers from penalties or interest
charged by the ATO.
The commissioner of taxation has released TR 2000/16, which outlines the
procedures to be followed and circumstances in which a case will be considered.
In circumstances for which the profts of an Australian resident company are
taxed by another country and in the opinion of the ATO it is in contravention to
the double-tax treaty but the competent authorities fail to resolve the case, it may
result in double tax.
b. Where there is no double-tax treaty:
In circumstances for which a transfer pricing adjustment is made by the authorities
of a country with which Australia does not have a DTA (such as Hong Kong), there
is no mechanism for providing relief from double taxation, other than pursuing
domestic relief through the Australian appeals process.
Non-resident taxpayers
The non-resident party to certain transactions may also obtain relief from double
taxation through the operation of domestic legislation in Australia.
Division 13 of Pt III of the ITAA allows for consequential adjustments to be made to
the income or deductions of the non-resident party to a transaction, where a transfer
pricing adjustment has been made in relation to that non-resident taxpayer. For
example, where withholding tax has been paid on interest, the provision prevents
double taxation by allowing the withholding tax to be recalculated based on the
adjusted interest (i.e. as revised for the transfer pricing agreement).
Australia
1315. Advance pricing arrangements
A formal APA process is available in Australia. APAs represent an agreement between
a taxpayer and the tax authority to establish the transfer pricing methodology to be
used in ensuring arms-length transfer prices are achieved for tax purposes. The ATO
continues to support and promote its APA programme as part of its transfer pricing
compliance programme. The APA programme is well-established within the ATO, with
more than100 APAs completed or renewed since its inception. It is also a relatively
fexible programme, with limited procedural requirements concerning the form and
timing of applications and a willingness to negotiate on the part of the ATO.
It is noteworthy that the ATO is becoming more selective in entering into APA
discussions with taxpayers. The ATO has discouraged a number of APA applications
where it believes one or more of the following factors exist:
Timely agreement was unlikely in relation to the appropriate transfer pricing
methodology to apply, appropriate comparable data and, an arms-length outcome;
A lack of materiality in the dealings in the context of the business;
Insuffcient complexity to warrant the level of certainty provided by an APA; and
Obtaining a tax beneft in either Australia or overseas was a principal element of
the dealings.
Taxation Ruling TR 95/23 provides guidance in dealing with Australias APA process.
The ATO is also currently seeking ways to streamline the APA process and is exploring
the possibility of a more cost-effective alternative to an APA, which would enable
companies to limit or quantify their risk from a transfer pricing perspective. In
particular, an alternative to an APA would award a level of comfort to taxpayers that
do not have the resources to pursue an APA (for instance, certain taxpayers in the SME
market) or were denied access to the APA process.
In 2007, the ATO commissioned PricewaterhouseCoopers Legal to complete an
independent review of the APA programme. The ATO has recently received a draft
report from the review that gathered feedback on the programme from taxpayers,
advisers and ATO staff. At the time of writing, the ATO was in the fnal process of
redesigning the principles around the APA process.
Interaction with the new laws on the provision of advice implemented under the Review of
Self Assessment (ROSA)
In April 2006, the ATO undertook a comprehensive review of key aspects of income
tax self-assessment, resulting in legislative changes to the Taxation Administration
Act 1953 (TAA), applicable from 1 January 2006. The key change to the new private
binding rulings regime (PBR) resulted in an expanded defnition of matters on which
taxpayers may seek a private ruling, which now includes administration, procedure
and collection issues and ultimate conclusions of fact that must be determined in
applying a tax law. In short, technically, PBRs may cover transfer pricing arrangements.
Following these legislative changes, the ATO has recognised the overlap between the
PBR and the APA provisions. The ATO has stated that it has decided to retain the APA
programme in the belief that the APA programme provides more fexibility and enables
BAPAs to be obtained, although in theory taxpayers could seek a PBR in relation
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to a transfer pricing matter. While no further guidance has been published on the
interaction between the PBR and the APA programme, a new practice statement on the
provision of advice is planned by the ATO.
1316. Liaison with customs and other authorities
Customs
There is now an agreement in place between the ATO and the Australian Customs
Service (ACS) to exchange information relating to transfer pricing issues. It is
understood that the arrangement includes a database that enables members of the
ATO and ACS to freely exchange product and company pricing data. In addition, the
ATO and ACS also have begun to undertake joint audits on some taxpayers and develop
joint training with a view to increasing the level of joint activity in the future.
The ATO, the ACS, tax practitioners and taxpayers have actively debated the treatment
of customs duty when agreeing on APAs or making transfer pricing adjustments for a
number of years. In particular, a debate is ongoing as to whether notional adjustments
should be made for overpayment of customs duty, resulting from an increase in taxable
income, when audit settlements are reached. Currently, there is no convergence
between ATO adjustment requirements, customs valuation methodology and any
subsequent customs duty amendment/refund procedures. Some taxpayers have
individually approached the ACS to agree to the customs treatment of any adjustments
made under an APA.
There have been recent discussions between the ATO and the ACS regarding potential
harmonisation of transfer pricing and customs valuation rules concerning transfer
pricing adjustments. A conclusive outcome in this area would be an important
development for taxpayers that have previously faced uncertainty regarding
the customs duty implications of transfer pricing adjustments whether they are
self-assessed adjustments, adjustments resulting from an audit or compensating
adjustments arising under an audit adjustment.
A draft practice statement on the interaction between customs valuation rules and
transfer pricing was released in 2007, with the fnal statement to be published in 2008.
Other authorities
In addition to its liaison with the ACS, it is understood that specialist transfer pricing
and goods and services tax (GST) auditors within the ATO are also cooperating for
the purposes of identifying cases of particular concern to each other. For example,
information in the Schedule 25A is sometimes used to identify taxpayers for GST
reviews; and information such as invoices and other documentation reviewed in GST
audits can sometimes identify issues that may trigger a transfer pricing review.
It is also understood that the ATO has had some similar cooperation with foreign
revenue authorities. The ATO and overseas revenue authorities share information
that might be relevant to particular industries or transaction types. Specifcally, in its
200708 compliance programme, the ATO stated that it completed 874 exchange of
information requests with treaty partners during 200607. This has led to a number of
simultaneous audits of taxpayers in multiple jurisdictions.
Australia
1317. OECD issues
Australia is an OECD member and has a representative on the OECD Transfer Pricing
Task Force. The ATO is an active participant in OECD working parties for emerging
areas of transfer pricing such as business restructuring.
The ATO generally has followed the OECD Guidelines in relation to transfer pricing,
the principles of which are refected in Australias tax rulings, but is under no
obligation to follow them.
In calendar year 2001, substantial changes to Australias thin capitalisation regime
became effective. The legislation is lengthy and complex.
The legislation has introduced a safe harbour debt amount. An alternative test is the
arms-length debt amount, which potentially can increase the permissible interest
deduction. The meaning of arms length for the purposes of the thin capitalisation
provisions is explained in TR 2002/16.
The application of International Financial Reporting Standards (IFRS) from 1 January
2005, (December balances) impacted some taxpayers thin capitalisation position,
which is measured with reference to Australias Generally Accepted Accounting
Principles (AGAAP). To provide some short-term relief to taxpayers who were impacted
by the transition to IFRS, the government announced a three-year transitional period
for thin capitalisation purposes. In summary, taxpayers had the choice to apply AGAAP
for an additional three years.
1319. Management services and other services
Taxation Ruling TR 1999/1 sets out the ATOs position on whether prices for services,
or dealings between associated enterprises in relation to the provision of services,
conform to the arms-length principle.
According to the ruling, whether a service has been, or will be, provided by the
performance of an activity, and whether a charge should be levied depends upon
whether the activity has conferred, or is expected to confer, a beneft to a related party.
The ruling introduces administrative practices or a safe harbour, which allow for
a 7.5% markup on non-core services provided or received where service revenue/
expenses are not more than 15% of the Australian groups total revenue/expenses. A
markup of between 5% and 10% may be permitted if the services are provided to, or
received from, another country that requires a different markup. Taxpayers relying
on the administrative concession must apply a consistent markup for the relevant
servicesglobally.
Examples of non-core services include administration and human resource matters,
but specifcally exclude technical and marketing services.
A
The ruling also allows for smaller companies that receive or provide services worth not
more than AUD500,000 per annum, to apply the administrative practices to all services
(i.e. core and non-core).
The adoption of a safe harbour markup does not remove the requirement for taxpayers
to document their intragroup services transactions. The safe harbour markup will
only remove the necessity for taxpayers to include benchmarking analysis of their
intragroup services markups within their documentation.
The ATO continues to focus on the pricing of management and other group services
and has recently broadened its attention to include both inbound and outbound
groupservices.
1320. Marketing and other intangibles
Intangibles have been an area of focus for the ATO for a number of years. The ATOs
position on the application of Australias transfer pricing rules to marketing services
provided by an Australian enterprise that uses trademarks and names it does not own is
outlined in its 2006 publication titled Marketing Intangibles. The booklet is intended
to be consistent with previous ATO rulings and with OECD Guidelines.
In determining whether an arrangement for the provision of marketing services
is consistent with the arms-length principle, the ATO considers the following
issuesrelevant:
The nature of the contractual arrangements;
The extent to which the activities are expected to beneft the trade name owner
and/or the marketer;
Whether the level of marketing activities performed by the marketer exceeds that of
comparable independent enterprises; and
Whether the marketer is properly compensated by a normal return on its activities
or should receive an additional return on the trade name.
The ATO is likely to challenge an arrangement in which a distributor pays a royalty
yet receives no rights to use a trade name other than to distribute a branded product.
Furthermore, if the ATO perceives that a distributor is performing a greater level of
marketing than comparable independent distributors, it will expect the taxpayer to
earn a higher level of proft than that of a routine distributor.
In addition to marketing intangibles, the ATO is also focusing on transfers of
intellectual property (IP) to international related parties. IP transfers must be
separately disclosed on Schedule 25A, and these are commonly a trigger for
ATOreviews.
1321. R&D tax concession program potential changes
forFY11
Australias tax rules allow a 125% tax deduction for eligible expenditure on R&D
activities that meet the tax law defnition. Repeated claimants may also be able to claim
a 175% deduction for increases in their R&D spend above prior-year averages.
Australia
The R&D programme generally requires companies to undertake the R&D activities on
their own behalf, which can exclude claims for R&D services undertaken in Australia
for foreign parent companies. However, since 200708 the rules can allow additional
deductions in some circumstances for R&D undertaken in Australia where the IP is
retained overseas.
The Australian government has been reviewing the R&D tax programme and is looking
to make considerable changes to it. The changes are intended to come into effect
from 1 July 2010 (pending parliamentary approvals). The proposed programme is
intended to increase the benefts available to some claimants, particularly companies
undertaking R&D in Australia for foreign parent companies and companies with less
than $20 million group turnover. At the time of print, the proposed programme had
not been fnalised and may receive further changes or be delayed in its introduction.
However, should companies be undertaking R&D activities in Australia, they should
consider their R&D tax position to ensure they take advantage of all R&D tax benefts.
Austria
14.
A
Austria
1401. Introduction
Austria, while being a member of the OECD and subscribing to the principles contained
in the 1995 OECD Guidelines on transfer pricing, actually has only general statutory
rules on transfer pricing. Signifcant interpretative guidelines are expected to be
published in 2010. Transfer pricing is, however, becoming increasingly important, and
this is refected by the increasing number of tax inspectors specialising in international
transactions.
Austria has only general statutory rules which are aimed at dealing with transfer
pricing. Consequently, the statutory authority for addressing transfer pricing issues
is found in the application of general legal concepts, such as substance over form and
anti-avoidance regulations, as well as the application of other regulations to deal with
issues such as fctitious transactions, hidden capital contributions and constructive
dividends. The requirements to apply the arms-length principle on inter-company
dealings and for adequate documentation of transfer prices are constituted in Article 6
Item 6 Income Tax Act and Articles 124, 131 and 138 Federal Fiscal Code, respectively.
The OECD Guidelines were published in Austria as administrative decrees. Although an
administrative decree does not have the force of law, this is nevertheless an important
indication of the acceptance of the principles contained in the OECD Guidelines and
the approach to transfer pricing that the Austrian authorities are likely to adopt.
In autumn 2009, the Austrian Ministry of Finance presented draft transfer pricing
guidelines. Currently the draft is in revision. The publication of the fnal guidelines is
expected in the near future.
No other binding regulations concerning transfer pricing have been published. If,
however, guidance is required on a particular transfer pricing problem, then a taxpayer
may submit the facts of that problem to the Austrian Ministry of Finance to obtain
comment on its legal aspects (an Express Answer Service (EAS) inquiry and Express
Answer Service reply, respectively). It should be noted that, although the reply of the
ministry is not legally binding, these replies are published in professional journals and
are referred to in practice.
International Transfer Pricing 2011 Austria 233
Austria
1404. Legal cases
Information on legal cases and the legal aspects of transfer pricing issues is set out
asfollows.
Administrative High Court decisions
Any decisions of this court are published without specifc details that could identify
the parties involved. Though court decisions on transfer pricing cases are scarce, some
decisions are worth mentioning:
The court ruled that a precise and detailed description of services rendered by
a foreign group company to a domestic recipient is required for the service or
licence fees to be tax-deductible. Thereby, the more incomprehensible the services
performed are, the more detailed the documentation has to be. Specifcally,
consulting services, the transfer of know-how and the procurement of business
contacts require a very detailed description as well as documentation for the
related expenses to be deductible for tax purposes.
The court ruled again that a precise and detailed description of the nature and
market value of all inter-company services rendered to a domestic recipient
is required for the fee paid for those services to be tax-deductible. A simple
submission of a large set of fles consisting of several (standalone or incoherent)
documents cannot be accepted as suffcient. The documents have to satisfactorily
demonstrate and to clearly represent in a comprehensible way the content and the
market price of each service received.
The court emphasised that inter-company service payments are tax-deductible
only if a willing-to-pay test is passed. If the services could have been obtained at
lower cost from third-party service providers, the willing-to-pay test is deemed to
befailed.
A German company engaged in the sales and support of software failed to allocate
profts to its Austrian permanent establishment (PE). The Austrian tax authorities
stated that the PE acts as a service provider and determined the arms-length
compensation for this function based on estimations applying the cost-plus
method. The Administrative High Court of Austria decided that such adjustments,
especially the determination of the markup, made by the tax authorities cannot
be based solely on vague assumptions and experience. The court stated that the
tax authorities have to prove the accuracy of their assumptions and must grant
access to the information on how such adjustments were computed, including the
requirement to provide detailed information on the comparables used to determine
the arms-length transfer price.
Tax Appeals Board decisions
In one of its recent decisions, the Tax Appeals Board did not accept a fat rate
remuneration for several services (marketing, fnancing, personnel, etc.) determined
as a percentage of the Austrian service recipients turnover. Although the board
acknowledged that the Austrian company needed the services for its operation, the
actual provision of these services was not proved credibly by the taxpayer. In addition,
the Austrian service recipient should be in the position to provide evidence on the
actual provision of services by the group companies and the beneft arising thereof.
Austria 234 www.pwc.com/internationaltp
A
Replies from the Austrian Ministry of Finance
(Express Answer Servicereplies)
EAS replies are also published without company-specifc data but with a short
summary of the relevant facts. Recently, several EAS replies have been signifcant,
details of which are as follows:
A company resident on the Virgin Islands holds intangibles (licences). These
rights are administratively used via an affliated company, resident in Guernsey.
An Austrian company is responsible for public relations, launching products
and arranging licence agreements. The consideration for services performed is
calculated according to the cost-plus method. In the reply, the Ministry of Finance
pointed out that if these facts are correctly stated, it cannot be required by the
Austrian tax authority that the intangibles be transferred to Austria and that the
royalties be taxed in Austria. This is valid provided the consideration received
by the Austrian company from other affliated companies corresponds with the
functions performed and the companies adhere to the OECD Guidelines.
An Austrian taxpayer acting as either contract manufacturer or commission agent
must provide adequate documentation to show that its activities are subordinate
to the principal, and in particular that it is not involved in the sale of the products
in the Austrian market in its own name. This documentation requirement is
especially onerous for a taxpayer who has previously been characterised as a fully
fedged manufacturer or distributor. In this case, the taxpayer must document how
its new status as a contract manufacturer or commission agent is refected by a
corresponding decrease in its functions and risk profle. The Austrian ministry has
provided some legislation for determining the status of such taxpayers.
Also in the context of the reorganisation of an Austrian distribution company into a
commission agent or commissionaire, the Ministry of Finance issued a letter ruling
that deals with goodwill aspects. The Ministry stated that if the subsidiary being
transformed does not receive any compensation for investments with respect to
customers, this might be deemed to deprive the subsidiary of the customer base
it has created throughout the past, as a result, constituting an infringement of the
arms-length principle. This is the view conveyed by some OECD member countries
in the course of an OECD working group on commissionaire arrangements. As
long as these OECD working papers are not fnal, the Austrian Ministry of Finance,
however, will not publish further general guidance on goodwill issues, but explicitly
refers such cases to the local tax offce.
In connection with the reorganisation of an Austrian distribution company into
a commissionaire, the Austrian Ministry of Finance stated that the Austrian
distribution company downsized to a commissionaire constitutes a PE of the French
parent company. Under the AustriaFrance double taxation agreement (DTA),
a French production entity has a PE in Austria when it sells its products through
a dependent agent that has binding authority for sales contracts. According to
the ministry, the dependent status is substantiated by the fact that the Austrian
subsidiary performs the sales activity for the French parent company only and it has
to follow the French producers instructions with regard to the product sales.
As part of a new group strategy, a Germany-based parent company closed its
manufacturing subsidiary in Austria and transferred the production activity to
Poland. According to the Austrian Ministry of Finance, the Austrian company
Austria
should be compensated for the estimated future proft potential lost through the
restructuring. To calculate the arms-length remuneration, it needs to be analysed
which assets, tangibles as well as intangibles, were transferred to the Polish
company. Furthermore, it has to be defned which entity receives the economic
beneft out of the restructuring to be able to determine by whom (i.e. the German
parent company, the Polish company or both jointly) the compensation has to
beborne.
In the absence of suitable comparables, an Austrian taxpayer providing
procurement services to a Swiss affliate may be remunerated on a cost-plus basis.
However, the taxpayer must show that it is providing pure procurement services
rather than acting as a buysell intermediary.
If an Austrian parent makes a one-time payment as a consideration for intangible
property (e.g. software) and associated technical support for the beneft of other
group companies, the Austrian tax authorities may deem the parent and those
affliates to have entered into a cost-sharing arrangement. Any cost-sharing
payments received by the Austrian parent would not be regarded as licensing
income and consequently would not be subject to withholding tax. However, this
holds true only if economic ownership is transferred to the cost-sharing affliates
(the transfer of a mere usage right is not suffcient).
A Japanese company was active in the feld of assisting in and enhancing export
activities of Austrian and other European manufacturing companies to Japan. One
of the members of the board of directors located in Austria performed the following
functions: assisting Japanese clients on their business trips to Austria, providing for
translations and executing managing activities on behalf of the Japanese company
(e.g. fnancing and management planning). This was deemed to be exceeding mere
preparatory and/or auxiliary activities, consequently creating a PE, if performed
from his dwelling in Austria. However, even if this Austria-based member of the
board of directors did not use his dwelling to carry out these activities (i.e. the
Japanese company being deemed to dispose of a fxed place of business in Austria),
the Austrian Ministry of Finance took the view that this Austria-based member
being entitled to form framework agreements on behalf of the Japanese company
would be deemed to be a dependent agent, as a result, creating a PE in Austria.
With respect to the allocation of profts to this Austria-based PE, the Austrian
Ministry of Finance deemed the cost-plus method to be appropriate. However,
in view of the fact that this PE would be very small, the Ministry explicitly stated
that a markup amounting to 5% to 10% should not be challenged, referring to a
respective German decree regarding controlling and coordination centres (BStBl. I
1984, 458).
The Austrian Ministry of Finance published an EAS reply concerning an Austrian
parent company that provides software (online games) through its subsidiary,
located on Gibraltar. The server that is needed for this business activity is
owned by the Austrian parent company and set up in Austria. The subsidiary on
Gibraltar concludes the sales contracts with the third-party customers. According
to the Austrian Ministry of Finance, this fact does not automatically lead to the
assumption that the subsidiary should receive the residual proft while the parent
company, performing the whole management activities, is remunerated as mere
service provider. Given such a case, it has to be frst defned by conducting a proper
A
functional analysis of which entity acts as entrepreneur and which one performs
routine functions. Based on this analysis, the entities have to be remunerated
at arms length. The question, if the server located in Austria establishes a PE of
the foreign subsidiary, must be answered in a next step following the functional
analysis and the determination of profts.
A server of an Austrian software company located in Liechtenstein is deemed to
create a PE. In a comment to this letter ruling, it was held that allocation of proft
to this PE would be based on the cost-plus method, whereas the main part of proft
derived from the development and marketing of the software should be allocated
to the respective department of the company as these functions, being essential for
the company in deriving its proft, could in no case be attributed to a machine.
The resale minus method is deemed to be the most adequate method to deduce
arms-length purchase prices for captive distribution companies. However, if this
method cannot reasonably be applied in a given case, the transactional net margin
method (TNMM) might be used. Generally, TNMM requires an examination on a
transaction-by-transaction basis. However, if an enterprise performs only one kind
of transactions (e.g. the distribution of cosmetics), the different transactions can
for the sake of simplifcation be regarded as one transaction when applying TNMM.
In case of inter-company loans, the Ministry of Finance is of the opinion that
the interest rate that should be paid to an independent bank is not a suitable
comparable since the credit risk borne by the independent bank is not comparable
to that which arises within the inter-company fnancing. The applied group
strategy can infuence the creditworthiness of the group entity borrowing from a
related party; however, this effect does not prevail in the same way if the lender
is an unrelated bank. The Ministry also referred to a German court decision that
stated that debit interest customary in banking cannot be applied as arms-length
intragroup interest since the lender group company does not practise banking
business and therefore does not have to bear the related costs (BStBl II 1990, 649).
Although in an EAS reply it is not possible to determine the exact arms-length
interest rate for an inter-company loan, the letter ruling suggests examining in
detail whether the credit risk related to an inter-company loan is actually higher
than that borne by interbank loans. If this is not the case, according to the Ministry,
the interbank interest rate (e.g. EURIBOR) should be applied without markup.
Further to this EAS reply, the Austrian Ministry of Finance has published in the
form of an administrative decree its view on inter-company loan transactions and
the appropriate interest rate. According to this, interest rates paid by Austrian
borrowers should lie in a range between the deposit interest rate of the lender
and the market credit interest rate of the borrower, which would be applicable for
parent guaranteed loans. The Ministry also suggests that to determine the adequate
inter-company interest rate, a detailed functional and risk analysis should be
conducted, including an analysis on the equity capitalisation of the lender. In case
of doubt, the mean value of the above range should be chosen. As an alternative,
the Ministry recommends using Euribor + 0.25%. The administrative decree
reveals a high degree of suspicion in relation to group fnancing entities located in
a tax haven. In such cases, according to the Ministry, cost-based remuneration (for
the fnance entity) is considered appropriate. This may consist of the refnancing
expenses at cost, as well as the relevant administrative costs plus a small markup.
Austria
If an Austrian company owned by an Austrian parent company has established a
fnance branch in Switzerland, the income of the Swiss branch is subject to Austrian
corporate income tax by virtue of the Austrian companys unlimited tax liability. To
decide whether, based on the AustriaSwitzerland DTA, the income of the Swiss
fnance branch has to be exempt from Austrian tax, the following issues have to
beexamined:
a. Does the Swiss branch constitute a PE in Switzerland based on the Austrian
General Fiscal Code? This would be the case if the branchs fxed place of
business in Switzerland enables it to carry out operating functions (instead of
merely holding activities).
b. Does the Swiss branch in fact perform the fnancing activity?
If the Swiss branch can effectively be regarded as a PE and carries out the
fnancing activity, the interest earned has to be allocated to the branch. The
Austrian company should therefore solely recognise remuneration for providing
management and support functions.
Sarbanes Oxley (SOX)-related costs arising in connection with the implementation
of an internal control system in a US-based group are deemed not to be deductible
with the Austrian subsidiary. The Austrian Ministry of Finance stated that SOX-
related costs have to be seen in connection with the control function of the US
parent company. Such costs can be borne by the Austrian subsidiary only if (and to
that extent) it benefts from the internal control system. Such benefts have to be
specifcally measurable.
The Austrian Ministry of Finance has interpreted a similar view in relation to costs
incurred through the implementation of a new software system within the whole
group. These costs are not a priori tax-deductible in Austria. The company has
to prove that changing its software system is needed and directly benefts from
the company. Incidental benefts of the groupwide implementation such as an
increasing effciency or synergy effects do not constitute such direct benefts. As
already described previously, the benefts of the Austrian group entity have to be
specifcally measurable.
A leased employee is deemed to create a dependent agent PE for a German
company in Austria provided he is dependent on the foreign (German) principal
and has to follow the principals instructions. The agent does not need to be directly
employed by the German principal.
A Swiss parent company intended to charge its Austrian subsidiary for using the
groups brand. According to the Austrian Ministry of Finance, this licence fee to be
paid by the Austrian distributor is treated as tax-deductible in Austria only if it is
determined at arms length. Based on this, in general, a distributor that only sells
branded products does not pay a licence fee for the producers brand in addition to
its purchase price. Therefore, the Ministry states that under such circumstances, a
licence payment seems to be not at arms length.
A
As a matter of principle, the tax authorities carry the burden of proof. If the tax
authorities challenge a tax return, the taxpayer does not have to prove the accuracy
of the return; rather, the tax authorities would have to prove the contrary. However,
based on the fact that tax authorities are entitled to ask for the documentation of
transfer pricing, if an accurate documentation is not provided, the burden of proof
switches to the taxpayer. In addition, in international tax cases, the taxpayer bears a
special liability of cooperation (see section 1406).
In Austria, it is not usual for the tax authorities to carry out an audit specifcally in
respect of transfer prices alone. However, recently experience shows that already at the
beginning of a tax audit, inspectors request a description of the transfer pricing system
in place. Typically, transfer prices represent one part of a tax audit. If transfer pricing
or benchmarking studies exist, they have to be provided to the tax auditors. The tax
authorities have special experts who are retracing and reviewing the correctness and
comparability of such studies.
The tax authorities aim at auditing companies exceeding certain size thresholds on a
three- to fve-year basis.
For smaller companies, there are three possible ways for a company to be selected for a
tax audit:
Time Those companies that have not been audited for an extended period are
likely to be selected.
Industry group selection Tax authorities might focus on certain industries from
time to time.
Individual selection Some companies are selected individually, based on
professional judgement or exceptional fuctuations in key ratios.
The provision of information and duty of the taxpayer to cooperate with
the tax authorities
The taxpayer has a general duty to cooperate with the tax authorities, although
decisions of the Administrative Court indicate that there is a limit to this duty insofar
as the tax authorities cannot demand impossible, unreasonable or unnecessary
information from the taxpayer.
There is an increased duty to cooperate where transactions with foreign countries are
involved. Under this increased duty to cooperate, the taxpayer has a duty to obtain
evidence and submit this to the tax authorities. The possibility of administrative
assistance from other (foreign) tax authorities does not suspend the duty of the
taxpayer to cooperate with the Austrian authorities.
1407 The audit procedure
There is no special procedure for transfer pricing investigations, which are seen as part
of a normal tax audit. In this procedure, the tax auditors visit the companys premises,
Austria
interview the relevant company personnel and inspect the companys books and
records. As far as transfer pricing is concerned, tax inspectors increasingly request a
summary of the transfer pricing system applied.
It should be noted that the conduct of the taxpayer during the tax audit can
signifcantly affect both the outcome of the inquiry and the amount of any adjustment.
If the taxpayer is able to maintain an objective approach and can provide good
documentary evidence to support the transfer pricing scheme in place, he or she will
have a much better chance of defending it against any adjustments proposed by the
taxauthorities.
After the end of a tax audit, the tax inspector usually issues a list of fndings, which
is discussed with the company and/or the tax adviser. If the company agrees to the
fndings, the list forms the basis for the revised assessments covering the audited years.
If, however, agreement could not be reached on any particular issues, then the tax
offce would still issue revised assessments in accordance with the inspectors fndings
but the company could appeal against the assessments.
If an appeal is fled by the company, it will be heard by the Tax Appeals Board
(Unabhngiger Finanzsenat). The company may fle a further appeal against a decision
of the Tax Appeals Board with the Administrative High Court.
If tax is paid late, a late payment surcharge will be imposed, amounting to 2% of
the unpaid amount. An additional surcharge of 1% would be levied if tax is not paid
within three months as of the date it has become due and an additional 1% in case of
late payment of the second surcharge. This surcharge is not tax-deductible, and no
supplementary interest will be charged. If, however, the tax liability relating to past
years is increased as a result of a tax audit, interest will be charged on the difference
between the tax paid and the fnal tax assessed. The period for which interest is
levied starts from October following the assessment year and lasts for 48 months at a
maximum. The interest rate amounts to 2% above the base interest rate.
Within the tax audit department, there are units that specialise in international
transactions. The staff in these units receive special training, which includes
participating in audits and training courses in other countries. Indeed, the number
of these specialised auditors has been constantly increasing in recent years. Inquiries
are normally undertaken by tax inspectors from the tax audit department without the
assistance of lawyers, economists or other kinds of experts. The tax authorities have
access to the Orbis/Amadeus database. Mutual agreement procedures are conducted
by the Ministry of Finance.
A
Use
It is very important that the taxpayer prepares reasoned documentary evidence of the
issues that were considered when determining the transfer prices. This documentation
should be prepared before any transactions occur using those transfer prices.
The Austrian tax authorities have gained much experience lately by increasing the
number of transfer pricing audits. They have recently formed a strict view on what
constitutes a reasonably reliable process for using databases to provide comparable
data on margins or profts. Critical elements of the search strategy are geographic
region (Central and Eastern Europe is not readily comparable), independence criterion
(25% preferred), loss-makers, size and intangibles.
Availability
If a company is legally obliged to publish its fnancial statements (such a requirement
exists for all companies other than very small partnerships and individual enterprises),
then there is access to the fnancial information contained therein; otherwise, access to
such information is not normally publicly available.
If the transfer pricing policy of a company were being investigated by the tax
authorities, it would be possible for advisers to use information on comparable
companies in defence of the policy of the investigated company. Such information is,
however, extremely diffcult to obtain. Furthermore, tax advisers are bound to keep
confdential any information obtained on other clients in the course of their work. Tax
authorities certainly have access to more information than advisers, and this would
be obtained through investigations into other taxpayers transfer pricing policies;
however, the tax authorities too are bound to keep this information confdential.
There are no particular transactions that run a higher risk of being attacked than any
other transactions. However, it can be stated that transactions with group companies
based in low-tax jurisdictions, cross-border transfer of functions and fnancing
transactions are regularly examined.
If a double taxation treaty exists that contains provisions for mutual agreement
procedures, it is very likely that these procedures would be used to avoid double
taxation. According to information obtained from the Ministry of Finance, there are
only a few cases where such an agreement between the tax authorities involved could
not be reached. In such cases or where there is no double taxation treaty, settlement
could be achieved under the Arbitration Convention. (The convention re-entered
into force retroactively as of 1 January 2000. Currently the Convention is applicable
between Austria and the 14 other pre-2004 European Union Member States except
Greece). Otherwise, Article 48 of the Austrian Fiscal Code and a decree of the
Ministry of Finance provide unilateral measures to avoid double taxation where no
DTA is applicable. Taxpayers subject to taxation on Austrian-sourced income may fle
Austria
an application for a double taxation relief to the Ministry of Finance, and it may be
granted at the Ministrys discretion.
The competent authority procedure may be initiated by the taxpayer, too. In case
no competent authority procedure clause is given under the respective DTA, double
taxation may be avoided by administrative assistance proceedings (EC Administrative
Assistance Directive and EC Administrative Assistance Act) carried out by the tax
auditauthorities.
There is no formal procedure for obtaining advance pricing agreements (APAs)
in Austria. Nevertheless, the Austrian Ministry of Finance recently entered into
agreements (similar to APAs) with foreign tax administrations on the basis of Article 25
(competent authority) of an applicable DTA.
As noted previously, at present it is possible to obtain a ruling from the Ministry of
Finance in connection with a particular transfer pricing issue, but such a ruling is
not binding on either the tax authorities or the taxpayer. Furthermore, the Ministry
provides guidance on legal questions only. Therefore, no ministerial ruling can be
obtained on whether the transfer prices in a specifc case comply with the arms-length
principle. In such a case, a ruling from the competent tax offce can be obtained.
However, it usually releases a tax audit with the taxpayer in Austria. A draft law
regarding the implementation of binding rulings was published recently (see detail
in1415).
Detailed transfer pricing guidelines are expected to be issued by the Austrian Ministry
of Finance in 2010. In addition, the Ministry recently issued a draft law that should
enable taxpayers to ask for binding APAs regarding certain issues in taxation such as
transfer pricing. It is intended that fees between EUR1,500 and EUR20,000 will be
charged for such APAs depending on the companys size. These regulations will become
effective as of 1 January 2011.
Tax authorities and customs authorities may exchange information. Experience
suggests, however, that different authorities do not in fact deal very closely with each
other where transfer prices are concerned.
Transfer pricing adjustments for direct tax purposes are not normally refected in
declarations and assessments, respectively, for customs or any other indirect taxes.
1417. OECD issues
Austria is a member of the OECD. In our experience, the Austrian Ministry of Finance
is very inclined to follow the positions of the OECD as expressed in the Model
Commentary and the various OECD reports (e.g. partnership report, report on the
attribution of profts to a PE).
A
A joint investigation by Austria and other countries tax authority is possible on a
bilateral basis by referring to a clause in an applicable Double Tax Treaty as well as on a
bi- or multilateral basis through multilateral controls. The latter possibility is available
through Austrias participation in the EUs Fiscalis 2013 programme. This programme
aims at improving the functioning of the tax system in the EU by strengthening
cooperation between participating countries, their administrations and any other
bodies. Multilateral controls have become standard procedures in Austria and take on
average one and a half years. The legal basis for multilateral controls varies depending
on the type of tax involved and can include one or more of the following sources:
Regulation 1798/2003 for VAT (Art 12-13);
Council Directive 77/799/EEC for direct taxes;
Council Directive 92/12/EEC and Regulation 2073/2004 for excise taxes;
Double Tax Treaties and OECD Convention on Mutual Administrative Assistance in
Tax Matters; and
Decision No. 2235/2002/EC.
There are no statutory rules on permissible debt equity ratios. As a rule of thumb,
debt to equity ratios of 3:1 would in principle not be challenged by tax authorities,
provided the terms of the debt are otherwise at arms length. A recent decision of
the Tax Appeals Board indicates that even a much higher debt to equity ratio could
be permissible provided that the ability of the company to pay the interest rates and
to repay the loan principal at maturity date are supported by a business plan that is
based on realistic assumptions. However, it is not clear whether the Administrative
High Court will confrm this position. Where, for example, the interest rate is higher
than an arms-length rate, the consequences are that a deduction would be denied for
the excessive interest, that corresponding amount would be qualifed as a constructive
dividend and withholding tax would also be payable . (There is normally no
withholding tax on interest payments to foreign lenders, whether related or unrelated,
unless the loan is secured by real estate.)
1420. Management services
Where the amount of a management charge has been calculated on an arms-length
basis, the management fee would normally be tax-deductible. The following issues
should, however, also be considered where management services agreements are
beingconcluded:
A detailed contract should be drawn up;
The terms of the agreement should not be retroactive; and
Documentary evidence to substantiate the provision of services and its benefts to
the recipient should be maintained.
Azerbaijan
15.
International Transfer Pricing 2011 243 Azerbaijan
1501. Introduction
The transfer pricing concept is relatively new to Azeri tax law, although in the pre-
tax code legislation there were some limited transfer pricing regulations focused
principally on circumstances where goods, work, or services were sold at or below cost
or bartered/transferred without charge.
The current transfer pricing rules were introduced in the current tax code effective
from 1 January 2001, and have been amended several times since then. These rules
mainly focus on the determination of prices on the sale of goods, work, or services and
establish the principle of arms-length pricing for transactions between related parties
and, in certain instances, the approach for making adjustments to transfer prices.
In practice, the tax authorities have limited experience in dealing with transfer pricing,
mainly making adjustments to taxpayers profts by disallowing certain deductible costs
or challenging interest rates or the markup on services that were not, in their opinion,
incurred or charged on an arms-length basis.
Scope
Under the tax code, market price is defned as the price for goods, works, or services,
based on the relationship of demand and supply. A contractual price should be deemed
the market price between counterparties for tax purposes, unless the contract or
transaction falls under one of the exceptions below.
Under the tax code, the tax authorities may apply market price adjustments in the
following cases:
Barter transactions;
Import and export operations;
Transactions between related persons;
Transactions in which the prices within 30 days deviate by more than 30% either
way from the prices set by the taxpayer for identical or homogeneous goods, works,
or services; and
A property of an entity was insured for the amount exceeding net book value of
such property.
A
Azerbaijan 244 www.pwc.com/internationaltp
Related parties
Persons are considered related in the following cases:
If one person holds, directly or indirectly, 20% or more of the value or number
of shares or voting rights in the other entity, or in an entity that actually controls
bothentities;
If one individual is subordinate to the other with regard to offcial position;
If persons are under the direct or indirect control of a third person; and
If persons have a direct or indirect control over a third person.
Pricing methods
The tax code lists the following methods for determining the market price:
Comparable uncontrolled price (CUP) method;
Resale price method; and
Cost-plus method.
The tax code establishes the priority of pricing methods to be used by the tax
authorities to determine market prices, according to which the CUP method should be
used frst before all other methods.
If the determination of the market price is not possible under any of the methods
above, the market price should be determined by an expert.
Comparability factors
In determining the market price, the tax authorities are required to take into account
usual discounts from, or markups to, prices. In particular, the tax code gives specifc
circumstances of how the discounts or markups can be caused, such as deterioration of
the quality of goods or the expiry of a products life.
In addition, the tax code sets out the commonly accepted principle that, for the
purposes of determining the market price, only transactions carried out under
comparable conditions should be taken into account. In particular, the following
factors should be evaluated:
Quantity (volume) of supply;
Quality level of goods and other consumption indicators;
Period within which liabilities should be fulflled;
Terms of payment;
Change of demand for goods (works, services) and supply (including seasonal
fuctuations of consumer demand); and
Country of origin of goods and place of purchase or procurement.
In the Profts Tax section of the tax code, there is a separate list of comparability factors
that should be looked at to identify borrowings that can be treated as taking place
under comparable circumstances. In particular, borrowings should take place in the
same currency and be under the same terms and conditions.
There is no statutory requirement in Azeri law that requires transfer pricing
documentation to be prepared, apart from a general requirement for taxpayers to
International Transfer Pricing 2011 Azerbaijan 245
Azerbaijan
maintain and retain accounting and tax records and documents. It is, however, clear
that taxpayers that do not take steps to prepare documentation for their transfer
pricing systems, in general or for specifc transactions, will face an increased risk of
being subject to an in-depth transfer pricing audit.
Other regulations
Currently, besides linked provisions stipulated in the tax code, there are no other
specifc regulations in Azerbaijan relating to transfer pricing.
1503. Legal cases
Very few court cases have been related to transfer pricing in Azerbaijan.
Under the tax code, the burden of proof rests with the tax authorities to demonstrate
that the price charged by a taxpayer signifcantly fuctuates from the market price.
Unless otherwise proved, prices set by taxpayers are deemed to be the market prices.
However, if the documentation requested by the tax authorities is inappropriate
or unavailable, then the tax authorities can determine the adequate pricing levels,
whereby the burden of proof would be shifted to the taxpayer.
Currently, the tax authorities do not have specifc procedures in the tax code for
conducting separate transfer pricing audits. Control over prices is primarily made in
the course of tax audits.
Taxpayers have the right to appeal to higher level tax authorities or to court.
There is no separate penalty regime for the violation of transfer pricing rules; however,
transfer pricing adjustments made by the tax authority in the course of a tax audit that
would increase the taxable revenue of the taxpayer (e.g. by disallowing the deduction
of the costs in relation to excessive pricing levels), may lead to the underpayment
oftax.
In case of a successful challenge by the authorities, a penalty of 50% of the
underestimated tax may be imposed on the taxpayer. In addition, an interest payment
of 0.1% per day also would accrue until the tax is paid in full.
Although the arms-length principle has existed in the tax legislation since 2001,
the enforcement of this principle is not common practice. Absence of statistical
information for benchmarking purposes and the lack of modern information systems
hamper the effective application of transfer pricing regulations in Azerbaijan.
Azerbaijan 246 www.pwc.com/internationaltp
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The tax code provides that comparables for the determination of market prices are
to be taken only from offcial and open information sources. The tax code does not
defne or specify what sources are considered offcial and open, but gives examples
of such possible sources databases of authorities in the specifc market, information
submitted by taxpayers to tax authorities, or advertisements.
In practice, in the majority of tax audits where transfer pricing issues have been raised,
the tax authorities have relied on information they collect from other similar taxpayers,
or directly from alternative producers or sellers of similar goods in the local market
(primarily, state-owned concerns). Information published by the State Statistics
Committee has not been commonly used.
Occasionally, the Azeri tax authorities undertake extensive data-gathering involving
comparables to obtain an in-depth knowledge of specifc industry practices and
pricing policies. The data obtained from comparables have been used in some cases
to make transfer pricing adjustments on a single-transaction basis without regard
to overall company proftability or multiple-year data. In that situation, taxpayers
have been faced with considerable diffculty in challenging the position, as no
specifc data is provided on the comparables to allow verifcation and submission of
counter-arguments.
1510 Risk transactions or industries
The types of transactions typically scrutinised by the Azeri tax authorities in tax
auditsinclude:
Sale/purchase of goods, where the supplier is an overseas entity, even unrelated to
the taxpayer;
Provision of centralised head-offce services, and technical/management fees;
Import transactions and recovery of related input value added tax (VAT); and
Interest rates on inter-company loans.
All industries are subject to the transfer pricing regulations in Azerbaijan.
Currently, there are 25 effective double-tax treaties with Azerbaijan. However, there is
no experience with the application of the transfer pricing provision in those treaties.
Currently, there are no procedures in Azerbaijan for obtaining an advance pricing
agreement (APA). However, it is possible to obtain a written opinion from the tax
authorities on transfer pricing issues. Such opinions are not binding.
International Transfer Pricing 2011 Azerbaijan 247
Azerbaijan
The Ministry of Taxes has started consultations with the Organisation for Economic Co-
operation and Development (OECD) on adopting new, more detailed transfer pricing
regulations. The general expectation is that the OECD-type guidelines and models will
be adopted in Azerbaijan at some point in the future, but the government has not yet
indicated a target date.
The tax and customs authorities communicate with each other on various transfer
pricing issues and have access to each others respective databases.
1515. OECD issues
Azerbaijan is not a member of the OECD. However, as mentioned, the general
expectation is that the OECD-type guidelines and models are expected to be adopted
inAzerbaijan.
Usually, transfer pricing investigations are conducted by the tax authorities only.
However, in some audits the tax authorities have engaged experts from other
governmental bodies, such as the Ministry of Justice, the State Customs Committee
and others.
There are no thin capitalisation rules in Azerbaijan.
Currently, there are no specifc rules or unifed practice with regard to the application
of the transfer pricing rules to management service charges in Azerbaijan.
Belgium
16.
B
Belgium
1601. Introduction
The Belgian tax authorities turned their attention towards transfer pricing in the
early 1990s. Belgium is now becoming more aggressive in the feld of transfer pricing
as it becomes increasingly aware of the active interest adopted (typically) in the
surrounding countries and the risk of seeing Belgiums taxable basis eroded. This focus
on transfer pricing resulted in the issuing of a Dutch/French translation of the 1995
OECD Guidelines (and the 1996, 1997 and 1998 additions thereto) and of a revenue
document that comments on the 1995 OECD Guidelines and serves as an instruction
to tax auditors. As of 1 January 2003, the Belgian government also introduced a new
broadened ruling practice aimed at providing foreign investors upfront certainty
regarding their ultimate tax bill. In 2004, further changes to the ruling procedure were
made to enhance a fexible cooperation between taxpayers and the Ruling Commission.
A specialist transfer pricing team has been established and, in 2006, the Belgian tax
authorities also installed a special transfer pricing investigation squad. Finally, during
2006, the Belgian government issued a second transfer pricing practice note endorsing
the EU Code of Conduct on transfer pricing documentation.
The Belgian Income Tax Code (ITC) did not provide specifc rules on inter-company
pricing until mid-2004, with the formal introduction of the arms-length principle in a
second paragraph to Article 185 of the ITC.
In addition, the authorities can make use of other more general provisions in the ITC to
challenge transfer prices. For example, in some cases where the Belgian tax authorities
raise the issue of transfer pricing, the general rules on the deductibility of business
expenses are applicable. Furthermore, the ITC contains provisions that tackle artifcial
inbound or outbound proft shifting. These are the so-called provisions on abnormal or
gratuitous benefts.
Arms-length principle
In 2004, article 185 of the ITC was expanded to include the arms-length principle in
Belgian tax law for the frst time. Article 185, paragraph 2 of the ITC now allows for a
unilateral adjustment to the Belgian tax basis, similar to the corresponding adjustment
of Article 9 of the OECD Model Double Taxation Treaty. The underlying assumption
is that, in case of downward adjustment, the excess proft forms part of the profts
of the foreign-related party. Which part of the proft is deemed to be derived from the
related party dealings and how the part of the profts of the foreign-related party
condition should be interpreted, has yet to be agreed with the Ruling Commission.
Various rulings on this topic have been issued in the meantime.
International Transfer Pricing 2011 Belgium 249
Belgium
Deductibility of expenses
General rules
The general rule concerning the deductibility of expenses is contained in Article 49
of the ITC. This article stipulates that a tax deduction is allowed only if an expense is
incurred for the beneft of the taxpayer and is connected with the taxpayers business
activity. This connection must be demonstrated by the taxpayer. The expense itself
must be real and necessary; incurred to obtain and retain taxable income; and be paid,
accrued or booked as a defnite and fxed liability during the taxable period.
Since 1 January 1997, this general rule on the deductibility of business expenses
is more closely monitored before tax relief is granted with respect to fees paid to
companies for conducting a directors mandate or other similar functions as well
as for other management services. The burden of proof lies on the taxpayer, who
must now justify the professional character of these fees. Furthermore, the fees
which unreasonably exceed the professional needs of the company are taxed as
disallowedexpenses.
Excessive expenses
As a matter of principle, the tax authorities and courts may not test whether a business
decision was expedient. Although the company bears the burden of proof that
expenses are necessarily linked with its operations or functions, the authorities have no
right to question whether the expenses are useful or appropriate. However, Article 53
of the ITC provides that relief may be denied for any excessive expenses incurred, and
this will be the case if the expense is not reasonable in light of the activities carried out.
No case law exists on the application of this article in the context of transfer pricing.
Interest payments
Article 55 of the ITC provides that interest paid is a tax-deductible business expense,
provided that the rate of interest does not exceed normal rates after taking into account
the specifc risks of the operation.
Abnormal or gratuitous benefts
Article 26 of the ITC provides authority for the taxable profts of individual companies
or enterprises in Belgium to be increased where the authorities can demonstrate that
any proft transfers were abnormal or gratuitous benefts granted to individuals
or companies established in Belgium or abroad. This does not apply if the benefts
transferred are subject to (Belgian) tax in the hands of the recipient(s). Although this
article seems to have become obsolete because of the formal introduction of the arms-
length principle in Belgian tax law by Article 185, paragraph 2 of the ITC, this is not
true for situations where the latter article does not apply. This may, for example, be the
case for pure Belgian transactions where the recipient of the beneft is not subject to
taxation on said advantage.
The Belgian ITC does not defne abnormal or gratuitous benefts and, consequently,
the issue has been subject to review in the courts. Case law suggests that abnormal
refers to that which is not consistent with common practice, while gratuitous refers
to the fact that a beneft is not granted in the course of the execution of a contractual
obligation, but is granted where there is none or insuffcient consideration (Court of
Cassation, 31 October1979, NV Regents Park Co Belgium, Bull. Bel. 590).
The Belgian legislator inserted in Article 26 paragraph 1 of the ITC the following
wording: notwithstanding the application of Article 49. This means that the
Belgium 250 www.pwc.com/internationaltp
B
application of Article 26 of the ITC does not exclude the application of Article 49 of the
ITC. In other words, even if the abnormal or gratuitous beneft is taken into account
for determining the taxable basis of the benefciary, the tax deductibility of the related
expenses can still be denied in the hands of the grantor. This could result in economic
double taxation. This provision has come into play as from tax year 2008.
Article 207 of the ITC provides that a Belgian company that receives (directly or
indirectly) abnormal or gratuitous benefts from a company upon which it is directly
or indirectly dependent, may not use any current year losses or losses carried forward,
nor may it apply the participation exemption, investment deduction or notional
interest deduction against the taxable income arising from the beneft. In an answer
to a recent Parliamentary question (L. Van Campenhout, 2 April 2004), the Belgian
Minister of Finance has given a very broad interpretation to this provision by declaring
that in the case of received abnormal or gratuitous benefts, the minimum taxable
basis of the receiving company equals at least the amount of the beneft. The previous
administrative tolerance under which abnormal or gratuitous benefts received from
abroad were not tackled has been abolished as from tax year 2004.
Notional interest deduction
On 22 June 2005, the Belgian tax law on the notional interest deduction was passed.
The new rules are intended frst to ensure equal treatment of debt and equity funding,
and, second, to provide a successor to the Belgian coordination centres.
Companies liable to Belgian corporation tax (including Belgian branches of foreign
companies) are granted a notional interest deduction equal to the 10-year state bond
rate on the equity shown in the companys individual Belgian fnancial statement. The
equity requires slight alteration (e.g. holdings in subsidiary companies (inter alia) are
to be trimmed off in assessing the relevant equity fgure).
To the extent that the interest deduction does not have a direct tax effect (e.g. in loss
situations), the interest deduction can be carried forward for the next seven years. The
measure thus allows obtaining tax relief for what is deemed an arms-length interest
rate calculated on the adjusted equity for which no charge is reported in the proft and
loss statement.
The notional interest deduction results in a yearly deduction from the tax base equal to
a percentage 4.473% for assessment year 2010 and 3.8% for assessment years 2011
and 2012 of the companys adjusted equity.
The legislation has come into force as from assessment year 2007 (i.e. fnancial years
ending on or after 31 December 2006).
Patent income deduction
On 27 April 2007, the Belgian parliament approved the law introducing a tax deduction
for new patent income (PID) amounting to 80% of the income, thereby resulting in
effective taxation of the income at the maximum rate of 6.8%.
To beneft from the PID, the Belgian company or branch can exploit the patents owned
by it, or licensed to it, in different ways.
Belgium
A frst option available to the Belgian company or branch is to licence the patents or
extended patent certifcates to related and unrelated parties.
Alternatively, the Belgian company or branch can exploit the patents by
manufacturing, or having manufactured by a contract manufacturer, products in which
the patents are used and supply the products to related or unrelated customers. It may
also use the patents in the rendering of services.
For patents licensed by the Belgian company or branch to any related or unrelated
party, the PID amounts to 80% of the gross licence income derived from the patents
and patent certifcates, to the extent the gross income does not exceed an arms-length
income. The PID applies to variable and fxed patent licence fees, as well as other
patent income, such as milestone payments.
For patents used by the Belgian company or branch for the manufacture of patented
products manufactured by itself or by a contract manufacturer on its behalf the PID
amounts to 80% of the patent remuneration embedded in the sales price of patented
products. In the case of services, the PID amounts to 80% of the patent remuneration
embedded in the service fees.
The new tax measure is aimed at encouraging Belgian companies and establishments
to play an active role in patent research and development, as well as patent ownership.
The tax deduction is to apply to new patent income and has come into force as from
fnancial years ending on or after 31 December 2007.
1603. Administrative guidelines
Initial guidelines
On 28 June 1999, administrative guidelines were issued relating to transfer pricing.
The guidelines are broadly based on the OECD Guidelines. The reason for issuing the
guidelines is of a purely offensive nature. The guidelines stipulate that Belgium risks
being forced to make corresponding downward proft adjustments if no adequate
measures are taken to counterattack aggressive revenue action in other countries.
Although no specifc penalty rules are imposed, the guidelines urge tax inspectors
to carry out in-depth transfer pricing audits where the taxpayer fails to show
documentary evidence that efforts have been made to fx arms-length inter-
company prices. Consequently, taxpayers may beneft from preparing a defence fle
upfront, substantiating their transfer pricing methodology. In addition, the guidelines
underscore the importance of conducting a proper functional analysis and refer to a list
of generic functional analysis questions.
Guidelines on Arbitration Convention
On 7 July 2000, the Belgian tax authorities issued administrative guidelines on the
technicalities of applying the Arbitration Convention. The guidelines offer guidance
to taxation offcers and tax practitioners into how the tax authorities will apply the
Convention. It is also an acknowledgement by the Belgian tax authorities of the need to
develop an effcient practice to resolve issues of international double taxation.
B
Guidelines on transfer pricing audits and documentation
Introduction
The Belgian tax authorities published, in November 2006, administrative guidelines on
transfer pricing audits and documentation.
In light of certain recent developments, such as the formal set-up of a specialist
transfer pricing investigation squad and the approved EU Code of Conduct on transfer
pricing documentation, the need had obviously arisen in Belgium for an update of the
previous transfer pricing administrative guidelines and for new guidance, particularly
on transfer pricing audits and documentation requirements. The 2006 administrative
guidelines fll this need and, at the same time, confrm the integration in Belgian tax
practice of the EU Code of Conduct. The Code of Conduct is added as an appendix to
the administrative guidelines.
Cases with a higher risk of prompting an audit
The administrative guidelines contain a list of cases (which is not exhaustive) where
it may be advisable to check the transfer pricing practices. Among the situations
listed in the administrative guidelines are transactions with tax havens and low-
tax jurisdictions, back-to-back operations, and so-called guidelines/conduit
structures, as well as situations that are much more frequent (i.e. entities that suffer
structural losses, business reorganisations or migrations and the charge-out of
managementfees).
Pre-audit meeting
The administrative guidelines acknowledge the fact that an investigation into the
transfer pricing dealings of a business and the documentation relating thereto form
a complex whole and are signifcantly affected by widely diverse company-specifc
factors. To this end, the administrative guidelines suggest the possibility of holding a
pre-audit meeting before issuing any transfer pricing documentation request. The
purpose of this pre-audit meeting is to explore, in consultation with the taxpayer, what
should be the appropriate scope of the tax audit, what documentation is relevant to the
transfer pricing investigation, if there is any readily available documentation, etc.
Concept of prudent business manager
As to the question of what proactive effort is required when putting together transfer
pricing documentation, the administrative guidelines refer to the concept of a prudent
business manager (i.e. given the nature of the transactions that take place between
related companies, it is only normal, as a prudent business manager, to maintain
written documentation that underpins the arms-length character of the transfer
pricing applied).
The administrative guidelines list the information that can be prepared to this end.
Flexibility as to the language of the documentation
The administrative guidelines acknowledge the reality that a large part of the transfer
pricing documentation may not be available in one of the offcial languages of Belgium
(i.e. Dutch, French, or German). Reasons for this inadequacy have to do, inter alia,
with the multinational character of business, the growing tendency of organising
transfer pricing studies at a pan-European or global level, or the need to ask a foreign-
related company for information.
Belgium
Inspectors are urged to apply the fexibility they feel in conscience to be necessary
when they evaluate the reasons given by the taxpayer for submitting documentation
in a foreign language. This applies particularly to pan-European or worldwide transfer
pricing studies, group transfer pricing policies and contracts with foreign entities.
Code of conduct on transfer pricing
The administrative guidelines ratify the standardised and partly centralised approach
to transfer pricing documentation that is recommended in the Code of Conduct.
This also means that concepts such as the master-fle and country-specifc
documentation are now offcially introduced into a Belgian context. The resolution
of the EU Council on this Code of Conduct is added to the administrative guidelines as
anappendix.
Pan-European benchmarks
The administrative guidelines confrm the current practice whereby the use of pan-
European data cannot per se be rejected in the context of a benchmark analysis.
The use of pan-European analyses fnds its justifcation not only in the often-existing
lack of suffcient points of reference on the Belgian market, but also in the fact that
many multinational businesses prefer to spread the cost of investing in a benchmark
analysis over various countries.
Treatment of tax havens
As of 1 January 2010, Belgian companies and Belgian permanent establishments of
foreign companies are required to report in their annual tax returns all payments,
direct and indirect, to tax havens totalling EUR100,000 or more.
Within the context of this new provision, tax havens are considered to be:
Countries that have been identifed by the OECD as not suffciently cooperative in
the domain of international exchange of information; and
Countries that appear on a list (still to be drafted by the Belgian tax authorities and
to be processed under the form of a Royal Decree) of countries with no or low (less
than 10%) taxes.
Payments made, directly or indirectly, to such tax havens and which have not been
reported accordingly are not accepted as deductible business expenses. The same
applies for payments that have been appropriately reported, but for which the taxpayer
concerned has not provided suffcient proof that the payments have been made in the
context of real and sincere transactions with persons other than artifcial constructions.
The latter proof can be provided by all means of proof as defned in the Belgian Income
Tax Code.
Accounting guidelines
The Belgian Commission for Accounting Standards has caused some discussion in
the accounting and tax feld by issuing advice that deviates from current accounting
practice. As Belgian tax law, in principle, follows accounting law (unless it explicitly
deviates hereof), these evolutions may also impact the transfer pricing feld. Broadly
speaking, the discussion relates to the acquisition of assets for free or below-
marketvalue.
B
Until now, Belgian accounting law basically referred to the historical cost to determine
the acquisition value of assets, provided the principle of fair image of the balance sheet
is not impaired.
If the acquisition price is below fair value, the accounting standard stipulates that the
difference between fair value and historical cost is treated as an exceptional proft at
the level of the acquiring company.
In 2009, a new Royal Decree introduced additional reporting requirements in statutory
and consolidated accounts made under Belgian GAAP. The additional reporting
requirements cover (1) information on non-arms-length inter-company transactions
and (2) information on the off-balance-sheet operations that could have an impact
on the balance sheet. By ratifying this Royal Decree, the Belgian legislator complies
with the content of the European Directive 2006/46/EC of the European Parliament
and of the Council of 14 June 2006. These new accounting rules introduce a new
burden of proof on the arms-length character of inter-company transactions. More in
particular, since the board of directors and the statutory auditor have to approve and
sign these accounts, suffcient evidence should be available to draw conclusions on
the arms-length nature of inter-company transactions. Henceforth, for transactions
covered by these new accounting rules, transfer pricing documentation may prove to
be extremely useful or even required to comply with accounting law and to manage
directorsliability.
1604. Legal cases
Belgian authorities did not signifcantly turn their attention to transfer pricing until the
beginning of the 1990s. Relatively few important transfer pricing cases have take place
in Belgium.
In 1995, the Supreme Court decided that the beneft of losses carried forward in a loss-
making company is denied where there has been an abnormal transfer of proft from a
proftable company to that loss-making entity (Supreme Court, 23 February 1995).
On 21 May 1997, the Liege Court of Appeal rendered a favourable decision recognising
the acceptability of a set-off between advantages of transactions of related parties.
In the case at hand, a Belgian distribution entity acquired the contractual rights
(from a group affliate) to distribute certain high-value branded products in the
Benelux countries. However, this was subject to the Belgian entity contracting out
the distribution of certain dutiable brands to a Swiss affliate. The Belgian authorities
stipulated that the BelgianSwiss transaction granted abnormal or gratuitous benefts
to the Swiss entity. However, it was demonstrated that the transfer of proft potential
to a foreign-related party subsequently generated an inbound transfer of proft from
another foreign-related party. The court based its decision on the economic reality
in a group context, and the fact that different companies were involved (and thus an
indirect set-off was made) did not jeopardise the possibility to net the advantages
against each other. The Ghent Court of Appeal has also confrmed the acceptance of
some form of economic solidarity in April 1999. In this case, the court ruled in favour
of a Belgian company that had granted quality discounts to its UK affliates to secure
the going concern of the latter, as this was done for its own commercial interest (contra
Brussels Court of Appeal 12 April 2000). Also, the Ruling Commission (see below)
confrms the view of the Belgian courts by granting rulings over the acceptability
Belgium
of certain benefts being granted between related entities because of particular
intragroup reasons.
The Ghent Court of Appeal ruled in November 2002 in a high-profle tax case that an
advantage received by a Belgian company pursuant to the acquisition of shares at book
value, which was lower than market value, may create a Belgian tax liability on the
basis of Article 24 of the ITC.
The Bergen Court of Appeal ruled in favour of analysing in detail why certain
related party transactions take place under terms and conditions that might at frst
glance breach the arms-length standard. In the case at hand, the Court accepted
the granting of interest-free loans, as otherwise the group might have faced adverse
fnancialcircumstances.
Finally, in the case of SGI v the Belgian State, the European Court of Justice (ECJ)
delivered a judgment dated January 2010 that clarifes the position of transfer pricing
rules within the framework of European law. The relevant provisions of the Belgian
income-tax law (Article 26) allow for adjustments in the cases of abnormal or
gratuitous benefts granted to a foreign affliate, but not in a domestic context.
The ECJ found that (a) there was in principle a breach of the EU freedom of
establishment, but (b) the Belgian legislation was justifed as being within the public
interest, provided (c) it was proportional.
Proportionality in this context means that (1) the expenses disallowed (or income
imputed) are limited to the excess (shortfall) over the arms-length amount; and (2)
there is a defence of commercial justifcation.
The court remitted the case back to the Belgian courts to consider whether the way in
which the national legislation was applied met the two tests of proportionality.
In theory, taxpayers must demonstrate that business expenses qualify as deductible
expenses in accordance with Article 49 of the ITC, while the tax authorities must
demonstrate that proft transfers to an affliate are abnormal or gratuitous benefts.
In practice, however, the tax authorities have actually requested on several occasions
that taxpayers demonstrate that the transfer pricing methodology adopted is on an
arms-length basis (see below).
Since 1997, the tax authorities have scrutinised the deductibility of management
service fees in a more stringent way. The taxpayer is required to demonstrate that any
services provided are both necessary to the business of the recipient and charged at
market value.
As noted above, Belgian tax authorities have issued administrative guidelines on
transfer pricing audits and documentation. Although these guidelines are not legally
binding, they play a pivotal role in current (and future) transfer pricing audits.
B
The administrative guidelines published in November 2006 contain a list of cases
where it may be advisable to check the transfer pricing practices (see in this respect
paragraph 1603).
Transfer pricing enquiries may also arise in the course of a routine tax audit.
During the course of an audit, the inspector would normally visit the companys
premises. The 1999 administrative guidelines urge tax inspectors to interview as many
people as possible, including staff with an operational responsibility, to get a fair idea
of the functions, assets and risks involved.
The tax audit normally begins with a written request for information. The taxpayer
must provide the data requested within (in principle) one month. However, the
2006 administrative guidelines preach fexibility as to this one-month period. Any
documentary evidence considered relevant to the audit can be requested and reviewed
by the authorities. As to the issue of obtaining information from foreign companies, the
approach of the administrative guidelines seems to be more demanding than the OECD
Guidelines. Indeed, the fact that a Belgian subsidiary argues that it did not receive
any information from its foreign parent on its transfer pricing policy can be deemed to
refect a lack of cooperation.
The 2006 administrative guidelines stimulate companies to have a pre-audit meeting
with the authorities to (1) discuss the transfer pricing policy carried out with the
group, (2) discuss the level of transfer pricing documentation already available, and
(3) avoid having irrelevant questions raised which ask the taxpayer to prepare an
unreasonable amount of work. This focused approach should save a lot of time for the
taxpayer as well as the tax authorities.
Since assessment year 1999, new revised assessments and appeals procedures have
been introduced. The main features can be summarised as follows:
Once the tax inspector has completed the analysis, any adjustment is proposed in a
notifcation of amendment outlining the reasons for the proposed amendment. The
company has 30 days to agree or to express disagreement. The tax inspector then
makes an assessment for the amount of tax which he or she believe is due (taking into
account any relevant comments of the company with which the inspector agrees).
Thereafter the company has three months within which to lodge an appeal with the
Regional Director of Taxes. The decision of the Regional Director of Taxes may be
appealed and litigated. In a number of circumstances, the intervention of the courts
can be sought prior to receiving the decision of the Regional Director of Taxes.
Non-deductible expenses or penalties may be charged in respect of any increased
assessment. In addition, tax increases in the range of 10% to 50% of the increased tax
can be imposed.
Belgium
In practice, discussion has arisen as to whether penalties or increases of tax can be
levied in the context of abnormal or gratuitous benefts granted by a Belgian taxpayer.
Although conficting case law exists (e.g. Antwerp Court of Appeal, 17 January 1989),
the Antwerp Court of Appeal ruled on 15 April 1993 that by its mere nature, abnormal
and gratuitous benefts are always elements that are not spontaneously declared in the
companys tax return and can therefore not give rise to an additional tax penalty.
It is unlikely that this reasoning can be upheld in cases where Article 185, Section 2 of
the ITC is applicable.
Within the Central Tax Administration, several attempts have been made to improve
the quality of transfer pricing audits and the search for comparable information. To
this end, a specialist transfer pricing team (STPT) was established to ensure coherent
application of the transfer pricing rules by the tax authorities, with a view to achieving
consistency in the application of tax policies.
In short, the mission statement of the STPT is to:
Act as the central point of contact for all tax authorities facing transfer pricing
matters;
Maintain contacts with the private sector and governmental bodies in the area of
transfer pricing;
Formulate proposals and render advice with respect to transfer pricing;
Take initiatives and collaborate in the area of learning and education, with a view
to a better sharing of transfer pricing knowledge within the tax authorities; and
Take initiatives and collaborate with respect to publications that the tax authorities
have to issue with respect to transfer pricing.
In addition to creating the STPT, in 2006, the Belgian tax authorities also installed
an experienced special transfer pricing investigation squad (special TP team) with a
twofold mission:
Build up TP expertise to the beneft of all feld tax inspectors and develop the
appropriate procedure to conduct tax audits in this area according to the OECD
principles; and
Carry out transfer pricing audits of multinationals present in Belgium through a
subsidiary or branch.
Use
As indicated above, Belgium, in its capacity as an OECD member, has adopted the
OECD Guidelines. Comparable information could, therefore, be used in defending a
pricing policy in accordance with the terms of the OECD Guidelines. Note, however,
that the preferred method of the authorities is the comparable uncontrolled price
(CUP) method, although, if it is not possible to fnd CUPs, it may be possible to use
other transfer pricing methods that are acceptable within the terms of the OECD
Guidelines. Practice shows that in most cases, the TNMM is used to test the arms-
length nature of inter-company transactions.
B
The Belgian authorities normally follow the revised chapters I to III of the
OECDGuidelines.
Availability
The search for comparables relies primarily upon databases that provide fnancial
data on the major Belgian companies. These databases provide comprehensive annual
fnancial data, historical information and information on business activities, all of
which is largely extracted and compiled from statutory accounts.
In addition, the Belgian National Bank (BNB) maintains a database that contains all
statutory accounts. Entries are classifed according to NACE industry code (i.e. by type
of economic activity in which the company is engaged).
Information on comparable fnancial instruments (such as cash-pooling, factoring,
etc.) can be obtained from banks. This information (e.g. market interest rates) can then
be used to support or defend a transfer pricing policy.
The 1999 administrative guidelines acknowledge that Belgium is a small country, so
suffcient comparable data may be diffcult to obtain. Consequently, the use of foreign
comparables is accepted, provided proper explanation can be provided as to the
validity of using surrogate markets. The 2006 administrative guidelines reconfrm that
pan-European data cannot per se be rejected in the context of a benchmark analysis.
Generally, there are no industry sectors which are more likely to be challenged than
any other and, since there are no excluded transactions, all transactions between
related companies may be under scrutiny.
Furthermore, the authorities are more likely to question the price of services than
the transfer of goods, and it is noticeable that some transactions are attracting
increasingattention.
Debt waivers
According to Article 207 of the ITC, in some circumstances a Belgian company
receiving abnormal or gratuitous benefts, whether directly or indirectly, is not
allowed to offset among others current year losses or losses carried forward against
these benefts. The circumstances in which this applies are those where the company
receiving the benefts is directly or indirectly dependent on the company granting such
benefts. This rule is being used stringently in cases where a loss-making company
benefts from a debt waiver. In these circumstances, the waiver is treated as an
abnormal or gratuitous beneft, although certain court cases (and also rulings) confrm
the acceptability of intragroup debt waivers under particular circumstances.
In the beginning of 2009, however, the Belgian administration introduced a Continuity
Act, which assists companies with judicial restructuring in a court of law. The act
provides, among other things, a tax relief for a waiver of debt on both the creditor and
debtor side. If a creditor waives debts according to the judicial restructuring procedure,
the debtors proft resulting from the debt reduction granted by the creditor should
remain tax-exempt and the creditors expenses resulting from waiving the debt will
remain tax-deductible within Belgium. In this respect, the Act modifed section 48 of
Belgium
the ITC, which now explicitly states that, following approval by the court, expenses
incurred due to a waiver of debt will qualify as tax-deductible. Similarly (exceptional),
profts are tax-exempt for the company receiving the waiver.
Permanent establishments transactions with head offce
The tax rules and administrative practices can be summarised as follows.
It is acceptable that, for tax purposes, a contractual relationship exists between a head
offce and its permanent establishment (PE). Hence, the arms-length principle applies
to most transactions between the head offce and the PE, such as the sale of goods
and the provision of services based on the separate entity approach. It is accepted that
notional profts can arise from internal transfers and that, in accordance with this
treatment, these might be subject to taxation before any proft is actually realised by
the enterprise as a whole.
Services
During a tax audit, particular attention would be paid to payments such as
management fees or technical support fees to establish whether these payments should
actually have taken the form of dividends.
Unilateral
As of 1 January 2003, the Belgian government introduced a new ruling practice
that seeks to increase upfront legal certainty for investors, while taking into account
national and international tax standards.
Under the new regime, a ruling is defned as an upfront agreement, which is a legal
act by the Federal Public Service of Finance in conformity with the rules in force with
respect to the application of law to a specifc situation or operation that has not yet
produced a tax effect.
Previously, a taxpayer could apply for a ruling only in a limited number of cases. Now, a
taxpayer may apply for a ruling in all cases unless there is a specifc exclusion. Although
the Ministry of Finance acknowledges that it is impossible to provide a comprehensive
list of all excluded topics, the new ruling practice nevertheless explicitly excludes some
ruling categories to demonstrate the open nature of the new ruling system. To this end,
a specifc Royal Decree confrming the exclusions was published in January 2003.
A taxpayer may not apply for a ruling involving: tax rates, computations, returns and
audits; evidence, statutes of limitation and professional secrecy; matters governed by
a specifc approval procedure; issues requiring liaison between the Ministry of Finance
with other authorities, whereby the former cannot rule unilaterally; matters governed
by diplomatic rules; penalty provisions and tax increases; systems of notional taxation
as for instance used in the agricultural sector; and tax exemptions.
In 2004, further changes to the ruling procedure were made to enhance a fexible
cooperation between taxpayers and the Ruling Commission. At the same time, the
ruling procedure itself has been rendered more effcient. These changes took effect 1
January 2005.
B
The provisions of double taxation treaties fall within the scope of the new ruling
practice and, therefore, the Belgian competent authority is involved in the preparatory
phase of making the ruling decision to ensure consistency of the decisions of the Ruling
Commission in this respect.
Summaries of the rulings are published on an anonymous basis in the form of
individual or collective summaries. The rulings are published at the governments
website, unless a foreign taxpayer is involved and the treaty partner has rules
preventing publication. In such cases, approval to publish the ruling is requested.
Under the revised ruling practice, the use of prefling meetings is encouraged.
A request for an advance ruling can be fled by (registered) mail, fax, or email.
The Ruling Commission must confrm receipt of a request within fve working
days. Subsequently, a meeting is organised allowing the Ruling Commission to
raise questions and the applicant to support its request. Recent experiences have
demonstrated the effectiveness of the Commission and its willingness to accommodate,
within the borders of the national and international legal framework, the search by
the taxpayer for upfront certainty. Although there is no legally binding term to issue
a ruling, it is the Ruling Commissions intention to issue its decision within a three-
month period. In most cases, this three-month period is adhered to.
Bilateral/Multilateral
Under the new ruling practice, taxpayers may be invited to open multilateral
discussions with other competent authorities. These issues are dealt with on a case-by-
case basis according to the relevant competent authority provision as stipulated in the
tax treaty.
Recent experience shows that the Belgian tax authorities are also promoting bilateral
or multilateral agreements and that they take a cooperative position for realising
suchagreements.
1614. Competent authorities
On 27 November 2006 the US and Belgium signed a new income-tax treaty and
protocol to replace the 1970 income-tax treaty. This new treaty and protocol entered
into force on 28 December 2007. The new treaty introduces an innovative binding
arbitration procedure in the context of the mutual agreement procedure (MAP).
Indeed, when the competent authorities are unable to reach an agreement, the case
shall be resolved through arbitration within six months from referral. In this type of
arbitration, each of the tax authorities proposes only one fgure for settlement, and the
arbitrator must select one of the fgures (baseball arbitration).
Practice has shown a signifcant increase in transfer pricing audits in Belgium. This
trend is expected to continue.
Within that framework, the importance of having available upfront transfer pricing
documentation will only increase.
In terms of new laws, no developments are anticipated in the coming months.
Belgium
Although it is possible for an exchange of information to take place between the
income tax and customs authorities, this rarely happens in practice.
A facility exists for the Belgian tax authorities to exchange information with the tax
authorities of another country. According to Belgian law, such an exchange must be
organised through the Central Tax Administration. A number of bilateral treaties have
been concluded to facilitate this process.
The 1999 administrative guidelines also consider the possibility of conducting joint
investigations with foreign tax authorities.
Belgium is currently involved in several of these multilateral audits.
The arms-length principle applies to fnancing arrangements between affliated
parties. Article 55 of the ITC provides that interest paid is a tax-deductible business
expense, provided that the rate of interest does not exceed normal rates, taking into
account the specifc risks of the operation (e.g. the fnancial status of the debtor and
the duration of the loan).
In addition, note that related party loans from shareholders or directors of a Belgian
borrowing company are subject to specifc restriction.
A Royal Decree, issued in January 1997, provides that where a companys debt-to-
equity ratio exceeds 7:1, interest is no longer tax-deductible when paid to persons
who are subject to a considerably more favourable tax regime than in Belgium. This
applies to interest payments made after 1 January 1997, unless the payments are under
a contract concluded before 18 October 1996. The EU Lankhorst-Hohorst case is not
expected to impact the Belgian thin capitalisation rules.
Brazil
17.
B
Brazil
1701. Introduction
From the outset, Brazils transfer pricing rules, which took effect on 1 January 1997,
have been very controversial. Contrary to the OECD Guidelines, US transfer pricing
regulations, and the transfer pricing rules introduced by some of Brazils key Latin
American trading partners such as Mexico and Argentina, Brazils transfer pricing
rules do not adopt the internationally accepted arms-length principle. Instead, Brazils
transfer pricing rules defne maximum price ceilings for deductible expenses on inter-
company import transactions and minimum gross income foors for inter-company
export transactions.
The rules address imports and exports of products, services and rights charged
between related parties. The rules also cover inter-company fnancing transactions
that are not registered with the Brazilian Central Bank, and all import and export
transactions between Brazilian residents (individual or legal entity) and residents in
either low-tax jurisdictions (as defned in the Brazilian legislation) or jurisdictions with
internal legislation that call for secrecy relating to corporate ownership, regardless of
any relation.
Through the provision of safe harbours and exemptions, the rules were designed to
facilitate the monitoring of inter-company transactions by the Brazilian tax authorities
while they develop more profound technical skills and experience in the domain.
Since the Brazilian rules do not adopt the arms-length principle, multinational
companies with Brazilian operations have had to evaluate their potential tax exposure
and develop a special transfer pricing plan to defend and optimise their overall
international tax burden. From the outset, planning to avoid potential double taxation
has been especially important.
In view of the substantial double taxation and documentation burdens, several
international chambers of commerce and multinational companies have lobbied
for changes to the current regulatory framework, in order to align Brazils transfer
pricing rules with international standards, including the adoption of the arms-length
principle. This effort has so far been unsuccessful.
In order to prevent income-tax evasion the Brazilian government introduced transfer
pricing rules specifcally aimed at an area over which it felt that it had little control
import and export transactions conducted by multinationals with foreign-related
parties. The rules require that a Brazilian company substantiate its inter-company
International Transfer Pricing 2011 Brazil 263
Brazil
import and export prices on an annual basis by comparing the actual transfer price
with a benchmark price determined under any one of the Brazilian equivalents of
the OECDs comparable uncontrolled price method (CUP method), resale price
method (RPM) or cost-plus method (CP method). Taxpayers are required to apply the
same method, which they elect, for each product or type of transaction consistently
throughout the respective fscal year. However, taxpayers are not required to apply the
same method for different products and services.
While incorporating these transaction-based methods, the drafters of the Brazilian
transfer pricing rules excluded proft-based methods, such as the transactional net
margin method (TNMM) or proft split methods (PSM). This is contrary to the OECD
Guidelines and the US transfer pricing regulations, as well as the transfer pricing
regulations introduced in Mexico and Argentina.
Other material differences from internationally adopted transfer pricing regimes
include the Brazilian transfer pricing legislations exclusion of a best method or
most appropriate method rule; accordingly, a taxpayer may choose the respective
pricing method. In addition, the Brazilian transfer pricing rules explicitly exclude
inter-company royalties and technical, scientifc, administrative or similar assistance
fees, which remain subject to previously established deductibility limits and other
specifcregulations.
Rules regarding imports of goods, services or rights
Deductible import prices relating to the acquisition of property, services and rights
from foreign-related parties should be determined under one of the following three
Brazilian equivalents of the OECDs traditional transaction methods:
Comparable independent price method (PIC)
This Brazilian equivalent to the CUP method is defned as the weighted average price
for the year of identical or similar property, services, or rights obtained either in Brazil
or abroad in buy/sell transactions using similar payment terms. For this purpose, only
buy/sell transactions conducted by unrelated parties may be used.
Resale price less proft method (PRL)
The Brazilian equivalent to the RPM is defned as the weighted average price for the
year of the resale of property, services or rights minus unconditional discounts, taxes
and contributions on sales, commissions and a gross proft margin of 20% calculated
based on the resale price (less unconditional discounts). If value is added before resale,
the margin proft is increased to 60%, calculated based on the percentage of the value
imported over the fnal resale price. In applying the PRL, a Brazilian taxpayer may use
his/her own prices (wholesale or retail), established with unrelated persons.
Importantly, a provisional measure published on 29 December 2009 (PM 478),
proposed changing the PRL method through amendments to the Brazilian transfer
pricing legislation. Such change would have taken effect on 1 January 2010. Under
the new provision, the resale minus method is applied in the same way for imports
of products for resale or for inputs to be used in a manufacturing process. The new
sales minus method (PVL) should be calculated considering a margin of 35%, as
opposed to the previous 20% applicable to products for resale and the 60% applicable
to inputs. However, PM 478 was not voted on by Congress within the constitutional
deadline, and consequently lost its validity. The deadline expired on 1 June 2010, and
Brazil 264 www.pwc.com/internationaltp
B
therefore, the new sales minus method establishing the 35% statutory proft margin
was notapproved.
Production cost plus proft method (CPL)
This Brazilian equivalent of the CP method is defned as the weighted average cost
incurred for the year to produce identical or similar property, services, or rights in the
country where they were originally produced, increased for taxes and duties imposed
by that country on exportation plus a gross proft margin of 20%, and calculated based
on the obtained cost.
Production costs for application of the CPL are limited to costs of goods, services, or
rights sold. Operating expenses, such as R&D, selling and administrative expenses,
may not be included in the production costs of goods sold to Brazil.
In the event that more than one method is used, the method that provides the highest
value for imported products will be considered by the Brazilian tax authorities
as the appropriate import price. This is intended to provide taxpayers with the
fexibility to choose the method most suitable to them. The Brazilian rules require
that each import transaction be tested by the benchmark price determined using one
of the three methods, as applicable to the type of transaction (this also applies to
exporttransactions).
If the import sales price of a specifc inter-company transaction is equal to or less
than the benchmark price determined by one of the methods, no adjustment is
required. Alternatively, if the import sales price exceeds the determined benchmark
price, the taxpayer is required to adjust the calculation basis of income tax and
socialcontribution.
The aforementioned excess must be accounted for in the retained earnings account
(debit) against the asset account or against the corresponding cost or expense if the
good, service or right has already been charged to the income statement.
One of the most controversial issues often raised with regard to import transactions is
the treatment of freight and insurance costs, as well as Brazilian import duty costs for
purposes of applying the Brazilian transfer pricing rules. The current transfer pricing
law considers freight and insurance costs and the Brazilian import duty costs borne by
the Brazilian taxpayer as an integral part of import costs (i.e. the tested import price).
Meanwhile, the initial transfer pricing regulations of 1997 gave taxpayers the option to
include or exclude such cost items.
Because of this controversy, the treatment of freight and insurance costs and Brazilian
import duty costs borne by the Brazilian taxpayer became a matter of interpretation.
Interpreting the legislation as requiring the inclusion of import duties and freight and
insurance charges assumed by the taxpayer as part of the actual transfer price leads
to an increase in the actual transfer price. From an economic perspective, however,
considering that the payment of import duties and freight and insurance costs does not
result in a transfer of profts to a foreign entity, taxpayers should be allowed to use only
the free on board (FOB) price paid for imports as the tested transfer price.
According to the latest regulatory norms published in November 2002, taxpayers may
compare a benchmark price calculated under the CPL or PIC methods with an actual
Brazil
transfer price that includes or excludes freight and insurance costs as well as Brazilian
import duty costs borne by the Brazilian taxpayer. Meanwhile, for testing under the
PRL, freight and insurance costs and Brazilian import duty costs borne by the Brazilian
taxpayer must be added to the actual transfer price as well as to the benchmark
PRLprice.
Rules regarding exports of goods, services and rights
In the case of export sales, the regulations provide a safe harbour whereby a taxpayer
will be deemed to have an appropriate transfer price with respect to export sales when
the average export sales price is at least 90% of the average domestic sales price of
the same property, services, or intangible rights in the Brazilian market during the
same period under similar payment terms. When a company does not conduct sales
transactions in the Brazilian market, the determination of the average price is based on
data obtained from other companies that sell identical or similar property, services, or
intangible rights in the Brazilian market. When it is determined that the export sales
price is less than 90% of the average sales price in the Brazilian market, the Brazilian
company is required to substantiate its export transfer prices based on the benchmark
obtained using one of the following Brazilian equivalents of the OECDs traditional
transaction methods:
Export sales price method (PVEx)
This Brazilian equivalent of the CUP method is defned as the weighted average of
the export sales price charged by the company to other customers or other national
exporters of identical or similar property, services, or rights during the same tax year
using similar payment terms.
Resale price methods
The Brazilian versions of the RPM for export transactions are defned as the weighted
average price of identical or similar property, services, or rights in the country of
destination under similar payment terms reduced by the taxes included in the price
imposed by that country and one of the following:
A proft margin of 15%, calculated by reference to the wholesale price in the
country of destination (wholesale price in country of destination less proft
method, or PVA); and
A proft margin of 30%, calculated by reference to the retail price in the country of
destination (retail price in country of destination less proft method, or PVV).
Purchase or production cost-plus taxes and proft method (CAP)
This Brazilian equivalent of the CP method is defned as the weighted average cost of
acquisition or production of exported property, services, or rights increased for taxes
and duties imposed by Brazil, plus a proft margin of 15%, calculated based on the sum
of the costs, taxes and duties.
In the event that the export sales price of a specifc inter-company transaction is equal
to or more than the transfer price determined by one of these methods, no adjustment
is required. On the other hand, if the export sales price of a specifc inter-company
export transaction is less than the determined transfer price, the taxpayer is required to
make an adjustment to the calculation bases of income tax and social contribution.
B
Rules regarding interest on debt paid to a foreign-related person
The statutory rules provide that interest on related party loans that are duly registered
with the Brazilian Central Bank will not be subject to transfer pricing adjustments.
However, interest paid on a loan issued to a related person that is not registered with
the Brazilian Central Bank will be deductible only to the extent that the interest rate
equals the LIBOR dollar rate for six-month loans plus 3% per year (adjusted to the
contract period). The actual amount of the interest paid on the loan in excess of this
limitation will not be deductible for income-tax and social contribution purposes.
The rules do not provide a reallocation rule, which would treat the foreign lender as
having received less interest income for withholding tax purposes. Because the foreign
lender actually received the full amount of the interest in cash, the foreign lender will
still be required to pay withholding tax at the rate of 15% on the full amount paid,
including the excess interest.
Similarly, loans extended by a Brazilian company to a foreign-related party that are not
registered with the Brazilian Central Bank must charge interest at least equal to the
LIBOR dollar rate for six-month loans plus 3%.
Rules regarding royalties and technical assistance
The statutory rules expressly exclude royalties and technical, scientifc, administrative
or similar assistance remittances from the scope of the transfer pricing legislation.
Accordingly, provisions of the Brazilian income-tax law established before the Brazilian
transfer pricing rules went into effect still regulate the remittances and deductibility of
inter-company payments for royalties and technical assistance fees.
According to this preceding legislation, royalties for the use of patents, trademarks and
know-how, as well as remuneration for technical, scientifc, administrative or other
assistance paid by a Brazilian entity to a foreign-related party are only deductible up to
a fxed percentage limit set by the Brazilian Ministry of Finance. The percentage limit
depends on the type of underlying royalty, product or industry involved (the maximum
is 5% of related revenues, 1% in the case of trademarks).
Additionally, royalties and technical assistance fees are only deductible if the
underlying contracts signed between the related parties have been approved by the
National Institute of Industrial Property (INPI) and registered with the Brazilian
Central Bank after 31 December 1991. Royalty payments that do not comply with these
regulations and restrictions are not deductible for income tax.
Consequently, while royalty and technical assistance payments are not subject to
transfer pricing rules, they are subject to rules that impose fxed parameters that are
not in accordance with the arms-length principle, except for royalties for the use
of a copyright (e.g. software licences), which are not subject to the rate limitations
mentioned above and, in most cases, are paid at much higher rates. Such remittances
are subject to Brazils transfer pricing rules for import transactions.
As of 1 January 2002, all royalty and technical, scientifc, administrative or similar
assistance remittances to non-residents are subject to a withholding tax of 15% and a
contribution to a federal R&D investment fund (the Contribuio de Interveno no
Domnio Econmico, or CIDE) of 10%.
Brazil
The Brazilian transfer pricing regulations make no mention of royalty and technical
assistance payments received by a Brazilian taxpayer from a foreign-related party.
Hence, such foreign-source revenues should be subject to Brazils transfer pricing rules
for export transactions.
Defnition of related persons
Brazils transfer pricing rules provide a much broader defnition of related parties than
do internationally accepted transfer pricing principles. As described in the following
section, the regulations go so far as to characterise foreign persons as being related
when both are located in low-tax jurisdictions, whether or not a relationship exists
between them. The statutory list of related persons illustrates that the transfer pricing
regulations clearly target foreign-related parties since none of the listed relationships
would result in a Brazilian company being considered as related to another Brazilian
company. Consequently, the transfer pricing rules do not apply to two Brazilian
sister companies, leaving the possibility for multinationals to conduct inter-company
transfers between their Brazilian subsidiaries on non-arms-length terms. Inter-
company transactions in a purely domestic context are covered by the disguised
dividend distribution rules described below, which are less rigorous.
Under the statutory rules, a foreign company and a Brazilian company may be
considered to be related if the foreign company owns as little as 10% of the Brazilian
company, or when the same person owns at least 10% of the capital of each.
Additionally, regardless of any underlying relationship, the Brazilian defnition of
related parties considers a foreign person to be related to a Brazilian company if, in
the case of export transactions, the foreign person operates as an exclusive agent of
the Brazilian company or, in the case of import transactions, the Brazilian company
operates as an exclusive agent of the foreign person. This broad defnition was
specifcally designed to control potential price manipulations between third parties
in an exclusive commercial relationship. For these purposes, exclusivity is evidenced
by a formal written contract, or in the absence of one, by the practice of commercial
operations relating to a specifc product, service or right that are carried out exclusively
between the two companies or exclusively via the intermediation of one of them. An
exclusive distributor or dealer is considered to be the individual or legal entity with
exclusive rights in one region or throughout the entire country.
Companies located in low-tax jurisdictions or benefciaries of privileged
tax regime
Under the regulations, the transfer pricing rules apply to transactions conducted with
a foreign resident, even if unrelated, that is domiciled in a country that does not tax
income or that taxes income at a rate of less than 20%, or in a jurisdiction with internal
legislation allowing secrecy in regard to corporate ownership. For these purposes, the
tax legislation of the referred country applicable to individuals or legal entities will be
considered, depending on the nature of the party with which the operation was carried
out. The transfer pricing provisions also apply to transactions performed in a privileged
tax regime, between individuals or legal entities resident or domiciled in Brazil and any
individuals or legal entities, even if not related, resident or domiciled abroad. These
rules create some practical compliance issues because they require Brazilian companies
to inform the tax authorities regarding transactions conducted with companies in tax
havens even though the parties are completely unrelated and the transactions were
contracted at arms length.
B
In an effort to facilitate compliance by taxpayers, the Brazilian tax authorities have
issued a list of jurisdictions that they consider to be tax havens or without disclosure of
corporate ownership. This list currently includes the following jurisdictions: American
Samoa, Andorra, Anguilla, Antigua and Barbuda, Dutch Antilles, Aruba, Ascencion
Islands, Bahamas, Bahrain, Barbados, Belize, Bermuda, Brunei, Campione DItalia,
Singapore, Cyprus, Costa Rica, Djibouti, Dominica, French Polynesia, Gibraltar,
Granada, Cayman Islands, Cook Islands, Island of Madeira (Portugal), Isle of Man,
Pitcairn Islands, Qeshm Island, Channel Islands (Jersey, Guernsey, Alderney, Sark),
Hong Kong, Kiribati, Marshall Islands, Samoa Islands, Solomon Islands, St Helena
Island, Turks and Caicos Islands, British Virgin Islands, US Virgin Islands, Labuan,
Lebanon, Liberia, Liechtenstein, Macau, Maldives, Mauritius, Monaco, Monserrat,
Nauru, Nieui, Norfolk, Oman, Panama, Saint Kitts and Nevis, Saint Lucia, Saint Pierre
and Miquelon, Saint Vincent and Grenadines, San Marino, Seychelles, Swaziland,
Switzerland, Tonga, Tristan da Cunha, Vanuatu and United Arab Emirates. The list of
privileged tax regimes includes: holding companies incorporated under Luxembourg
law, Sociedad Anonima Financiera de Inversion (SAFI) incorporated under Uruguayan
law until December 2010, holding companies incorporated under Danish law, holding
companies incorporated under Dutch law, international trading companies (ITC)
incorporated under Icelandic law, offshore (KFT) companies incorporated under
Hungarian law, LLCs incorporated under US state law (in which the equity interest is
held by non-residents and which are not subject to US federal income tax), Entidad de
Tenencia de Valores Extranjeros (ETVEs) incorporated under Spanish law and ITCs and
international holding companies (IHC) incorporated under Maltese law.
Contemporaneous documentation requirements
Many taxpayers initially failed to appreciate the complexities created by the Brazilian
transfer pricing rules and their practical application to particular circumstances.
The general impression held by many companies was that the fxed-income margins
established by the Brazilian rules made it easier to comply with the rules and
eliminated the need for detailed economic studies and supporting documentation.
In practice, however, the application of the rules has shown that they are more
complicated than they might appear. The amount of information necessary to comply
with the rules was underestimated because the regulations did not provide any
contemporaneous documentation requirements.
This changed in August 1999, when the Brazilian tax authorities issued new
information requirements concerning transfer pricing as part of the manual for fling
the annual income-tax return (Declarao de Informaes Econmico-Fiscais da
Pessoa Jurdica, or DIPJ). These documentation requirements, which include fve new
information forms (Fichas) in the tax return for disclosure of transactions conducted
with foreign-related parties, greatly increased the transfer pricing compliance
burden. These forms oblige taxpayers fling their annual tax returns to provide
detailed disclosure regarding their inter-company import and export transactions,
the method applied to test the inter-company price for the 49 largest import and
export transactions, and the amount of any adjustments to income resulting from the
application of the method to a specifc transaction during the fscal year in question.
For most companies, the elements needed to comply with the information
requirements imposed by the new information returns and a possible transfer
pricing audit should be available through analytical information or the accounting
Brazil
system. However, many companies have yet to develop the systems that can provide
the information needed to comply with these requirements as well as for purposes
of determining the best transfer pricing methodology. Companies need to develop
the necessary information-reporting systems and controls that can provide reliable
accounting information regarding all transactions conducted with foreign parties to
both facilitate compliance with the Brazilian transfer pricing rules and to properly
defend on audit.
Divergence margin
For inter-company import and export transactions, even if the actually practised
transfer price is above the determined transfer price (for import transactions) or below
the determined transfer price (for export transactions), no adjustment will be required
as long as the actual import transfer price does not exceed the determined transfer
price by more than 5% (i.e. as long as the actual export transfer price is not below the
calculated transfer price by more than 5%).
Relief of proof rule for inter-company export transactions
In addition to the statutory 90% safe harbour rule for inter-company export
transactions, there is a secondary compliance rule (herein referred to as the relief of
proof rule) whereby a taxpayer may be relieved of the obligation to substantiate the
export sales price to foreign-related persons using one of the statutory methods if it can
demonstrate either of the following:
Net income derived from inter-company export sales, taking into account the
annual average for the calculation period and the two preceding years, excluding
companies in low-tax jurisdictions and transactions for which the taxpayer is
permitted to use different fxed margins is at least 5% of the revenue from such
sales; and
Net revenues from exports do not exceed 5% of the taxpayers total net revenues in
the corresponding fscal year.
If a taxpayer can satisfy the relief of proof rule, the taxpayer may prove that the export
sales prices charged to related foreign persons are adequate for Brazilian tax purposes
using only the export documents related to those transactions.
The relief from proof rules do not apply to export transactions carried out with
companies located in low-tax jurisdictions or benefciaries of privileged tax regime.
Exchange adjustment
In an attempt to minimise the effect of the appreciation of local currency vis--vis the
US dollar and the euro, the Brazilian authorities issued ordinances and normative
instructions at the end of 2005, 2006, 2007 and 2008, which amended the Brazilian
transfer pricing legislation for export transactions only. Per these amendments,
Brazilian exporting companies were allowed to increase their export revenues for
calendar years 2005, 2006, 2007 and 2008 (for transfer pricing calculation purposes
only), using the ratio of 1.35, 1.29, 1.28 and 1.20, respectively. This exceptional
measure only applied for fscal years 2005, 2006, 2007 and 2008, and for the statutory
90% safe harbour, 5% net income relief of proof and CAP method. For 2009, no
exchange adjustment was allowed.
B
Cost-contribution arrangements
No statutory or other regulations on cost-contribution arrangements have been
enacted at this point. Accordingly, deductibility of expenses deriving from cost-
contribution arrangements is subject to Brazils general rules on deductibility,
which require deductible expenses to be (1) actually incurred, (2) ordinary and
necessary for the transactions or business activities of the Brazilian entity, and (3)
properlydocumented.
Based on our experience, Brazilian tax authorities will assume that related charges
merely represent an allocation of costs made by the foreign company. Consequently,
they will disallow deductibility for income tax and social contribution on net income
unless the Brazilian taxpayer can prove that it actually received an identifable
beneft from each of the charged services specifed in any corresponding contracts.
Suffcient support documentation is crucial to substantiate any claims that expenses
are ordinary and necessary, especially in the case of international inter-company cost-
contributionarrangements.
In past decisions, the Brazilian tax authorities and local courts have repeatedly ruled
against the deductibility of expenses deriving from cost-contribution arrangements
due to the lack of proof that services and related benefts had actually been received by
the Brazilian entity. In addition, in past decisions, Brazilian tax authorities have ruled
against the deductibility of R&D expenses incurred by a foreign-related party
and allocated as part of the production cost base in the calculation of the CPL for
inter-company import transactions.
With the exception of cost-contribution arrangements involving technical and scientifc
assistance with a transfer of technology, which are treated the same as royalties (please
see above), resulting inter-company charges will have to comply with Brazils transfer
pricing regulations, in order to be fully deductible. Due to the nature of the transaction,
the CPL is usually the most practicable documentation method.
1704. Legal cases
Prior to 1 January 2000, the PRL method was defned as the average price for the year
of the resale of the property, services, or rights less unconditional discounts, taxes and
contributions on sales, commissions and a gross proft margin of 20% calculated based
on the resale price. As per Normative Instruction 38, issued in 1997, the PRL method
was unavailable to the importation of any product, service, or right acquired for use by
the Brazilian importer in the local production of another product or service.
Based on this, the Brazilian tax authorities issued rulings as to the application of
the PRL to the importation of active ingredients used to produce medicines for
fnal consumption. The rulings held that the resale price method could not be used
even where the Brazilian company had imported active ingredients in order to be
transformed into fnal format for sale to consumers, since the product sold is different
from the product that was imported. Hence, these rulings had precluded the use of
the PRL method by industries such as the pharmaceutical industry, which relied on
their Brazilian subsidiaries to function as mere contract manufacturers or assemblers
of products that are developed and produced abroad and merely put into fnal format
(e.g. through assembly or packaging) by the Brazilian company.
Brazil
Due to the severe diffculty of complying with this strict interpretation, the Brazilian
government amended the PRL method in October 1999 for inter-company import
transactions performed as from 1 January 2000, which involve an industrialisation
process in Brazil before resale. Under the amendment, the PRL for inputs has been
defned as the average resale price of the fnal product for the year less unconditional
discounts, taxes and contributions on sales, commissions, the value added in Brazil
and a proft margin of 60%. The 60% amended PRL method offered, as of 1 January
2000, an alternative to these industries. Nevertheless, the Brazilian tax authorities kept
assessing entities (mainly pharmaceutical) for tax years 1997 to 1999, which had used
the PRL method (minus a proft margin of 20%) for import transactions of product,
service, or right acquired to be used by the Brazilian importer in the local production of
another product or service.
These assessed entities contested the assessment (issued for tax years 1998 and 1999),
at the Brazilian Taxpayers Council. The main arguments raised by the entities were
that the Normative Instruction 38 (which is in general terms an interpretation bulletin
of the law) could not prohibit the application of the PRL method, as the Law 9430 did
not include such exclusion. Additionally, it was argued that neither of the two other
methods (PIC and CPL) were applicable, that is, no comparables were available and
the foreign parent companies were unwilling to disclose their production costs for the
imported pharmaceutical ingredients.
The Taxpayers Council upheld the entities arguments and overturned the assessments
issued by the Brazilian authorities. Such decisions represent a foremost precedent
as the Brazilian authorities, based on the same grounds, have assessed other
Brazilianentities.
Another issue under dispute between taxpayers and the tax authorities relates to the
mechanics for calculating the PRL 60%. Normative Instruction (IN) 243 issued in
2002, which replaced IN 38, introduced signifcant changes to the calculation of the
PRL method, creating a controversy regarding whether it expanded the scope beyond
what the law intended. As a result of this controversy, most companies ignored the IN
243 provisions related to the PRL 60% calculation, which would yield much higher
taxable income than the mechanics of IN 32. The Brazilian tax authorities have begun
issuing large tax assessments based on IN 243, and the outcome of these disputes may
take a long time for the courts to resolve.
The taxpayer is obliged to satisfy the burden of proof that it has complied with the
transfer pricing regulations as of the date the annual corporate income-tax return
is fled. However, the fact that the Brazilian rules allow taxpayers to choose from
several methods for each type of transaction provides properly prepared taxpayers an
advantage over the tax authorities. Proper and timely preparation enables taxpayers to
collect the necessary information and choose the most appropriate method in advance.
The rules also state that the tax authorities can disregard information when considered
unsuitable or inconsistent. Assuming the methodology is applied and documented
correctly, taxpayers can satisfy the burden of proof and push the burden back to the
tax authorities. This also applies when a taxpayer can satisfy the relief of proof rule for
inter-company export transactions.
B
Audits are the Brazilian tax authorities main enforcement tool with regard to transfer
pricing. Transfer pricing may be reviewed as part of a comprehensive tax audit or
through a specifc transfer pricing audit.
The audit procedure occurs annually, except in some cases such as suspicion of fraud.
As part of the audit process, the regulations require a Brazilian taxpayer to provide
the transfer pricing calculation used to test inter-company transactions conducted
with foreign-related parties, along with supporting documentation. Since the
taxpayer is obliged to satisfy the burden of proof that it has complied with the transfer
pricing regulations as of the date the tax return is fled, it is important for taxpayers
to have their support and calculations prepared at that time. If the taxpayer fails
to provide complete information regarding the methodologies and the supporting
documentation, the regulations grant the tax inspector the authority to make a transfer
pricing adjustment based on available fnancial information by applying one of the
applicable methods.
As part of the audit process, the tax inspectors typically request that the methods
used by the taxpayer be reconciled with the accounting books and records. The tax
inspector also requests any signifcant accounting information used to independently
confrm the calculations performed by the company. The information requested by
the tax inspector may be quite burdensome and may require the company to provide
confdential data regarding the production cost per product, the prices charged in the
domestic market, and the prices charged to foreign-related and independent parties.
As previously mentioned, companies need to develop the necessary information-
reporting systems and controls that can provide reliable accounting information
regarding all transactions conducted with foreign-related parties in advance to
properly defend on audit.
1708. Assessments and penalties
In making an assessment, the tax inspector is not required to use the most favourable
method available. Consequently, the inspector will most likely use the method that
is most easily applied under the circumstances and assess income tax and social
contribution at the maximum combined rate of 34%. The objective of an assessment
would not necessarily result in the true arms-length result but would be based on an
objective price determined by the regulations.
In the case of exports, tax inspectors would most likely use the CAP, because they
could rely on the Brazilian cost accounting information of the taxpayer. In the case
of imports, the tax inspector may have independent data collected from customs
authorities, using import prices set by other importers for comparable products, based
on the customs valuation rules, or use the PRL.
If the Brazilian tax authorities were to conclude that there is a defciency and make
an income adjustment, penalties may be imposed at the rate of 75% of the assessed
tax defciency. The rate may be reduced by 50% of the penalty imposed if the taxpayer
Brazil
agrees to pay the assessed tax defciency within 30 days without contesting the
assessment. In some cases when the taxpayer fails to provide the required information,
the penalty rate may be increased to 112.5% of the tax liability. In addition, interest
would be imposed on the amount of the tax defciency from the date the tax would
have been due if it had been properly recognised. In this instance, the interest rate used
is the federal rate established by the Brazilian Central Bank known as SELIC.
The Brazilian tax authorities have created a group of agents specialised in transfer
pricing audits. In addition, all tax agencies have a special area dedicated to the
investigation and development of audits that conduct studies and form databases that
can be used to compare prices and proft margins across industries and to identify
questionable companies for audit. The electronic contemporaneous documentation
fling requirements (DIPJ) for transfer pricing purposes facilitate the creation of such
comprehensive databases. Since taxpayers are required to report in the DIPJ the
average annual transfer prices for the 49 largest inter-company import and export
transactions, the Brazilian tax authorities will be able to test these prices using the
prices of similar products traded by other companies. In addition, as mentioned earlier,
the tax inspector may also use data collected from the customs authorities electronic
Integrated System for International Trade (Sistema Integrado de Comrcio Exterior,
orSISCOMEX).
In principle, it should not be possible to have different import values for customs and
transfer pricing purposes. However, in determining import sales prices, the transfer
pricing rules and customs valuation rules are not the same. It is quite common to fnd
that the customs and transfer pricing rules result in different import prices. In practice,
many multinational companies fnd themselves having to use an import sales price for
customs purposes, which is higher than the price determined by the transfer pricing
rules. As a result, these companies pay higher customs duties and, at the same time,
make a downward adjustment to the price for transfer pricing purposes.
Should the Brazilian tax authorities adjust transfer prices, it is possible that the
same income could be taxed twice, once in Brazil and once in the foreign country.
Multinational companies conducting transactions with their Brazilian affliates
through countries that do not have double-tax agreements with Brazil, such as the US
and the UK, cannot pursue competent authority relief as a means of preventing double
taxation arising from an income adjustment. Conversely, multinational companies
conducting transactions with their Brazilian affliates through countries that have
double-tax agreements with Brazil may appeal for relief under the competent authority
provisions of Brazils tax treaties. However, few taxpayers have tested this recourse,
and none successfully. This is because Brazilian transfer pricing rules were enacted
after the various tax treaties had been signed, so the reasons for evoking competent
authority relief on transfer pricing grounds did not yet exist.
B
While Brazils transfer pricing rules do not expressly refer to the institution of advance
pricing agreements (APAs), the statutory rules offer some leeway for the negotiation
of an advance ruling from the tax authorities, stating that a taxpayers transfer prices
are appropriate, even though they do not meet the fxed proft margins contained in
the statute. The regulations specifcally state that taxpayers may fle ruling requests to
alter the fxed proft margins for either industry sectors or individual taxpayers. Careful
planning and substantial documentation will be necessary to justify lower margins to
the Brazilian tax authorities.
To date, however, the few companies that fled ruling requests with the Brazilian tax
authorities have not succeeded in obtaining different margins.
1713. OECD issues
As with many other countries, Brazil is still in the early stages of developing its transfer
pricing policies. Brazils transfer pricing regime has been criticised abroad for its failure
to abide by international transfer pricing principles. The Brazilian transfer pricing rules
focus not on the identifcation of the true arms-length price or proft but on objective
methods for determining what the appropriate transfer price should be for Brazilian
tax purposes. The regulations themselves do not mention the arms-length principle,
and the rules do not expressly require that related parties conduct their operations in
the same manner as independent parties.
Brazil is not an OECD member country. However, in the preamble to the tax bill
that introduced the transfer pricing rules, the Brazilian government stated that the
new rules conformed to the rules adopted by OECD member countries. In a recent
ruling, the Brazilian tax authorities reaffrmed their opinion that Brazils transfer
pricing regulations are in line with the arms-length principle as established in Article
9 of the OECD Model Tax Convention. Although these pronouncements appear to
be an endorsement of the arms-length principle as the norm for evaluating the
results achieved by multinational enterprises in their international inter-company
transactions, the regulations do not provide the same level of explicit guidance and
fexibility provided by the OECD Guidelines.
The fxed percentage margin rules, which have the appearance of safe harbours, are
designed to facilitate administration and compliance and not necessarily to foster a fair
and fexible system seeking maximum compatibility with the arms-length principle.
The Brazilian rules prescribe methodologies for computing arms-length prices that
are different from the methodologies approved by the US regulations and the OECD
Guidelines and apply to transactions between certain unrelated parties. In other areas,
such as technology transfers and cost-contribution arrangements, Brazil has failed
altogether to establish transfer pricing rules.
The question is whether non-Brazilian OECD-compliant methods may be applied by
taxpayers in valid situations when the three Brazilian transaction-based methods
cannot be applied for practical reasons (for example, lack of applicability in general
or lack of reliable information). In the case of transactions conducted with related
parties in treaty countries, there is a strong basis supporting the conclusion that the
treaties, which are based on the OECD model treaty and supersede Brazilian domestic
Brazil
laws, should allow a Brazilian company to apply proft-based methods accepted by
theOECD.
In practice, however, the Brazilian tax authorities have demonstrated that they clearly
do not agree with this interpretation, especially when it comes to methodologies
not provided in the Brazilian transfer pricing regulations. In transfer pricing audits,
the Brazilian tax authorities have repeatedly rejected economic studies prepared in
line with the arms-length principle under observance of the OECD Guidelines as
acceptable documentation. It can be assumed that the Brazilian tax authorities do
not want to set a precedent that would allow multinational companies to bypass the
rigid Brazilian documentation methods in favour of more fexible OECD approaches.
Defending the use of OECD methodologies may eventually be resolved in the courts,
although such a resolution would involve a lengthy and costly legal process.
1714. Disguised dividend distributions
Brazils income tax law lists seven types of related party transactions (domestic and
international) that are deemed to give rise to disguised distributions of dividends.
In summary, such disguised distributions of dividends encompass all transactions
between a Brazilian legal entity and its individual or corporate administrator(s) and/
or controlling partner(s) or shareholder(s), which are negotiated at terms more
favourable than fair market value. In the concrete case of related party fnancing
transactions, these rules have a certain analogy to thin capitalisation rules or practices.
Amounts characterised as disguised dividends are added to the taxable income of
the legal entity deemed to have performed such a disguised distribution. This rule
does not apply when the taxpayer can substantiate that the terms of the related party
transactions were at fair market value. However, as previously mentioned, compliance
with these disguised dividend distribution rules is less rigorously enforced than
compliance with the transfer pricing rules, which focus exclusively on international
inter-company transactions.
Bulgaria
18.
B
Bulgaria
1801. Introduction
The Bulgarian tax legislation requires that taxpayers determine their taxable profts
and income by applying the arms-length principle to the prices for which they
exchange goods, services and intangibles with related parties (i.e. transfer prices).
Interest on loans provided by related parties should be consistent with market
conditions at the time the loan agreement is concluded.
The transfer pricing rules apply for transactions between resident persons, as well as
for transactions between resident persons and non-residents.
Bulgarian transfer pricing rules are provided in the Corporate Income Tax Act (CITA),
Tax and Social Security Procedures code, as well as in the Ordinance H-9 for
implementation of the transfer pricing methods, issued by the Minister of Finance on
29 August 2006.
The CITA sets the arms-length principle and explicitly determines cases where the
prices are deemed not to comply with the principle (e.g. in cases of receiving or
granting loans against an interest, which differs from the market interest rate effective
at the time the loan agreement is concluded).
The Tax and Social Security Procedures code includes a defnition of related parties
and stipulates the method to be used when determining prices on transactions between
related parties.
Defnition of related parties
For tax purposes, related parties are:
Spouses, relatives of the direct descent without restrictions and relatives of the
collateral descent up to the third degree included, and in-law lineage, up to and
including the second degree;
Employer and employee;
Persons, one of whom participates in the management of the other or of
itssubsidiary;
Partners;
Persons in whose management or supervisory bodies one and the same legal
or natural person participates, including when the natural person represents
anotherperson;
International Transfer Pricing 2011 Bulgaria 277
Bulgaria
A company and a person who own more than 5% of the voting shares of
thecompany;
Persons whose activity is controlled directly or indirectly by a third party or by
itssubsidiary;
Persons who control together directly or indirectly a third party or its subsidiary;
Persons, one of whom is an agent of the other;
Persons, one of whom has made a donation to the other;
Persons who participate directly or indirectly in the management, control or capital
of another person or persons where conditions different from the usual may be
negotiated between them; and
Persons, one of whom controls the other.
In addition, according to specifc provisions in the Tax and Social Security Procedures
code, if a party to a transaction is a non-resident person, the revenue authorities may
deem that the parties are related if:
The non-resident entity is incorporated in a country, which is not an EU Member
and in which the proft or the corporate tax due on the income, which the non-
resident has realised or would realise from the transactions, is below 40% of the tax
due in Bulgaria, except if there is evidence that the non-resident person is subject
to preferential tax treatment, or that the non-resident has sold the goods or services
on the domestic market; and
The country in which the non-resident is incorporated, denies or is not able to
provide information regarding the effected transactions or the relations, when
there is an applicable double-tax treaty with this country.
Methods for determining market prices
For the purposes of transfer pricing rules, market prices are determined by:
The comparable uncontrolled method (CUP);
The resale price method (RPM);
The cost-plus method (CPM);
The transactional net margin method (TNMM); and
The proft split method (PSM).
The Ordinance N
o
H-9 for implementation of the transfer pricing methods stipulates
the methods to be used when determining prices on related party transactions, the
application of each method, as well as the approach of the tax authorities in case the
taxpayer has transfer pricing documentation in place.
According to the Bulgarian legislation, the taxable person is obliged to hold evidence
that its relations with related parties are in line with the arms-length principle. The tax
provisions do not contain specifc requirements regarding the fling of transfer pricing
documentation with revenue authorities.
The recently issued internal transfer pricing guidelines of the National Revenue
Agency, however, contain indications as to the types of documents that the revenue
authorities may request from taxpayers during tax procedures (e.g. during tax audits,
procedures for double-tax treaty application, etc.). Although the guidelines do not
introduce obligatory transfer pricing documentation requirements for taxpayers,
Bulgaria 278 www.pwc.com/internationaltp
B
they do specify the approach the revenue authorities should follow when examining
intragroup transactions.
According to the Ordinance N
o
H-9 for implementation of the transfer pricing methods,
if companies have available transfer pricing documentation the revenue authorities are
obliged to start their analyses of the intragroup prices based on the method chosen by
the taxpayer.
The Bulgarian National Revenue Agency published internal transfer pricing guidelines
on 8 February 2010. Generally, the guidelines contain information on recommended
documentation that the revenue authorities should request during tax procedures, the
transfer pricing methods, as well as some procedural rules for the avoidance of double
taxation. The guidelines will be used by the revenue authorities when auditing related
party transactions and are not obligatory for taxpayers.
1804. Legal cases
To date there have been few court cases related to transfer pricing issues, and all of
them occurred prior to the implementation of the Ordinance H-9. Most of them set
the general principle for determination of the prices on related party transactions by
referring to the transfer pricing methods stipulated in the tax legislation.
Taxpayers should be able to prove that the transfer prices are market-based. If the
taxpayer does not provide evidence that the transfer prices are market-based, the
revenue authorities may estimate the market prices. In such a case, the burden of
proof shifts to the revenue/tax authorities and they should back up their fndings with
suffcient evidence.
Transfer pricing may be examined during a regular tax audit, as there are no separate
procedures for transfer pricing investigations.
During a tax audit, the revenue authorities may request additional information in
order to make an assessment related to transfer pricing. The term for provision of
information by the taxpayer will be determined in the tax authoritys request (however,
the term cannot be less than seven days).
If the transfer prices are not market-based, the revenue authorities may adjust the
taxable result of the entity, and assess additional tax liabilities. Any tax assessments
can be appealed at an administrative level. If the appeal fails, the assessments may be
challenged in the court.
The statute of limitations (i.e. the period within which state authorities are entitled to
collect the tax liabilities and other related mandatory payments) is fve years from the
Bulgaria
end of the year in which the tax liabilities became payable. However, this period could
be extended in certain cases (e.g. a tax audit). However, the maximum period of the
statute of limitation is 10 years.
Apart from an adverse tax assessment in respect of additional tax liabilities, the
taxpayer may be subject to certain penalties.
If the taxpayer does not determine his tax obligations correctly and fles a tax return
declaring lower tax liabilities than as per strictly applying the transfer pricing
provisions, a penalty between EUR250 and EUR1,500 may be imposed.
The difference between the agreed transfer prices and the market price may be
considered as a hidden proft distribution, which will be associated with a penalty
equal to 20% of the respective difference.
If the taxpayer does not provide evidence that the prices agreed with the related
parties are market-based, a penalty between EUR25 and EUR250 may be levied.
Bulgarian revenue authorities do not have special teams dealing with transfer
pricing issues. The relevant investigations are performed as a part of the general tax
auditprocedures.
The taxpayers may use all relevant sources of comparable information, in order
to support the arms-length compliance of the transfer prices with the relevant
marketconditions.
If the tax authorities challenge the transfer prices, they may use various sources such
as statistical information, stock market data, and other specialised price information.
The tax authorities should duly quote the source of its information.
In Bulgaria there are no databases containing information on unrelated-party
transactions.
The fnancial statements of the local companies are publicly available, but are not
collected in a single database that can be used for transfer pricing studies.
No transactions or industries can be considered exposed to transfer pricing
investigations at a higher risk.
The double-tax treaties concluded by Bulgaria provide taxpayers the opportunity to
initiate a mutual agreement procedure for the purposes of eliminating double taxation.
Bulgaria 280 www.pwc.com/internationaltp
B
Regulations with respect to the mutual agreement procedure and the exchange of
information with EU Member States have been introduced in the Bulgarian Tax and
Social Security Procedures Code as of 1 January 2007.
EU Arbitration Convention is applicable to Bulgaria per the European Parliament
resolution of 17 June 2008.
There is no publicly available information on the competent authority proceedings
undergone in Bulgaria.
There is no possibility of obtaining advance pricing agreements (APAs), pursuant to the
local legislation. However, it is possible to obtain a written opinion from the revenue
authorities on a case-by-case basis. Such opinions are not binding, but they may
provide protection from assessment of interest for late payment and penalties.
Although certain transfer pricing rules have been present in the Bulgarian tax
legislation for a long time, there are no developed transfer pricing practices. However,
in view of the recent amendments to the legislation, we expect revenue authorities will
begin to pay greater attention to this area.
Pursuant to the customs legislation, the base on which the customs duties are
calculated may be amended when the parties in the transaction are related. There
are rules for determining the arms-length price for customs duties purposes using
available data on comparable transactions.
1816. OECD issues
Bulgaria is not a member of the OECD. However, the general principles of the OECD
Guidelines are implemented in the Bulgarian transfer pricing rules and followed by the
Bulgarian tax authorities.
We are currently unaware of any simultaneous transfer pricing audits performed by the
Bulgarian tax authorities and those of other countries.
According to the Bulgarian thin capitalisation rules, the interest expenses incurred by a
resident company may not be fully deductible if the average debt-to-equity ratio of the
company exceeds 3:1 in the respective year. However, even if the debt-to-equity test is
not met, the thin capitalisation restrictions may not apply if the company has suffcient
profts before interest to cover its interest expenses.
Bulgaria
Interest under bank loans or fnancial leases are not restricted by the thin capitalisation
rules unless the transaction is between related parties or the respective loan or lease is
guaranteed by a related party.
The Bulgarian thin capitalisation rules also do not apply to interest disallowed on
other grounds (e.g. for transfer pricing purposes) and interest and other loan-related
expenses capitalised in the value of an asset in accordance with the applicable
accounting standards.
Even if some interest expenses are disallowed under thin capitalisation rules, they may
be reversed during the following fve consecutive years if there are suffcient profts.
The Bulgarian transfer pricing rules do not contain specifc tax regulations regarding
management services.
Canada
19.
C
Canada
1901. Introduction
Canadian transfer pricing legislation and administrative guidelines are generally
consistent with the OECD Guidelines. Statutory rules require that transactions between
related parties be carried out under arms-length terms and conditions. Penalties may
be imposed where contemporaneous documentation requirements are not met. There
have been two major transfer pricing cases litigated in Canada, and the number of
cases is expected to increase as the transfer pricing-related audit activity of the Canada
Revenue Agency (CRA) continues to intensify under ongoing mandates from the
federal government.
Canada has adopted International Financial Reporting Standards (IFRS), which will
become effective for public companies in their frst tax year on or after 1 January 2011
(or earlier with approval of the Canadian Securities Administrators). IFRS is optional
for private companies. A Canadian companys transfer pricing policies may need to be
reassessed in light of IFRS, as accounting practices transition to comply with the new
standards. For example, Canadian companies will need to assess how the adoption of
IFRS affects comparability to US companies used in a transactional net margin method
(TNMM) analysis, and how to address multiple-year analysis that includes periods of
different accounting practices.
Statutory rules specifc to transfer pricing
The Canadian statutory rules on transfer pricing contained in section 247 of Canadas
Income Tax Act (ITA) are effective for taxation periods beginning after 1997. These
rules embody the arms-length principle.
Transfer price is broadly defned to cover the consideration paid in all related party
transactions. Qualifying cost contribution arrangements are also specifcally covered
in the Canadian rules (see section 1921).
Transactions between related parties will be adjusted where the terms and conditions
differ from those that would have been made between parties dealing at arms length.
If arms-length parties would not have entered into the transaction, the nature of
the transaction can be adjusted (or recharacterised) in circumstances where it is
reasonable to consider that the primary purpose of the transaction is to obtain a tax
beneft. A reduction, avoidance or deferral of tax (or increase in a refund of tax) will be
viewed to be a tax beneft.
International Transfer Pricing 2011 Canada 283
Canada
The legislation contains no specifc guidelines or safe harbours to measure
arms length; rather, it leaves scope for the application of judgement. The best
protection against a tax authority adjustment, and penalties, is the maintenance of
contemporaneous documentation. The nature of the documentation required to avoid
penalties is described in the legislation.
The legislation is supported by administrative guidelines in the CRAs Information
Circular 87-2R (IC 87-2R) and the CRAs Transfer Pricing Memoranda (TPM-02
through TPM-12). The circular is cross-referenced to the OECD Guidelines.
To summarise the highlights of the Canadian legislation and administrative guidance:
The CRA recognises the following fve arms-length pricing methods in the circular:
comparable uncontrolled price (CUP), cost plus, resale price, proft split and
transactional net margin method (TNMM). The CRA will examine the application
of the method selected by a taxpayer to ensure that the selected method produces
the most reliable measure of an arms-length result (IC 87-2R paragraphs 47 to 63);
Related-party transactions may be adjusted if the CRA determines that they are not
on arms-length terms (section 247(2));
Transfer pricing adjustments that result in a net increase in income or a net
decrease in a loss may be subject to a non-deductible 10% penalty (section 247(3))
for taxation years beginning after 1998 (see section 1909);
Set-offs may reduce the amount of the adjustment subject to penalty where
supporting documentation for the transaction that relates to the favourable
adjustment is available (section 247(3)) and is approved by the Minister (section
247(10));
Penalties may not apply to a transaction where reasonable efforts were made to
determine and use arms-length transfer prices. Contemporaneous documentation
standards are legislated for that purpose (section 247(4)); and
IC 87-2R also provides some administrative guidelines on cost-contribution
arrangements, intangible property and intragroup services.
Other general provisions
Section 69(1) of the ITA contains the general rule for inadequate consideration, which
directs that a taxpayer who has acquired anything from, or disposed of anything to, a
person (whether resident or non-resident) with whom the taxpayer does not deal at
arms length will be deemed to have done so at fair market value. This section applies
only to transfers of property (or interest in property), whether tangible or intangible.
Section 67 of the ITA contains a general provision restricting the deductibility of
expenses to amounts that are reasonable in the circumstances, and section 18(1)(a)
restricts the deduction of expenses to those incurred for the purpose of gaining or
producing income from a business or property.
Where property or services have been obtained by a resident taxpayer from a related
non-resident at an overvalued amount or transferred from a resident taxpayer to a
non-resident at an undervalued amount, a beneft will have been conferred on the
non-resident. The amount will be recharacterised as a dividend and will be subject to
non-resident withholding tax of 25%. The withholding tax may be reduced depending
upon the provisions of a relevant tax treaty. These provisions may apply to transactions
with any related party, not just the parent or a shareholder. This result is accomplished
Canada 284 www.pwc.com/internationaltp
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through the combination of provisions in section 15(1), section 56(2), section 214(3)
(a) and section 212(2) of the ITA.
The Canadian legislation also includes a general anti-avoidance rule (GAAR) in
section 245 of the ITA that can apply to any transaction considered to be an avoidance
transaction. In transfer pricing situations, if the specifc provisions of section 247(2)
cannot be applied by the CRA, it is possible that the GAAR will be applied by the CRA.
Legislation relating to inter-company debt
Detailed legislation with respect to inter-company debt and interest charges also exists,
as follows:
Section 15(2) Loan treated as a dividend
This provision applies where a loan or any other indebtedness that is owing to a
corporation resident in Canada by a non-resident shareholder or a non-resident
person not acting at arms length with a non-resident shareholder has not been repaid
within one year (i.e. 365 days) from the end of the corporations tax year in which
the indebtedness arose. Where this provision applies, the amount is deemed to have
been paid as a dividend and is subject to non-resident withholding tax of 25%. The
withholding tax may be reduced depending upon the provisions of a relevant tax
treaty. Anti-avoidance rules prevent a long-term loan from being disguised by a series
of short-term loans and repayments. There are a number of exceptions to these rules,
such as loans to a foreign corporation that is a foreign affliate (defned as a foreign
corporation in which the Canadian corporation has an equity interest of at least 1%
and together with related parties has an equity interest of at least 10%).
The ITA provides a mechanism for the non-resident to apply for a refund of
withholding tax paid, within a certain period of time, upon the repayment of the loan
or indebtedness when the repayment is not part of a series of loans and repayments.
Section 17 Deemed interest income
Where a loan or other indebtedness owing from a non-resident to a corporation
resident in Canada is outstanding for one year (i.e. 365 days) or longer without a
reasonable rate of interest being charged, the corporation is deemed to earn income
from the loan or other indebtedness computed at a prescribed rate of interest and this
amount, net of any interest actually received, is included in the corporations income
for tax purposes. Section 17 does not apply, however, if section 15(2) as described
above applies to the loan or indebtedness. Loans to controlled foreign affliates are
excluded from the deemed interest rule provided that the funds loaned are used by
the controlled foreign affliate to earn income from an active business. Accordingly,
loans made downstream to these affliates can be non-interest-bearing. However, the
deductibility of any interest expense incurred in Canada relating to making such a loan
must be considered under the general interest deductibility guidelines.
Avoidance of these rules through the use of a trust or partnership is not possible where
a corporation resident in Canada is a benefciary or partner of the trust or partnership.
A further anti-avoidance provision imputes interest to the Canadian resident
corporation on an amount owing between two non-residents when it is reasonable to
conclude that such indebtedness arose because of a loan or transfer of property by the
corporation to a person or partnership.
Canada
Section 80.4(2) Deemed beneft treated as a dividend
Where a related non-resident has received a loan from or become indebted to a
corporation resident in Canada at a rate of interest less than the prescribed rate or at a
rate otherwise considered favourable to the non-resident, then the non-resident will be
deemed to have received a shareholder beneft under section 15(1). Loans to foreign
affliates are excluded from the deemed beneft rule. The amount of the beneft is
calculated by comparing the interest rate charged with the prescribed rate of interest.
This beneft is deemed to be a dividend and is subject to non-resident withholding tax
of 25%. The withholding tax may be reduced by the provisions of a relevant tax treaty.
This section does not apply, however, where section 15(2) as described above applies
or where the non-resident is a foreign affliate of the Canadian taxpayer.
Section 18(4) Thin capitalisation
The thin capitalisation rules can result in the permanent denial of an interest expense
deduction to a corporation resident in Canada (see section 1919).
Section 78(1) Unpaid expenses included in income
This provision applies where a corporation resident in Canada has previously deducted
an amount that is owing to a related non-resident and has not paid or settled the
liability within two tax years following the year in which the liability was incurred. In
these circumstances, the unpaid amount is included in the income of the corporation in
the third tax year following the year in which the liability was incurred. Alternatively,
an election may be fled to have the liability deemed as paid and loaned back to
the corporation on the frst day of the third tax year, although this may result in a
withholding tax liability on the amount deemed as paid. If such an election is fled late
(i.e. more than six months after the third year), 25% of the unpaid amount will still be
included in income in the third year.
Reporting requirements relating to transfer pricing
Section 231.6 Foreign-based information or documentation
The CRA may formally serve notice requiring a person resident or carrying on business
in Canada to provide foreign-based information or documentation where this is
relevant to the administration or enforcement of the ITA. Supporting documents
for inter-company charges and transfer pricing are prime examples of the types of
information likely to be formally required. If the information or documentation is
not produced following the delivery of the notice, then that information may not be
used as a defence against a later reassessment. Such notices requiring the taxpayer to
provide certain information must set out the time frame for production, a reasonable
period of not less than 90 days. Taxpayers can bring forth an application to have the
requirement varied by a judge. Failure to provide the information or documentation
may lead to possible fnes or possible imprisonment as discussed in section 238(1). In
a 2003 decision, the Tax Court of Canada (TCC) prohibited Glaxo SmithKline Inc. from
submitting foreign-based documents as evidence in its transfer pricing trial, because
the documents had not been provided to the CRA earlier when it had served a notice
pursuant to section 231.6(2). In a 2005 decision, the TCC upheld the CRAs right to
request such documentation from Saipem Luxembourg, S.A.
Section 233.1 Annual information return: non-arms-length transactions with non-
resident persons
Persons carrying on business in Canada are required to fle an annual information
return reporting transactions with related non-residents. For every type of transaction
(e.g. tangible property, services, royalty arrangements, factoring, securitisations and
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securities, lease payments, securities lending, derivative contracts, etc.) it is necessary
to identify the transfer pricing methodology used.
The prescribed form, Form T106, Information Return of Non-Arms-length
Transactions with Non-Residents (see also section 1906), also asks for the North
American Industrial Classifcation System (NAICS) codes for the transactions reported,
whether any income or deductions are affected by requests for competent authority
assistance or by assessment by foreign tax administrations, and whether an advance
pricing arrangement in either country governs the transfer pricing methodology.
A separate T106 form is required for each related non-resident that has reportable
transactions with the Canadian taxpayer. Each form asks if contemporaneous
documentation has been prepared for transactions with that related non-resident. The
CRA imposes late-fling penalties with respect to these forms.
A de minimis exception removes the fling requirement where the total market value of
reportable transactions with all related non-residents does not exceed CAD1 million.
Foreign reporting requirements
Canadian residents are required to report their holdings in foreign properties and
certain transactions with foreign trusts and non-resident corporations. Signifcant
penalties will be assessed for failure to comply with these rules.
Section 233.2 Information returns relating to transfers or loans to a non-resident trust
Generally, amounts transferred or loaned by a Canadian resident to a non-resident
trust, or to a company controlled by such a trust, must be reported annually on Form
T1141. The fling deadlines generally depend upon whether the Canadian resident is
an individual, corporation, trust or partnership. The rules are complex and should be
reviewed in detail for possible application.
Section 233.6 Information return relating to distributions from and indebtedness to a
non-resident trust
Where a Canadian resident is a benefciary of a non-resident trust and is either
indebted to or receives a distribution from such trust, such transactions must be
reported on Form T1142.
Section 233.3 Information return relating to foreign property
Where the cost of the Canadian resident taxpayers total specifed foreign property
exceeds CAD100,000 at any time in the year, Form T1135 should be fled. The foreign
property defnition is comprehensive. Specifc exclusions from the defnition include
personal assets (e.g. condominiums), property used exclusively in an active business
and assets in a pension fund trust.
Section 233.4 Information return relating to foreign affliates
Where a person (including a corporation) or a partnership resident in Canada has
an interest in a corporation or a trust that is a foreign affliate or a controlled foreign
affliate, the person or partnership is required to fle an information return (Form
T1134A or T1134B) for each such corporation or trust. Financial statements of the
corporation or trust must also be submitted. The fling deadline for these information
returns is 15 months after the person or partnerships taxation year-end.
Canada
Treaty-based disclosure
Any non-resident corporation that carries on business in Canada and is claiming a
treaty-based exemption from Canadian tax must fle a Canadian income tax return,
together with Schedules 91 and 97. This fling will identify those non-resident
companies that are carrying on business in Canada without a permanent establishment
(PE) or that are eligible for any other type of treaty exemption from Canadian
incometax.
The CRA releases information explaining its interpretation of various taxation matters
through a series of publications. This series includes:
Information circulars, which deal with administrative and procedural matters;
Interpretation bulletins, which outline the CRAs interpretation of specifc law;
Advance tax rulings, which summarise certain advance tax rulings given by the
CRA; and
Other documents.
These publications represent what is known as departmental practice, in that they
do not have the authority of legislation. However, the courts have found that these
publications, while not determinative, can be persuasive where there is any doubt
about the meaning of the legislation. News releases are another source of information,
which communicate current changes in and confrm the current position of the CRA on
income-tax issues.
There are relatively few guidelines on transfer pricing published by the CRA. Those
available are summarised below.
Information Circular (IC) 87-2R: International Transfer Pricing
IC 87-2R, dated 27 September 1999, provides guidance with respect to the application
of the transfer pricing rules as amended in 1998 to conform to the 1995 OECD
Guidelines.
To complement IC 87-2R, the CRA has published other documents on various transfer
pricing matters. As of 1 March 2010, the following documents were available on the
CRAs website:
16 March 2001, IC 94-4R regarding advance pricing arrangements (see
section1914);
27 March 2003, TPM 02 Repatriation of Funds by Non-Residents Part XIII
Assessments: This document explains the CRAs policy on the repatriation of funds
following a transfer pricing adjustment under section 247(2) of the ITA;
20 October 2003, TPM 03 Downward Transfer Pricing Adjustments under
Subsection 247(2) [of the ITA]: This document provides guidance on dealing with
downward transfer pricing adjustments that may result from an audit or from a
taxpayer-requested adjustment;
27 October 2003, TPM 04 Third-Party Information: This document provides
guidelines on the use of confdential third-party information in the context of
transfer pricing audits by CRA auditors.
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13 October 2004, TPM 05 Contemporaneous Documentation: This document
provides directives to CRA auditors concerning requests for contemporaneous
documentation pursuant to section 247(4) of the ITA;
1 January 2005, IC 71-17R5 regarding competent authority assistance under
Canadas tax conventions (see section 1913);
18 March 2005, IC 94-4RSR (Special Release) regarding advance pricing
arrangements for small businesses (see section 1914);
16 May 2005, TPM 06 Bundled Transactions: This document explains that the
CRA will accept bundled transactions in certain circumstances;
2 August 2005, TPM 07 Referrals to the Transfer Pricing Review Committee:
This document replaces a 26 March 2003 document with the same title (TPM 01,
which remains available in an archive on the CRAs website for reference purposes).
Like its precursor, this document provides guidelines for referrals by CRA auditors
to the International Tax Directorate and the Transfer Pricing Review Committee
regarding the possible application of the penalty under section 247(3) of the ITA
or the possible recharacterisation of a transaction pursuant to section 247(2)(b).
The more recent version seeks to ensure a more open dialogue with taxpayers for
consistent and fair application of the transfer pricing penalties;
5 December 2005, TPM 08 The Dudney Decision Effects on Fixed Base or
Permanent Establishment Audits and Regulation 105 Treaty-Based Waiver
Guidelines: This document provides guidelines and a general framework for
permanent establishment determinations;
18 September 2006, TPM 09 Reasonable Efforts under Section 247 of the Income
Tax Act: This document provides guidance as to what constitutes reasonable efforts
to determine and use arms-length transfer prices or arms-length allocations; it
also provides examples of situations where taxpayers are more at risk for a transfer
pricing penalty;
29 June 2007, TPM 10 Advance Pricing Arrangement (APA) Rollback: This
document conveys the policy regarding an APA request to cover prior tax years,
sometimes referred to as an APA rollback.
28 October 2008, TPM 11 Advance Pricing Arrangement (APA) Rollback: This
document cancels and replaces TPM 10 with respect to APA rollbacks and clarifes
CRA policy on this issue; and
12 December 2008, TPM 12 Accelerated Competent Authority Procedure (ACAP):
This document provides guidance on ACAP, which provides for the resolution of a
Mutual Agreement Procedure (MAP) case to be applied to subsequent years.
The CRA provided guidance on range issues as they arise in testing a taxpayers
(or its affliates) proftability. This guidance on range issues that arise in the test
procedure was published in an article presented at the Canadian Tax Foundation
2002 Tax Conference by Ronald I. Simkover, Chief Economist, International Tax
Directorate, CRA.
In March 2003, the Pacifc Association of Tax Administrators (PATA), whose member
countries are Australia, Canada, Japan and the US, published its fnal transfer pricing
documentation package. This document presents the principles under which taxpayers
can prepare a single documentation package that meets the transfer pricing provisions
of each PATA member country. The use of PATAs documentation package is voluntary
and if its principles are satisfed will protect the taxpayer from the transfer pricing
documentation penalties that might otherwise apply in each of the four jurisdictions.
Canada
1904. Legal cases
Relatively few transfer pricing cases have been heard in Canada to date, as many
issues are resolved at the audit and appeals levels. Two important court cases relating
to transfer pricing have recently been decided by the Canadian courts. Both are
beingappealed.
GlaxoSmithKline v. The Queen 2008 TCC 324 (30 May 2008)
Canadas frst major transfer pricing court case, this decision illustrates the TCCs
endorsement of the hierarchy of methods set out in the OECD Guidelines, where
transactional methods are considered preferable to a proft-based analysis. At issue in
the case was whether the price paid by a pharmaceutical company to a related party for
an active ingredient used in a popular drug met the arms-length standard.
The pharmaceutical company, GlaxoSmithKline Inc. (GSK Canada), appealed a
reassessment by the Minister of National Revenue (the Minister) in which it increased
GSK Canadas income over the three-year period from 1990 to 1993 on the basis that
it overpaid its related party supplier for the purchase of ranitidine hydrochloride
(ranitidine). Ranitidine is an active ingredient in the heartburn drug known as Zantac,
which is sold by GSK Canada.
During the three-year period, GSK Canada purchased ranitidine from Adechsa S.A.
(Adechsa), a related party based in Switzerland, pursuant to a supply agreement. The
ranitidine was manufactured by a related party in Singapore. In terms of profts earned
from these sales, the companys transfer pricing policy allowed the manufacturer to
earn gross profts of approximately 90%; Adechsa was required to earn a minimum 4%
proft (as agreed with the Swiss tax authorities); and GSK Canada earned gross profts
of approximately 60% on the sale of Zantac.
Also of note, GSK Canada had separate inter-company licence and supply agreements
with respect to Zantac and paid a 6% royalty to a related party in the UK for the rights
to certain related intangibles and services.
The Minister submitted that in this case the comparable uncontrolled price (CUP
method was the preferred method for determining an arms-length price, and that
the price paid by generic pharmaceutical producers over the same period for generic
ranitidine, which ranged between CAD194 to CAD304/kilogram (kg), represented
a reasonable price that GSK Canada should pay. In fact, GSK Canada paid Adechsa
from CAD1,512 to CAD1,651/kg for ranitidine, and on reassessment, the Minister
disallowed the deduction of the amount of the purchase price paid that exceeded the
highest price paid by the generic pharmaceutical producers.
GSK Canada offered evidence that included a resale price method analysis as well as
a TNMM analysis. The resale price analysis involved third-party European licensees
of GSK that sold ranitidine products in local markets and were required to purchase
ranitidine from suppliers approved by the GSK Group. GSK Canadas expert witness
compared the gross margins earned by the European licensees to those earned by GSK
Canada and concluded that the prices paid by GSK Canada were not in excess of arms-
length prices.
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The TCC rejected this argument for a number of reasons, including the fact that
the European licensees did not operate in the same market as GSK Canada and had
obtained a number of intangibles and services in their agreements with the GSK Group
that were not provided to GSK Canada in its supply agreement with Adechsa.
The TCC agreed with the Minister with respect to both the CUP method and the choice
of comparable transactions. Specifcally, the TCC indicated that the highest price paid
by the generic pharmaceutical producers represented a reasonable price that GSK
Canada could have paid Adechsa. The court increased this price by $25/kg to account
for some additional processing performed by the manufacturer in Singapore.
Generally, the court confned its review to assessing a reasonable price for GSK Canada
to pay for ranitidine, examining only the terms of the supply agreement with Adechsa.
It did not consider the overall commercial arrangement whereby GSK Canada paid a
combination transfer price for the ranitidine as well as a 6% royalty for trademarks,
technical assistance, registration materials and marketing support, all of which GSK
Canada needed to sell Zantac at a premium price in the Canadian market.
From the judgment it is not clear if any consideration was given to whether GSK
Canada was rewarded for its functions, risks and intangibles, as one might expect in
arms-length arrangements (i.e. the court did not consider whether the 6% royalty
in conjunction with an approximate $1,500/kg transfer price reasonably rewarded
GSK Canada). By focusing only on the supply agreement, the court found that the
Ministers generic comparables were the closest comparables when analysed under the
comparability standards of the OECD Guidelines.
General Electric Capital Canada Inc. v. The Queen 2009 TCC 563 (4 December 2009)
Canadas second major transfer pricing case, General Electric Capital Canada Inc.
involves the deductibility of guarantee fees paid by a subsidiary to its parent.
The Minister disallowed General Electric Capital Canada Inc.s (GECCs) deduction
of guarantee fees paid to its US-based parent company, General Electric Capital
Corporation (GECUS), for guaranteeing GECCs third-party debts. Fees were in the
amount of CAD136 million and paid over the period from 1996 to 2000.
The Minister had concluded that GECC did not need a guarantee arrangement to
borrow money because its credit rating would be equalised with that of GECUS,
solely by reason of affliation (at the time, GECUS enjoyed an AAA credit rating).
Furthermore, GECUS would have incentive to provide implicit support to GECC in a
loan situation, as any defaults might affect the credit rating of the entire group. With
this in mind, the Minister concluded that GEEC received no economic beneft from
the guarantee (i.e. other then the benefts it already received at no cost, by affliation)
and that as a result the arms-length price of the guarantee was zero. Issues to be
determined by the TCC were whether the guarantee conferred a beneft on GECC and,
if so, a reasonable charge for this beneft.
GECC submitted that the guarantee provided a beneft beyond the implied support it
received by affliation with GECUS, because it enabled GECC to borrow large amounts
of capital at interest rates enjoyed by GECUS, which would not have been the case
with an implicit guarantee only. It further claimed that to measure the beneft of the
guarantee, its credit rating should be estimated without the explicit guarantee (i.e.
on a standalone basis) without factoring in any implicit support from GECUS. On this
Canada
basis, GECCs standalone credit rating was at best BB in the applicable years, and the
economic beneft enjoyed by GECC under the guarantee arrangement far exceeded the
fee paid to GECUS.
Furthermore, GEEC provided evidence that the decision to guarantee GECCs debt
obligations was a business decision (made in 1989, with payment of fees beginning in
1996). The purpose of the decision was to ensure that GECC had access to capital at
the lowest possible cost, so that it could compete with other lenders, such as banks,
with lower costs of capital. The TCC accepted this evidence, which was provided in
the testimony of a GECUS former treasurer who had implemented the guarantees.
The TCC also agreed that GECC received benefts from the guarantee, noting that it
enabled it to raise funds without having a standby bank facility to support debt issued
in commercial paper markets, and that it allowed it access to a pool of capital it would
not otherwise have had access to at interest rates available to an AAA-rated company.
Furthermore, GECC did not have to pay placement fees.
The TCC rejected the submission of the Minister, stating that implicit support from a
parent in these circumstances is of limited value, as few investors would believe it to
be the equivalent of an explicit guarantee. In this case, for example, the investment
community would have reacted negatively to the removal of the GECUS guarantee
from the GECC debt.
In terms of determining the appropriate charge for the fee, the TCC assumed a three-
notch increase to GECCs standalone credit rating, recognising that reputational
pressures and economic incentives would entice GECUS to provide support to
maintain its own AAA credit rating. GECCs standalone credit ratings of BB-/B+ were
subsequently increased to BBB/ BB+. The TCC concluded that a 1% guarantee fee is
equal to or below an arms-length price.
Generally, the TCC favoured the testimony of the witnesses that were in the business
trenches, giving more credence and value to business judgement in the economic
environment over the period. The TCC also accepted the quantitative evidence
presented that evaluated the creditworthiness of GECC and the beneft obtained by
GECC under the yield approach to estimating guarantee fees.
The TCC did not impose a strict separation of GECC and GECUS. Rather, in its
interpretation of the arms-length principle, it recognised and considered all of the
economically relevant characteristics of the transaction that may infuence the arms-
length price in their negotiations. In other words, the arms-length principle requires
that the TCC evaluate the guarantee transaction in place between GECC and GECUS
and consider the overall economics of the controlled transaction, including the overall
business environment, to ensure reliable comparisons to uncontrolled transactions.
The guarantee fee was established in the context of the parentsubsidiary relationship
where implicit support is a relevant economic characteristic, and should not be
included in the quantifcation of the beneft from which the fee is derived.
Current cases under review
In a case still pending, Tregaskiss Limited (Tregaskiss), a Canadian private corporation
that manufactures metal inert gas welding guns and related products, is asserting that
the CRA effectively recharacterised its Barbados distribution company as a call centre.
The CRA reallocated to Tregaskiss profts earned by the Barbados company on the basis
that it was actually a routine service provider. The Barbados company had a legal and
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operational presence in Barbados, operating from a 1,100-square-foot leased offce
premises and employing four staff: two offce clerks, an offce manager/bookkeeper
and the president/managing director. The president/managing director was the largest
shareholder of Tregaskiss, but also had more than 20 years of industry experience
and was responsible for sales, marketing, services and logistical operations at the
Barbadosplant.
Based on its assessment of the functions performed and risks assumed, the CRA
determined that the proft realised by the Barbados company should be comparable
to that earned by call centres rather than full-fedged distributors. It then increased
the price of goods sold to the Barbados company by Tregaskiss, who manufactured
the goods, to reallocate a substantial portion of the profts back to Canada. In making
this adjustment, the CRA also noted the lack of consideration paid by the Barbados
company, when it was established, for international distributorship rights, and the fact
that those rights covered territories served by existing wholesale distributors.
The recharacterisation of a transaction can have a very signifcant effect on the tax
position of the parties involved. While ongoing transactions may appear to the parties
to have arms-length terms and prices within their legal relationship, the CRA has the
discretion under certain circumstances to revise the nature of the relationship to refect
its particular characterisation. Any situations involving the transfer of assets, rights,
functions or operations that could have a material long-term effect on income streams
within a multinational group of related corporations must be reviewed to ensure that
fair market values have been established and paid.
Even when fair market value is established and paid, the CRA has attempted to
recharacterise a sale of rights as a licence of the rights for an ongoing royalty if that
results in a higher allocation of profts to Canada, arguing that no arms-length party
would enter into such a sale. The CRAs success with the recharacterisation provision
has yet to be proven in court.
Frequency of transfer pricing cases
Court cases on transfer pricing in Canada are not frequent. It is expected that the
number of cases will increase as the CRA continues to focus on transfer pricing
ingeneral.
Under the Canadian taxation system, the taxpayer makes a self-assessment of tax,
which is then assessed by the CRA (either with or without an audit). In the event of
an audit by the tax authorities, the burden of proof to satisfy the tax authorities that
transfer prices are arms length lies with the taxpayer.
This requirement took on a new dimension in the 1997 transfer pricing legislation. The
taxpayer is required to show that it has made reasonable efforts to determine and use
arms-length transfer prices in order to exclude any related adjustments from penalty.
The maintenance of complete and accurate contemporaneous documentation, as
provided in the legislation, will constitute reasonable efforts for these purposes (see
section 1906).
Canada
Transfer pricing is monitored initially through the routine tax audit process.
Typically, transfer pricing issues are referred to senior auditors who specialise in the
internationalarea.
Form T106 (see also section 1902) requires disclosure of information on transactions
with related non-resident persons. It is understood that information gathered from
these forms is used in selecting candidates for transfer pricing audits.
Provision of information and duty of the taxpayer to cooperate with the
tax authorities
If a transfer pricing question arises during an audit, prompt response to any requests
for information and evidence that all necessary resources are being dedicated to
gathering that information are important. The taxpayer should try to resolve the issues
with the feld auditor based on available information. Extensive delays in providing the
information should be avoided, because the feld auditor may interpret such delays as
an indication that transfer pricing policies and documents are informal or nonexistent.
Because the onus of proof is on the taxpayer to provide suffcient support for the arms-
length nature of its transfer pricing, it is in the taxpayers best interest to provide as
much supporting evidence as possible. As discussed earlier, section 231.6 of the ITA
requires foreign information or documents that are available or located outside Canada
to be provided to the CRA if these are relevant to the administration or enforcement of
the ITA. Failure to comply may result in the foreign-based information or documents
being inadmissible in defending a later reassessment in court.
Contemporaneous documentation
The CRA continues to pursue a relatively aggressive programme of transfer pricing
enforcement. Any transfer pricing adjustment may be subjected to a 10% penalty,
with some de minimis exceptions (see section 1909), unless the taxpayer has
made reasonable efforts to determine and use arms-length prices. This requires
contemporaneous documentation to be on hand at the time the tax returns for the year
are due (i.e. six months after the end of the taxation year for corporations).
As a minimum, the taxpayer should have a complete and accurate description of
thefollowing:
The property or services to which the transaction relates;
The terms and conditions of the transaction and their relationship, if any, to
the terms and conditions of each other transaction entered into between the
participants in the transaction;
An organisation chart the identity of the participants in the transaction and their
relationship to each other at the time the transaction was entered into;
A functional analysis the functions performed, the property used or contributed
and the risks assumed, in respect of the transaction, by the participants in the
transaction;
The data and methods considered and the analysis performed to determine the
transfer prices or the allocations of profts or losses or contributions to costs, as the
case may be, in respect of the transaction; and
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The assumptions, strategies and policies, if any, that infuenced the determination
of the transfer prices or the allocations of profts or losses or contributions to costs,
as the case may be, in respect of the transaction.
Where contemporaneous documentation has been prepared for a prior year, the ITA
provides that only those items that pertain to a material change in respect of a transfer
pricing transaction must be addressed.
1907. The transfer pricing audit procedure
Transfer pricing audits can be initiated in two ways: as part of a regular corporate audit
(where transfer pricing may be included in the audit at the discretion of the audit case
manager), or when a local international tax auditor screens a fle solely for a transfer
pricing audit, primarily using form T106 (see also section 1902), which taxpayers must
fle annually.
CRA auditors are required to provide a taxpayer with a written request for the
taxpayers contemporaneous documentation at the initial contact stage of a transfer
pricing audit. The request states that the transfer pricing documentation must be
provided within three months from the date of service of the request. Canadas transfer
pricing legislation offers no opportunity to negotiate an extension of the three-
month deadline: the time frame is specifed in the ITA and is not discretionary. If the
deadline is not met, the taxpayer will be deemed not to have made reasonable efforts
to determine and use arms-length transfer prices and may be subject to penalty if an
adjustment is ultimately assessed that exceeds the legislated penalty threshold.
After the CRA has been provided with the contemporaneous documentation, the
auditor will normally visit the taxpayers premises (and in some cases the premises
of the non-resident related party) to confrm the information contained in the
documentation. In some circumstances, the auditor may refer the case to the CRAs
head offce to obtain technical assistance from economists.
Statute of limitations
The legislative statute of limitations for most taxpayers is four years. However,
transactions with related non-resident persons can be subject to audit for up to seven
years after the tax year is initially assessed. In the rare situations where an audit may
take longer, the CRA can request that the taxpayer sign a waiver to extend beyond the
seven years. Such waiver must be signed within the seven-year period. The CRA has
stated that it is committed to timely review and audit.
The appropriate tax treaty should be consulted. Often treaties include a provision
whereby a taxpayer must be reassessed within a specifed period in order for the
taxpayer to preserve its right to request competent authority assistance in the event
of double taxation. Such a reassessment can be raised regardless of whether the audit
iscompleted.
1908. Reassessments and the appeals procedure
Many transfer pricing issues can be resolved with the feld auditor or the auditors
supervisor based on information provided and discussions held during the audit. If an
issue cannot be resolved, the CRA will issue a Notice of Reassessment for tax owing
based on its audit fndings. At this stage, a taxpayer may have two options. The frst is
Canada
to pursue the issue through the CRAs appeals division and possibly the Canadian tax
courts. The second (which is available only if the transfer pricing reassessment involves
a related entity in a country that has a tax treaty with Canada) is to request relief
through competent authority.
In either case, the taxpayer should fle a Notice of Objection. A taxpayer has 90 days
from the date of mailing of the Notice of Reassessment to fle this document. Doing
so can initiate the appeal process (if that is the desired option), or the taxpayer can
request the Notice of Objection be held in abeyance while the taxpayer pursues relief
through the competent authority process. If the taxpayer pursues the appeal process
and is not satisfed with the appeal result, the taxpayer may then seek a resolution in
the Canadian tax courts. If the taxpayer chooses to pursue relief through the competent
authority process, the Notice of Objection will protect the taxpayers rights of appeal in
the event that the competent authority process does not resolve the issue.
A taxpayer can request competent authority assistance after the taxpayer has
proceeded through the appeal process and/or obtained a decision from a Canadian tax
court. However, the Canadian competent authority will be bound by any settlement
with the CRAs appeals division or by a Canadian court decision in its dealings with
the foreign competent authority, without the ability to negotiate a different result.
Whether relief from double taxation is provided is at the sole discretion of the foreign
competent authority.
A large corporation (as defned under the ITA), may be required to remit 50% of any
amounts owing to the federal government as a result of the reassessment (tax, interest
and penalties) while appealing the Notice of Reassessment. This relief is not available
in the case of withholding taxes and provincial taxes.
For tax years commencing after 1998, the transfer pricing penalty provisions apply.
Transfer pricing adjustments can result from the following two circumstances:
A net increase in income or a net decrease in loss; and
A reduction in the taxpayers tax cost of non-depreciable and depreciable capital
property and eligible capital property.
These transfer pricing adjustments are liable for a 10% penalty, subject to
certainexceptions:
Penalties will not be applied where the net transfer pricing adjustment does not
exceed the lesser of 10% of the taxpayers gross revenue and CAD5 million; and
No penalties will be applied where the taxpayer has made reasonable efforts to
determine that its prices are and to document such on or before the date its tax
return is due for the taxation year (see section 1906). Taxpayers must be able to
provide this documentation to the Minister of National Revenue within three
months of a request for that purpose.
The legislation allows favourable adjustments to reduce unfavourable adjustments
when determining the amount subject to penalty. To obtain a set-off, however,
taxpayers must have documentation supporting the transaction to which the
favourable adjustment relates and receive the Ministers approval of the favourable
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adjustment. As a result, taxpayers without contemporaneous documentation cannot
beneft from set-offs.
During 2006, the CRA issued a transfer pricing memorandum (TPM-09), which
provides additional guidance on what constitutes reasonable efforts to determine and
use arms-length transfer prices. According to TPM-09, a reasonable effort is defned
as the degree of effort that an independent and competent person engaged in the
same line of business or endeavour would exercise under similar circumstances.
Furthermore, the CRA considers a taxpayer to have made reasonable efforts when
the taxpayer has taken all reasonable steps to ensure that [its] transfer prices or
allocations conform with the arms length principle.
Canadas penalties are based on the amount of the transfer pricing adjustment and can
apply when the taxpayer is in a loss position, such that no increased taxes are payable
as a result of the adjustment. In the event of capital transactions, the penalty applies to
the taxable portion of any gain. As of 30 September 2009, the TPRC has received 199
transfer pricing penalty referrals, with penalties recommended in 106 cases. In 55% of
the penalty-referred cases, documentation was either not prepared contemporaneously
(i.e. within six months of the taxpayers year-end) or not received by the CRA by the
documentation request deadline (i.e. three months after the request).
The TPRC has received 33 recharacterisation referrals. Of these, 15 have been
abandoned, nine have been approved for reassessment and nine are ongoing.
Interest (at rates prescribed by the CRA) is charged on the underpayment of income-
tax liabilities and withholding tax. This interest is not deductible for income-tax
purposes. Interest is not charged on transfer pricing penalties unless the penalty is not
paid within the required time frame.
Each of the CRAs tax services offces has international tax auditors who either conduct
the transfer pricing audit themselves or act in an advisory role to regular corporate
auditors. Supporting these international auditors when necessary are teams of
economists, lawyers or more senior international auditors located at the CRAs head
offce. At any time, if necessary, the CRA engages outside consultants to provide
expertise in specifc areas. Although this is normally done at the appeal level when
preparing for litigation, outside experts can be engaged during the audit process.
As the CRA views transfer pricing audits as high risk, it is placing more international
auditors and economists in the feld.
When reviewing a taxpayers proftability using a cost-plus method, resale method
or TNMM analysis, there are several databases that contain fnancial information on
comparable public companies that can be used to evaluate the appropriateness of
proft levels. Canadian databases contain limited information, as there are relatively
few public Canadian companies whose activities are narrow enough to provide good
comparables for routine activities. As a result of the lack of Canadian information, US
information is often used to evaluate proftability levels in Canada. US information, in
Canada
general, is more readily available and complete. Public databases are also available that
contain royalty and investment management agreements.
The CRA can also use secret comparables. This is non-public information that
the CRA has normally acquired through the administration and enforcement of
the ITA. Examples include fnancial information fled by taxpayers with their tax
returns and information acquired during an audit of another taxpayer. Since the
CRA may encounter resistance if it attempts to introduce secret comparables in a
court proceeding, their use on a routine audit is rare. In 2003 (see section 1903), the
CRA reaffrmed its right to collect confdential third-party information and use that
information as an audit tool for screening purposes, for secondary support and as a last
resort to form the basis of an assessment.
Although the CRA may not be targeting any particular industry for transfer pricing
audits, it has begun to adopt an industry-based audit approach by developing tax
service offces (TSOs) that have expertise in specifc industries. TSOs are currently
being piloted with respect to the following four industries: pharmaceutical (Laval,
Quebec), automotive (Windsor, Ontario), banking (Toronto, Ontario) and oil and gas
(Calgary, Alberta). It is not yet known whether this approach will be extended to other
industries. Over time, the CRA is expected to become more sophisticated with respect
to its understanding of transfer pricing issues in various industries and to develop
national industry-specifc audit procedures.
Specifc transactions being scrutinised by the CRA include intragroup services,
inter-company debt, interest charges, guarantee fees, royalty payments, intellectual
property migrations, contract manufacturing arrangements and restructuring and
plant closures. Again, the CRA may not focus on a particular type of transaction but,
based on recent audit experience, is paying more attention to intragroup services and
fnancial transactions.
In the 2005 federal budget, the CRA was infused with additional funding to expand its
Aggressive International Tax Planning (AITP) initiative, a division of the International
and Large Business Directorate. The AITP initiative is aimed at identifying and
responding to international transactions that may be designed to avoid paying income
tax in Canada. The additional funding, which was split equally between international
tax audits and tax avoidance audits, resulted in the hiring of 140 international and
avoidance auditors by CRA offces across Canada.
Canadas income-tax treaties contain two articles that are relevant to transfer pricing.
The Associated Enterprises article provides a defnition of related parties for the
purpose of the treaty and possibly a time line within which a reassessment can be
raised (in the absence of a time line, the time provided under domestic legislation
prevails). The mutual agreement procedure (MAP article provides the competent
authorities the ability to attempt to resolve taxation not in accordance with the treaty
(e.g. double taxation).
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A taxpayer does not need to wait for the issuance of a Notice of Reassessment before
fling a request for competent authority assistance. However, the competent authority
will not act upon such a request until a reassessment has been issued.
The competent authority process where a Canadian taxpayer has been reassessed
can be summarised as follows. The non-resident related party must fle a request
for competent authority assistance (complete submission) in the foreign country of
residence within the time frame contained in the treaty. A similar request is normally
fled simultaneously with the Canadian competent authority. Upon receipt of a
request from the non-resident, the foreign competent authority informs the Canadian
competent authority that it has received such a request, and requests a position
paper outlining the details pertaining to the reassessment. The Canadian competent
authority obtains the auditors working papers, reviews the case and provides the
position paper, after which negotiations between the competent authorities take place
through face-to-face meetings or correspondence to resolve the double taxation. Once
the competent authorities reach agreement, they each send a letter to the taxpayers
in their respective countries informing them of the proposed settlement to avoid the
double taxation. Once the taxpayers have accepted the proposed settlement, each
competent authority has the necessary adjustments processed in its respective country.
The timing for fling a competent authority request varies from treaty to treaty. It
is therefore extremely important to consult the MAP article of the relevant treaty.
Generally, the competent authority submission must be fled within two years from the
date of the Notice of Reassessment.
Canada currently has two treaties where the Associated Enterprises article requires the
other competent authority be notifed of a potential request for competent authority
assistance within six years from the end of the taxation year under audit. With this
notifcation provision, the MAP articles in those treaties do not contain a time frame
within which the competent authority submission must be fled.
If a request for competent authority assistance with a submission or notifcation is not
fled on time, a taxpayer may be denied relief by the competent authority of the non-
resident related party.
The CRAs Competent Authority Services Division is responsible for the competent
authority function as it pertains to the MAP and Exchange of Information articles
contained in the treaties. Case offcers in this division meet quarterly with their US
counterparts and occasionally with governments of other foreign jurisdictions to
discuss specifc cases.
With the signing of the protocol amending the Canada-US treaty on 21 September
2007, diplomatic notes were also exchanged by the two governments, which paved the
way for binding arbitration in MAP cases. The protocol was ratifed on 15 December
2008, and the earliest a case can proceed to arbitration is 15 December 2010. The
process is referred to as baseball arbitration, where an arbitration board comprised of
three members will select one of the proposed resolutions provided by the competent
authorities as its determination.
TPM 12 Accelerated Competent Authority Procedure was released 12 December
2008. This document provides guidance on the process where, upon request by the
Canada
taxpayer, the issues that gave rise to a MAP case can be addressed in subsequent years
by the competent authorities (see section 1902).
The CRAs MAP programme report for 2009 contained the following highlights:
A total of 316 new cases were accepted during the year;
Of new cases accepted, 109 were categorised as negotiable (i.e. involving another
tax administration);
Of the 306 cases in inventory that were completed, 83 were negotiable;
The average time to complete a negotiable competent authority case was 28
months; and
Full relief was granted in 89% of the negotiable cases.
1914. Advance pricing arrangements (APA)
Canada was one of the frst countries to implement an APA programme (it did so in the
early 1990s). The APA service is intended to assist Canadian taxpayers in determining
transfer prices acceptable to the CRA for the purposes of the ITA and, where negotiated
with tax authorities of other jurisdictions, the relevant treaties with those countries.
An APA is intended to consider proposed pricing arrangements or methodologies that
have prospective application. The APA is designed to seek agreement on an appropriate
transfer pricing methodology for a specifed cross-border transaction between related
parties, as opposed to seeking agreement on specifc prices. The service is offered
in addition to competent authority assistance on the appropriateness of historic
transactions that have been challenged by one or both of the jurisdictions involved.
APAs can be unilateral, bilateral or multilateral. At the conclusion of the procedure,
there is a binding agreement between the taxpayer and the CRA and, in the case of
bilateral or multilateral APAs, between the CRA and the other tax authorities involved.
IC 94-4R, dated 16 March 2001, outlines the procedures and guidelines for obtaining
APAs in Canada.
During 2007, the CRA announced the following changes to the APA programme as they
pertain to the rollback of transfer pricing methodologies agreed upon through the APA
process. The changes established the following regarding rollbacks:
A rollback will be considered if a request for contemporaneous documentation has
not been issued by the CRA;
The facts and circumstances are the same;
The foreign tax administration and the CRA both agreed to accept the APA
rollbackrequest;
The fling of a waiver for each year in question in accordance with the ITA;
Once an APA is in force, transactions occurring in tax years covered by the APA and
the rollback period will not be subject to a transfer pricing penalty;
The CRA will not issue a request for contemporaneous documentation for
transactions in a year that a taxpayer has requested to be covered by an APA
rollback at a pre-fling meeting; and
An APA rollback will not be permitted when a taxpayer requests a unilateral APA.
The frst year of implementation for a unilateral APA will be the frst taxation year for
which a tax return has not been fled.
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These changes will be refected in the next revision to IC 94-4R.
On 18 March 2005, the CRA released IC 94-4RSR (Special Release) on the topic of
advance pricing arrangements for small businesses. The key highlights contained in
this release are:
The programme will have a fxed nonrefundable administration fee of CAD5,000;
Taxpayers must have gross revenues of less than CAD50 million or a proposed
transaction to be covered by the APA of less than CAD10 million;
The programme will cover only transactions of tangible property and
routineservices;
Site visits will not be performed;
The minimum information required from a taxpayer is a functional analysis.
The CRA will perform the economic analysis if requested to do so;
The programme will pertain only to a unilateral APA without a rollback; and
Taxpayers annual reporting under the programme will be limited to stating, in
writing, whether the critical assumptions have or have not been breached.
The 2009 annual report on the APA programme published by the CRA reports
thefollowing:
Thirty-two new cases were accepted and 11 were completed. Of the completed
cases, two were unilateral and nine were bilateral;
The two unilateral cases took an average of 40.3 months to complete and the
bilateral cases took an average of 42.2 months;
Since the inception of the programme, 224 cases have been accepted and 126 have
been completed (99 bilateral, 24 unilateral and three multilateral);
For completed cases, the TNMM is the most common methodology (40% of cases),
followed by the proft split (22% of cases), comparable uncontrolled price (15% of
cases), cost plus (15% of cases) and resale price methods (7% of cases); and
When the TNMM was used, the operating margin has been the most used proft
level indicator (24% of cases), followed by total cost plus (12% of cases), the Berry
ratio and return on assets (4% of cases).
In 2003, the CRA began publishing documents on its website on various transfer
pricing matters (see section 1903). This mode of communicating CRA views and
evolving practices is expected to continue.
Customs programmes are administered by the Canada Border Services Agency (CBSA).
The role of the CBSA is to manage Canadas borders by administering and enforcing
domestic laws that govern trade and travel including customs and excise taxes.
Canada implemented the World Trade Organisations valuation code, under which the
primary basis of the value for customs purposes is the price actually paid or payable
in a sale for export. As a matter of policy, the CBSA does not generally challenge the
arms-length nature of a price in a sale between related parties. It will generally accept
that the transfer price was not infuenced by the relationship if the transfer price
was determined in accordance with the OECD Guidelines. The CBSA does, however,
Canada
closely scrutinise other payments fowing from the buyer to the related seller (e.g.
management fees) to determine whether these should be part of the price paid or
payable for the goods. In a 2009 policy statement (Memorandum D13-4-13), the CBSA
clearly states that it considers any such payment to be part of the dutiable value of the
goods, unless the importer can demonstrate that it should not be.
In the course of a valuation verifcation (i.e. an audit of the values declared on
customs entries), an importer that purchases goods from a related party can expect
to be asked to provide a copy of the documentation (such as a transfer pricing study)
which demonstrates that the transfer price was determined in accordance with the
OECD Guidelines.
There is no routine exchange of information between the two agencies. However, the
two agencies have been encouraged to have greater cooperation as anticipated by the
OECD Guidelines. The two agencies have tended to stress the difference between a
value calculated for income-tax purposes and a value calculated for customs purposes,
given the different legislative bases.
It should also be noted that income-tax decisions that are adverse to the taxpayer may
not result in the recovery of duty or tax that may have been payable on the import
of goods. Taxpayers are not required to report post-importation reductions in the
price to the CBSA, and no duty refund can be claimed based on the reduced customs
value. However, post-importation increases in the transfer price must be reported to
the CBSA, and additional duty (if any) must be paid. Failure to do so may result in
penalties being assessed against the importer.
1917. OECD issues
Canada is a member of the OECD. The Canadian transfer pricing legislation was
redrafted in 1997 to conform with the OECD Guidelines.
Most tax treaties contain exchange-of-information provisions that normally include
a provision for joint investigations. Canada and the US have an agreement in place
for joint investigations. Both groups of auditors on complex audits initiate these
investigations to minimise the time and effort.
Canada has had specifc legislation with respect to thin capitalisation and restricting
the amount of deductible interest since 1972. Therefore, this concept is well-
entrenched and is usually enforced through the general audit procedures of CRA
assessors and auditors.
Where a corporation resident in Canada has average outstanding debts to specifed
non-residents that exceed two times the corporations equity (as defned for the
purposes of the thin capitalisation rules), a portion of the related interest expense is
not deductible in computing the corporations income for tax purposes. It should be
noted that the disallowed portion of the interest expense is permanently disallowed.
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Outstanding debts to specifed non-residents is a defned term and generally refers
to interest-bearing debts or other obligations owed either to non-resident shareholders
who own (together with related persons) 25% or more of the voting shares of the
corporation or to persons related to such shareholders. The average of such debts is
determined using the greatest amount of such debt outstanding at any time during
each calendar month that ends in the year.
Equity is defned to include: (1) the retained earnings of the corporation as at
the beginning of the year, except to the extent that those earnings include retained
earnings of any other corporation; (2) the average of all amounts, each of which is the
corporations contributed surplus (determined, in the CRAs view, in accordance with
Canadian generally accepted accounting principles) at the beginning of each calendar
month that ends in the year, to the extent that it was contributed by a specifed non-
resident shareholder of the corporation; and (3) the average of all amounts each of
which is the corporations paid-up capital at the beginning of each calendar month that
ends in the year, excluding the paid-up capital in respect of shares of any class of the
capital stock of the corporation owned by a person other than a specifed non-resident
shareholder of the corporation.
International groups that have a Canadian holding company for their Canadian
operating company or companies should be cautious when a related non-resident
makes a loan directly to the Canadian operating company. The Canadian operating
company may not have any direct non-resident shareholders and, accordingly, a
portion or the entire amount of the interest could potentially become non-deductible
under the thin capitalisation rules. Where possible, loans from related non-residents
should be made to the Canadian holding company that has the direct non-resident
ownership, keeping in mind the lack of consolidated tax fling in Canada and the back-
to-back anti-avoidance provisions included in the thin capitalisation rules.
It should also be noted that because of the difference in timing with respect to
including debt and equity in the statutory averaging formula, interest may become
non-deductible, even where equity and debt are contributed concurrently, since the
thin capitalisation calculation does not recognise increases in equity amounts until the
beginning of the next calendar month.
1920. Intragroup services (management fees)
For intragroup service fees to be tax-deductible in Canada, a specifc expense must
be incurred and the expense must be reasonable in the circumstances. There should
also be documentary evidence to support the amount of the charge, such as a written
agreement to provide the services and working papers evidencing the expense charged.
Intragroup service charges are governed by section 247 of the ITA; there is no
specifc transfer pricing legislation for intragroup service fees. The CRAs position
on intragroup service fees for transfer pricing purposes is included in IC 87-2R.
The withholding tax legislation in section 212 of the ITA provides insight into what
constitutes intragroup services.
The province of Ontario assesses an additional 5% income tax on management fees
paid or payable to a related non-resident person. The tax is levied by requiring that
a portion of the expense be added back in calculating income for tax purposes. The
add-back is currently 5/14.0, being 5% over the current effective tax rate. In effect,
Canada
this constitutes a 5% withholding tax at the provincial level. The Ontario Ministry
of Revenue is very active in auditing compliance with this add-back. In order to be
exempt from the add-back, the taxpayer must demonstrate that the management
fee constitutes a reimbursement of costs incurred on its behalf. The Ontario test is
more stringent than the federal test. For Ontario purposes, the taxpayer must support
specifc expenses, whereas for federal purposes it is necessary only to demonstrate the
reasonableness of the charge.
1921. Qualifying cost-contribution arrangements
Qualifying cost-contribution arrangements provide a vehicle to share the costs and
risks of producing, developing or acquiring any property, or acquiring or performing
any services. The costs and risks should be shared in proportion to the benefts that
each participant is reasonably expected to derive from the property or services as a
result of the arrangement. Where a participants contribution is not consistent with its
share of expected benefts, a balancing payment may be appropriate.
Chile
20.
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Chile
2001. Introduction
Article 22 of Law 19,506, published in the Offcial Gazette on 30 July 1997, introduced
four new paragraphs to Article 38 of the Income Tax Law. These new paragraphs
contain the basic Chilean transfer pricing rules, which became effective from calendar
year 1997. A minor amendment to these rules was introduced by Law 19,840,
published in the Offcial Gazette on 23 November 2002.
In addition, the Chilean tax authority (Servicio de Impuestos Internos SII) issued
Circulars No. 3 and 57, both in 1998. These circulars contain the guidelines for the
application of the rules by the tax inspectors.
General
In general, Chilean transfer pricing rules are consistent with the OECD Guidelines.
There is a specifc interpretation of the application of the CUP method, which is
described below.
Scope of the rules
The rules apply to all types of transactions, including, among others, the
followingtransactions:
Sale of goods;
Provision of services;
Transfer of technology;
Use of patents and trademarks; and
Financing transactions (interest, commissions and other payments).
Concept of a related party
The rules establish a broad concept of related parties , which includes the following:
The branch or agency and its parent company, or another agency or related
company of the parent company;
A company incorporated abroad that participates, directly or indirectly, in the
management, control or capital of a company established in Chile or vice versa;
A person that participates, directly or indirectly, in the management, control or
capital of both a Chilean enterprise and a foreign enterprise;
When there is an agreement for exclusivity, joint performance, preferential
treatment, or economic, fnancial dependence or deposits of trust;
International Transfer Pricing 2011 Chile 305
Chile
When the transaction is performed with an enterprise established in a tax haven or
low-tax jurisdiction under the OECD; and
In some other cases where Circular 3 considers the transaction not entered into
between independent parties.
Methods
The tax authority is allowed to use the following methods:
A reasonable proftability given the nature of the transaction;
The resale price, meaning the resale price to third parties of goods acquired from
a related company, less the proft margin earned in similar transactions among
independent companies;
The cost plus a reasonable proft margin; and
The international market value for which data from the national customs service
and the Central Bank of Chile can be used.
Local taxpayers can apply the CUP method as a methodology for testing the
arms-length principle; however, the Chilean SII would not be entitled to use
it as a tool to determine an eventual transfer pricing adjustment on the same
cross-bordertransaction.
There is no best-method rule.
Neither the law nor the tax authority requires preparation of a transfer pricing
study or compliance with reporting requirements. There is no transfer pricing
documentationrequirement.
However, when conducting a transfer pricing examination, the tax authority welcomes
transfer pricing studies voluntarily prepared by the taxpayer to support their pricing.
The Chilean tax authorities request certain Chilean taxpayers to report their
transactions with non-resident taxpayers. The transactions must be reported on
oath on a form provided by the Chilean tax authorities. The information to be
disclosed includes: (1) identifcation of the Chilean taxpayer; (2) identifcation of
and information about the non-resident taxpayer, including name, tax identifcation
number, country of residence and type of relationship with the Chilean taxpayer (if
any); (3) type of transaction; (4) method used to price the transaction; (5) amounts
received or paid as a consideration for these transactions; and (6) proft or loss margin
from these transactions.
2004. Cases
At present, there is no administrative guidance or judicial precedence.
There are no specifc rules on the burden of proof relating to transfer pricing. However,
under the general rules in the Tax Code, it is generally considered that the burden of
proof lies with the SII.
Chile 306 www.pwc.com/internationaltp
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The tax authority has a specialised group that performs transfer pricing examinations.
This group is part of the International Tax Inspection Department (Departamento de
Fiscalizacin Internacional).
There is evidence of transfer pricing examinations into mining companies and
pharmaceuticals groups.
At present, there are no provisions enabling taxpayers to agree advance pricing
agreements (APAs) with the tax authority. However, the tax authority has expressed its
intention to implement APAs in the future.
It is expected that transfer pricing examination activity will increase in the near future.
It is also expected that the tax inspectors will become more skilled in this area, due to
increasing training and experience.
A recent interview with the head of the Chilean SII revealed that the SII will attack tax
evasion in Chile via the auditing of transfer pricing issues in key industries.
Finally, it is expected that documentation and reporting requirements will be
introduced in the near future.
2009. Liaison with customs authority and Central Bank
ofChile
The tax authority is allowed to request information from the customs authority and
Central Bank of Chile for transfer pricing examinations.
2010. Tax treaty activities
It is interesting to note that Chile has been very active in the area of treaties, expanding
its tax treaty network and concluding free-trade agreements with the European Union
and the US.
2011. OECD issues
On 11 January 2010, Chile became a member of the OECD, although the local
transfer pricing regulations do not expressly recognise the standards set by the
OECD Guidelines. However, the tax authority has generally adopted the arms-length
principle, and tax inspectors use the OECD Guidelines as general guidance.
China
21.
International Transfer Pricing 2011 307 China
2101. Introduction
Chinas new corporate income tax (CIT) law, together with its detailed implementation
regulations (DIR), introduced a set of new transfer pricing and anti-avoidance concepts
that strengthened transfer pricing enforcement in China.
In January 2009, Chinas State Administration of Taxation (SAT) issued a circular
titled Guo Shui Fa [2009] No. 2 (Circular 2), which contains the latest version of the
Implementation Measures of Special Tax Adjustments trial version (the measures).
Circular 2 marked a signifcant step up in Chinas transfer pricing enforcement regime.
The CIT law
The highest level of legislation in China is represented by laws , which can be enacted
only by the National Peoples Congress (NPC).
The new CIT law was promulgated on 16 March 2007 by the NPC and became effective
on 1 January 2008. Articles relevant to transfer pricing are found mainly in Chapter
6, Special Tax Adjustment. The CIT law provides the arms-length principle as the
guiding principle for related party transactions and empowers the tax authorities in
China to adjust a taxpayers taxable income if it fails to comply with the arms-length
principle in its dealings with related parties.
The DIR of the CIT law
The second level of tax legislation is represented by detailed implementation
regulations, which are promulgated by a super-ministerial organisation known as the
State Council.
The DIR of the CIT law, promulgated on 6 December 2007, provides more specifc
guidance relating to all aspects of the CIT law.
Specifcally with respect to Chapter 6, the DIR provides guidance not only on various
new concepts (such as cost-sharing, controlled foreign corporations, thin capitalisation
and general antiavoidance), but also imposes contemporaneous transfer pricing
documentation requirements and a special interest levy that could create a signifcant
impact for taxpayers.
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The measures under Circular 2
The third level of tax legislation is represented by circulars issued by the SAT. The
formal circulars issued by the SAT are usually designated as Guo Shui Fa and the
SAT also issues less formal letter rulings (known as Guo Shui Han) that can take the
form of replies by the SAT to specifc issues raised to them by one of their underlying
taxbureaux.
The measures, promulgated by the SAT under Circular 2 in January 2009 with an
effective date of 1 January 2008, lay out detailed rules on administering all the aspects
covered by special tax adjustments. The measures supersede past notices, affrm prior
positions and introduce a set of new obligations.
The measures also set the foundation for future developments. In fact, the connotation
that the measures are a trial version (as stated in the title) provides the SAT with
fexibility to issue further circulars to interpret and clarify the concepts after they
have accumulated more practical experience in the respective regimes.
In China, the burden of proof that a related party transaction was dealt at arms
length rests with the taxpayer. According to Paragraph 2 of Article 43 of the CIT law,
if the tax authorities conduct a transfer pricing investigation, the taxpayer under
investigation, its related parties and other relevant companies are obligated to provide
relevant information upon request. If the taxpayer under investigation fails to provide
information in relation to its related party transactions or provides false or incomplete
information that does not truly refect the situation of its related party transactions, the
tax authorities are authorised to deem the taxpayers taxable income.
According to the DIR, information required by the tax authorities during a transfer
pricing investigation may include the following:
The taxpayers contemporaneous transfer pricing documentation;
Relevant overseas information regarding resale price (or transfer price) and/or
ultimate sales price of tangible goods, intangible goods and services involved in the
related party transactions; and
Other relevant information relating to related party transactions.
2104. Information reporting
Annual tax return disclosure of related party transactions
Chinas annual related party transaction disclosure forms (required under Article 11
of Circular 2) were offcially introduced by the SAT in December 2008 under Guo Shui
Fa [2008] No. 114 (Circular 114). Circular 114, which took effect on 1 January 2008,
contains the fnal version of the transfer pricing-related forms that Chinese taxpayers
must fle as part of their new CIT returns.
Chinese taxpayers now face a signifcantly higher disclosure burden, as they must fle
as many as nine forms:
Form 1: Related Party Relationships Form;
Form 2: Summary of Related Party Transactions Form;
Form 3: Purchases and Sales Form;
International Transfer Pricing 2011 China 309
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Form 4: Services Form;
Form 5: Financing Form;
Form 6: Transfer of Intangible Assets Form;
Form 7: Transfer of Fixed Assets Form;
Form 8: Foreign Investment Status Form; and
Form 9: Foreign Payments Status Form.
These forms, which generally need to be fled by 31 May of the following year
along with the Chinese CIT returns, require taxpayers to indicate whether they
have contemporaneous documentation in place to substantiate their inter-company
arrangements and to provide detailed information on each type of related party
transaction (including specifying the applicable transfer pricing method).
In addition, a new special tax adjustment option in the annual CIT return package
allows taxpayers to make voluntary upward adjustments to their taxable income.
Its worth noting that, while the statutory fling deadline for CIT returns is 31 May,
some local-level tax authorities may impose an earlier fling due date. Therefore, it is
essential for taxpayers to closely monitor and follow the local requirements specifed by
the local-level tax authorities.
Contemporaneous transfer pricing documentation
Chinese taxpayers generally are required to have contemporaneous transfer pricing
documentation in place unless they meet any of the following criteria:
The annual amount of related party purchases and sales transactions is less than
RMB200 million and the annual amount for all other types of transactions (i.e.
services, royalties, interest, etc.) is less than RMB40 million;
The related party transactions are covered by an advance pricing arrangement; and
The foreign shareholding of the enterprise is below 50%, and the enterprise only
has domestic-related party transactions.
According to Article 14 of Circular 2, the contemporaneous transfer pricing
documentation package should contain 26 specifc items under the following
fveareas:
Organisational structure (four items);
Description of business operations (fve items);
Description of related party transactions (seven items);
Comparability analysis (fve items); and
Selection and application of transfer pricing method (fve items).
(Additional items are required for contemporaneous cost-sharing and/or thin
capitalisation documentation.)
It is important to note that, according to Circular 2, Chinese contemporaneous
documentation must be:
Prepared and maintained for each tax year;
Completed by 31 May of the following year (e.g. 31 May 2010 for 2009 tax year)
and kept for 10 years (e.g. until 31 May 2020, for 2009 tax year);
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Provided within 20 days of a request (or within 20 days of elimination of any force
majeure); and
In Chinese (including any source materials provided in English as part of
thedocumentation).
Tax underpayments that result from special tax adjustments (including transfer pricing
adjustments) are subject to an interest levy that includes a 5% penalty component.
That penalty component can be avoided if the taxpayer prepares and submits in a
timely manner contemporaneous documentation upon request, or it is otherwise
exempted from the documentation requirement. The interest levy is discussed in more
detail later.
Documentation requirement for loss-making companies with limited
functions/risks
According to Article 39 of Circular 2, companies engaged in simple manufacturing
activities based on orders from related parties must earn a stable rate of return and
should not be expected to bear the risks or suffer the losses associated with excess
capacity, product obsolescence and other such factors. In July 2009, the SAT issued
Guo Shui Han [2009] No. 363 (Circular 363). Circular 363 re-emphasised the SATs
position towards losses incurred by companies with limited functions and risks, and
even goes one step further than Circular 2 by requiring all loss companies with limited
functions and risks to prepare and submit contemporaneous documentation to their
in-charge tax authorities by 20 June following the loss-making year regardless of
whether the amount of related party transactions exceeds the materiality thresholds.
It is worth noting that, through Circular 363, the SAT has expanded the focus of
scrutiny to trading companies and contract R&D service providers in addition to
simplemanufacturers.
2105. Audit targets
Circular 2 provides an insight into the procedural aspects of a Chinese transfer pricing
audit, from the tax authorities determining which enterprises will be subject to audit
and conducting the audit to issuing a special tax adjustment notice, collecting
underpaid taxes (and interest), and a fve-year post-audit follow-up period. These
provisions are generally in line with Chinas previous transfer pricing rules and the way
that those prior rules were enforced in practice.
According to Circular 2, transfer pricing audits typically will focus on companies with
the following characteristics:
Signifcant amount or numerous types of related party transactions;
Long-term consecutive losses, low proftability, or fuctuating pattern of
profts/losses;
Proftability lower than those in the same industry, or with proftability that does
not match their functions/risks;
Business dealings with related parties in a tax haven;
Did not prepare contemporaneous documentation or complete transfer pricing-
related tax return disclosures; and
Other situations clearly indicating a violation of the arms-length principle.
Circular 2 also provides that, in principle, no transfer pricing audits will be carried out
on, and no transfer pricing adjustment will be made to, transactions between domestic-
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related parties that had the same effective tax burden, as long as such transactions did
not result in the reduction of the countrys total tax revenue.
It is also worth noting that the SAT has been continuing to strengthen its focus on
nationwide and industrywide transfer pricing audits. In a nationwide audit, companies
within a multinational group are simultaneously audited, whereas industrywide
audits focus on companies in specifc industries. The offce automation and computer
contract manufacturing industries are examples of industries with extensive transfer
audit activities in recent years. As evidenced in circulars such as Guo Shui Fa [2009]
No. 85 (Circular 85), which provides guidance to the local level tax authorities on
how to strengthen tax collection administration and anti-avoidance investigation, the
automotive and pharmaceutical industries are beginning to receive more attention.
2106. Audit information request
According to the CIT law, its DIR and Circular 2, not only the taxpayer under a transfer
pricing investigation, but also its related parties and other relevant companies (i.e.
potential comparable companies) are obligated to provide information as requested by
the in-charge tax authorities.
As previously mentioned, the taxpayer under an investigation should provide
contemporaneous documentation to tax authorities within 20 days of a request and
should provide other relevant documents required during an investigation within the
prescribed time frame according to the Notice of Tax Related Issues from the tax
authority. If timely submission of required documents is not possible due to special
circumstances, the taxpayer under investigation shall apply in writing for an extension.
An extension of up to 30 days may be granted, subject to the approval from the in-
charge tax authority. Related parties of the taxpayer under investigation or comparable
companies shall provide relevant information within the time frame as agreed with the
tax authorities (which generally will not be longer than 60 days).
If the taxpayer under audit fails to provide information within the prescribed time
frame as required by the tax authority or refuses to provide information as requested, it
may be subject to one or more of the following:
An administrative penalty of up to RMB10,000 in accordance with the Tax
Collection and Administration Law;
A special tax adjustment as determined by the tax authority by means of deeming
the taxpayers taxable income; and
An additional 5% interest levy on the amount of underpaid tax resulting from the
adjustment.
In early 2010, tax authorities in certain locations have shown distinct signs of increased
transfer pricing enforcement. Following the 31 December 2009 deadline for the 2008
documentation, a number of local-level tax authorities have taken either a blanket
approach (whereby all taxpayers exceeding the thresholds have been required to
submit documentation) or a targeted approach (e.g. focusing on large multinational
companies with signifcant related party transactions, or creating a list of potential
audit targets and requesting them to provide 2008 documentation) to the collection
of 2008 documentation. The documentation collection efforts may have multiple
objectives, including the creation of an internal database, identifcation of potential
audit targets and proactive tax compliance enforcement.
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Tax audits in China may be conducted at the taxpayers offces or at the tax authorities
offces. A transfer pricing audit procedure typically comprises the following main steps:
Desktop review and selection of transfer pricing audit targets by the tax authority;
Notifcation to the taxpayer of a transfer pricing audit and feld investigation by the
tax authority to raise inquiries, request accounting records and conduct
on-site verifcation;
Information request to taxpayer under investigation, its related parties, or other
relevant companies for relevant documents;
Negotiation and discussion with the taxpayer under investigation and the
taxauthority;
Initial assessment notice issued by the tax authority;
Further negotiation and discussion between the taxpayer and the tax authority,
asneeded;
Final assessment and issuance of Special Tax Adjustment Notice if there is an
adjustment or Special Tax Investigation Conclusion Notice if the related party
transactions under investigation are considered to be at arms length;
Settlement of underpaid taxes and interest levy; and
Post-audit follow-up management by the tax authority.
Article 45 of Circular 2 stipulates that there will be special supervision for a period of
fve years following a transfer pricing audit adjustment, during which taxpayers should
submit contemporaneous documentation before 20 June of each year, following the
year under follow-up administration, and any changes in operations, taxable income
and related party transactions will be monitored by the tax authorities. This longer
post-audit supervision period (it was previously three years) indicates that transfer
pricing compliance violations are being taken more seriously.
In addition, Article 123 of the DIR provides that adjustments may be made on a
retroactive basis for up to 10 years as a result of a special tax investigation.
2108. Transfer pricing methods
Article 111 of the DIR lists six appropriate methods for conducting transfer pricing
investigations. Those six methods, which are the same as those provided in the OECD
Guidelines, are as follows:
Comparable uncontrolled price method;
Resale price method;
Cost-plus method;
Transactional net margin method;
Proft split method; and
Other methods that are consistent with the arms-length principle.
Chapter 4 of Circular 2 provides guidance on the application of each of the fve
specifed methods. Circular 2 does not stipulate any hierarchy or preference in methods
used by tax authorities during a transfer pricing audit assessment. According to Article
22 of Circular 2, the most appropriate transfer pricing method should be selected
taking into account the following fve comparability factors:
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Characteristics of the assets or services involved in the transaction;
Functions and risks of each party engaged in the transaction;
Contractual terms;
Economic circumstances; and
Business strategies.
As directed in a tax circular prior to the new CIT law, Chinese tax authorities are
encouraged by the SAT to use the information databases of the National Bureau of
Statistics and Bureau van Dijk in transfer pricing audits (Note that, in recent years, the
SAT has subscribed to Bureau van Dijks OSIRIS database).
However, Article 37 of Circular 2 specifcally states that both public information
and non-public information (i.e. secret comparables) may be used by the Chinese
tax authorities during transfer pricing investigations and evaluations. The new CIT
law and its DIR also empower tax authorities to collect relevant information (e.g.
contemporaneous documentation) from potential comparable companies in the same
industry during an audit. Obviously, such information cannot be obtained in the
publicdomain.
Other relevant provisions under Circular 2 regarding the use of comparable
information involve the following:
Although Circular 2 has introduced the interquartile range as a method
of testing proftability, it is stated that in the context of a transfer pricing
investigation, companies with proftability below the median level may still be
subject to an adjustment to achieve at least the median proftability level of the
comparables;and
During transfer pricing investigations, the use of working capital adjustments is
discouraged and would require approval from the SAT if it is absolutely necessary.
2110. Assessments and appeal procedures
Transfer pricing audits in China are usually settled through negotiation. While the
conduct of the taxpayer should not signifcantly affect the outcome, a friendly working
relationship with the tax authorities is always to the taxpayers advantage, as Chinese
tax legislation gives broad discretionary powers to tax authorities.
When an enterprise under audit receives an initial assessment from the tax authority
and disagrees with the assessment, it may provide written explanations and documents
supporting the reasonableness of its transfer prices. Further discussions and
negotiations may continue until the tax authority reaches a conclusion and issues a
written notice of audit assessment in the form of a Special Tax Adjustment Notice or
a Special Tax Investigation Conclusion Notice. Once the written notice is issued, the
decision is considered fnal and further negotiation is not possible.
If the taxpayer disagrees with the adjustment, such dispute could be resolved through
the appeal procedures. Chinas Tax Collection and Administration Law provide
both administrative and judicial appeal procedures for resolving tax disputes. The
taxpayer may appeal to the tax authority at the next higher level within 60 days for
an administrative appeal, and a decision on the appeal must be made within 60 days.
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Before proceeding with the appeal process, the taxpayer is required to pay the taxes,
interest levy, and fne and surcharge (if any).
If the taxpayer is not satisfed with this decision, it may start legal proceedings in
Chinas Peoples Court within 15 days upon receiving the written decision. There have
been very few cases relating to transfer pricing brought before the Peoples Court at
the local level. The local court has found in favour of the SAT. Because there is limited
experience in court cases and the SAT has great discretionary powers, taxpayers
generally should seek mutually satisfactory resolution before the issuance of the
adjustment notice.
For related party transactions between China and a treaty country, mutual consultation
between the SAT and the competent authority of the treaty country is available to
taxpayers to resolve double taxation issues resulting from transfer pricing adjustments.
2111. Interest levy and penalties
Special interest levy
Under the CIT law, special tax adjustments (including transfer pricing adjustments) are
subject to a special interest levy. The special interest levy mechanism is different from
surcharges and fnes, which constitute the current penalty measures of tax collection
and administration.
Article 122 of the DIR defnes the rate for the special interest levy as based on the RMB
loan base rate applicable to the relevant period of tax delinquency as published by the
Peoples Bank of China (PBOC) in the tax year to which the tax payment relates, plus 5
percentage points. This interest levy is not deductible for CIT purposes.
Although companies with annual related party transactions below the materiality
thresholds for contemporaneous documentation are not subject to the 5% penalty
component of the interest levy, such protection does not apply in situations where
the amount of related party transactions originally falls below the thresholds, but
the restated amount of related party transactions as a result of a transfer pricing
adjustment exceeds the relevant threshold. Circular 2 further provides that the 5%
penalty component of the interest levy would be waived if the taxpayer has prepared
and provided contemporaneous documentation in a timely manner.
Fines
Taxpayers that fail to fle the Annual Related Party Transactions Disclosure Forms to
tax authorities or fail to maintain contemporaneous documentation and other relevant
information in accordance with Circular 2, shall be subject to different levels of fnes,
ranging from less than RMB2,000 up to RMB50,000, in accordance with Articles 60
and 62 of the Tax Collection and Administration Law.
Taxpayers that do not provide contemporaneous documentation or relevant
information on related party transactions or provide false or incomplete information
that does not truly refect the situation of their related party transactions, shall
be subject to different levels of fnes, ranging from less than RMB10,000 up to
RMB50,000, in accordance with Article 70 of the Tax Collection and Administration
Law and Article 96 of the Tax Collection Regulations. In addition, tax authorities also
have the authority to deem such taxpayers taxable income by referencing the proft
level of comparable companies, or the taxpayers cost plus reasonable expenses and
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proft, or apportioning a reasonable share of the groups total profts; or the deemed
proft determined based on other reasonable methods according to Article 44 of the
CIT law and Article 115 of the DIR.
Surcharge
In the context of transfer pricing adjustments, taxpayers that have exceptional
diffculty and cannot remit the tax payment on time shall apply for an extension in
accordance with Article 31 of the Tax Collection Law and Articles 41 and 42 of the
Tax Collection Regulations. A daily surcharge of 0.05% will be levied in accordance
with Article 32 of the Tax Collection Law if they do not apply for an extension and
fail to remit the underpaid taxes and interest levies before the deadline set by the tax
authorities on the adjustment notice.
2112. Corresponding adjustments
Circular 2 provides that corresponding adjustments should be allowed in the case of
a transfer pricing adjustment to avoid double taxation in China. If the corresponding
adjustment involves an overseas related party resident in a country with which
China has a tax treaty, then the SAT will upon application by the taxpayer initiate
negotiations with the competent authority of the other country based on the mutual
agreement procedure article of the treaty. (The statute of limitation for the application
of corresponding adjustments is three years; an application submitted after three
years will not be accepted or processed.) Application for the initiation of the mutual
agreement procedures should be submitted to both the SAT and the local tax
authorities simultaneously.
Where payment of interest, rent, or royalties to overseas related parties was disallowed
as the result of a transfer pricing adjustment, no refund of the excessive withholding
tax payment will be made. This treatment may result in double or even triple taxation
for multinational companies in some cases.
If the original adjustment is imposed by the overseas tax authority, then the Chinese
enterprise could submit a formal application for a corresponding adjustment to the
relevant Chinese tax authority within three years of the overseas related partys receipt
of the notice of the transfer pricing adjustment.
Circular 2 indicates that corresponding adjustments are not available in cases of
income taxes assessed on deemed dividends that result from non-deductible interest
expenses under the thin capitalisation rules.
Circular 2 also states that the results of a corresponding adjustment or mutual
agreement will be sent to the enterprise in written form from the SAT, via the in-charge
tax authority.
The SAT has a group of transfer pricing offcials to monitor, develop and interpret
transfer pricing regulations in China. These offcials have frequent exchanges with
tax authorities in other countries and with the OECD. Generally, this group does not
deal directly with taxpayers but acts in a supervisory and supporting role to the local
tax offcials who conduct audits. Initiation and conclusion of a transfer pricing audit
requires the approval of the SAT. In cases involving mutual agreement procedures or
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bilateral/multilateral advance pricing arrangements, the SAT takes the lead role in the
competent authority discussions.
2114. Advance pricing arrangements (APA)
Circular 2 provides guidance with respect to the various requirements and procedures
associated with applying for, negotiating, implementing and renewing APAs. In
general, these provisions are a restatement of the previous rules on APAs (i.e. Guo Shui
Fa [2004] No. 118), with several modifcations and amendments. The following points
are worth noting:
The SAT has specifed that APAs will, in general, be applicable to taxpayers
meeting the following conditions: 1) annual amount of related party transactions
over RMB40 million; 2) the taxpayer complies with the related party disclosure
requirements; and 3) the taxpayer prepares, maintains, and provides
contemporaneous documentation in accordance with the requirements;
The term for an APA will cover transactions for three to fve consecutive years (the
previous provisions provided that APAs normally cover two to four years);
Upon approval of the tax authorities, an APA may be rolled back (i.e. the pricing
policy and calculation method adopted in the APA may be applied to the evaluation
and adjustment of related party transactions in the year of application or any prior
years) if the related party transactions in the year of application are the same as or
similar to those covered by the APA;
An APA will be respected by the relevant state and local tax bureaus at all levels as
long as the taxpayer abides by all the terms and conditions of the APA this can be
regarded as a positive sign from the SAT to ensure certainty of APAs;
Pre-fling meetings with tax authorities may now be held anonymously;
Although the contemporaneous documentation requirements under Chapter 3 of
Circular 2 technically do not apply to taxpayers during the term of an APA, there
are numerous documentation requirements specifc to the implementation of an
APA that need to be provided to tax bureau within fve months of the end of each
tax year;
For bilateral or multilateral APAs, taxpayers should submit their flings (including
pre-fling and formal application) to both the SAT and the in-charge municipal or
equivalent level tax authorities simultaneously. Circular 2 also states that, where
the SAT accepts an application for a bilateral or multilateral APA, the SAT will enter
into negotiations with the competent authority of the treaty partner based upon the
relevant treatys mutual agreement procedures; and
Circular 2 states that, in the event that an APA is applied for but not ultimately
reached, any non-factual information regarding the taxpayer that was gathered
during the application and/or negotiation process may not be used for
taxinvestigations.
The APA guidance under Circular 2, in particular the introduction of the rollback
provision, anonymous prefling meetings, and dual application at both the SAT and in-
charge municipal or equivalent tax authority level (for bilateral and multilateral APAs),
will assist in making Chinas APA programme more attractive to taxpayers through the
removal of some of the uncertainty that has historically surrounded it. This additional
guidance also demonstrates the importance and commitment that the SAT is placing
on APAs and their desire to create a successful APA programme in China going forward.
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The SAT is expected to issue its frst annual APA report in 2010 to provide taxpayers
with more information and guidance on Chinas APA programme.
2115. Cost-sharing arrangement (CSA)
It was a breakthrough that CSAs for joint development of intangibles and sharing
of services were fnally written into the CIT law. Similar to the OECDs transfer
pricing guidelines, Circular 2 requires the following items to be contained in a
cost-sharingagreement:
Name of participants, their country (region) of residence, related party
relationships, and the rights and obligations under the agreement;
Content and scope of intangible assets or services covered by the cost-sharing
agreement, the specifc participants performing research and development
activities or service activities under the agreement, and their respective
responsibilities and tasks;
Term of the agreement;
Calculation methods and assumptions relating to the anticipated benefts to the
participants;
The amount, forms of payment, and valuation method of initial and subsequent
cost contribution by the participants, and explanation of conformity with the
arms-length principle;
Description of accounting methods adopted by participants and any changes;
Requirements on the procedure and treatment for participants entering into or
withdrawing from the agreement;
Requirements on the conditions and treatment of compensating payments
amongparticipants;
Requirements on the conditions and treatment of amendments to or termination of
the agreement; and
Requirements on the use of the results of the agreement by non-participants.
Circular 2 states that the costs borne by the participants in a CSA should be consistent
with those borne by an independent company for obtaining the anticipated benefts
under comparable circumstances, and that the anticipated benefts should be
reasonable, quantifable, and based on reasonable commercial assumptions and
common business practices. Failure to comply with the beneft test will be subject to
adjustment by tax authorities in the event of an audit assessment.
Some other relevant provisions of Circular 2 with respect to CSAs include
thefollowing:
Service-related cost-sharing agreements generally should be limited to group
procurement or group marketing strategies;
Buy-in and buy-out payments are required when there is a change to the
participants of an existing cost-sharing agreement;
During the term of a CSA, if there is a mismatch between the shared costs and the
actual benefts, then compensating adjustments should be made based on actual
circumstances to ensure the shared costs match the actual benefts;
If a CSA is not considered arms length or does not have a reasonable commercial
purpose or economic substance, costs allocated under the agreement (as well
as any appropriate compensating adjustments) will not be deductible for
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Taxpayers may apply for an APA to cover a CSA;
Participants to intangible development-related CSAs should not pay royalties for
intangible properties developed under the CSA;
The costs allocated under a CSA and deducted for CIT purposes by the taxpayer
would need to be clawed back if its term of operation turns out to be less than 20
years from the signing of the CSA; and
In addition to the contemporaneous transfer pricing documentation requirements
under Chapter 3, Circular 2 also includes specifc requirements for preparation of
contemporaneous documentation for CSAs, which needs to be submitted to the tax
authorities by 20 June of the following year.
2116. Controlled foreign corporations (CFC)
Article 45 of the CIT law provides for the inclusion in a Chinese taxpayers taxable
income the relevant profts of its CFCs established in countries with effective tax
burdens that are substantially lower than Chinas.
Circular 2 provides guidance for calculating the amount of the deemed income and any
associated tax credits. Pursuant to Circular 2, the deemed dividend income from a CFC
attributed to its Chinese resident enterprise shareholder should be determined using
the following formula:
Circular 2 allows for the exemption from recognition as Chinese taxable income any
deemed dividend from a CFC that meets at least one of the following criteria:
Is established in a country with an effective tax rate that is not low, as designated
by the SAT;
Has income derived mainly from active business operations; and
Has annual proft less than RMB5 million.
The newly introduced thin capitalisation rules under the CIT law are designed to
disallow the deduction of excessive related party interest expense pertaining to the
portion of related party debt that exceeds a certain prescribed debt-to-equity ratio.
Circular Cai Shui [2008] No. 121 (Circular 121), jointly published by the Ministry of
Finance and the SAT in October 2008, sets out the prescribed debt-to-equity ratios
(2:1 for non-fnancial enterprises and 5:1 for enterprises in the fnancial industry)
and other associated rules. Circular 121 also emphasises that excessive interest
from related party fnancing that exceeds the prescribed ratios may still be deductible
if an enterprise can provide documentation to support that the inter-company
fnancing arrangements comply with the arms-length principle, or if the effective
Income attributed
to a Chinese
resident enterprise
shareholder in the
current period
Amount of deemed
dividend distribution
Number of
shareholding days
Number of days in
the CFCs tax year
Shareholding
percentage
= x x
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tax burden of the Chinese borrowing company is not higher than that of the Chinese
lendingcompany.
Where the debt-to-equity ratio exceeds the prescribed ratio, the portion of related party
interest expense relating to the excess portion would not be deductible. Furthermore,
the non-deductible outbound interest expense paid to overseas related parties would
be deemed as a dividend distribution and subject to withholding tax at the higher of
the withholding tax rate on interest and the withholding tax rate ondividends.
Chapter 9 of Circular 2 provides specifc thin capitalisation administrative guidance,
which includes the following:
Mechanics for how to calculate the debt-to-equity ratio (on a monthly weighted
average basis); and
Related-party interest that is not arms length will be subject to a transfer
pricing investigation and adjustment before being evaluated for thin
capitalisationpurposes.
Preparation of contemporaneous thin capitalisation documentation is required in order
to deduct excessive interest expense. Circular 2 stipulates that such documentation
should include the following in order to demonstrate that all material aspects of the
related party fnancing arrangements conform to the arms-length principle:
Analysis of the taxpayers repayment capacity and borrowing capacity;
Analysis of the groups borrowing capacity and fnancing structure;
Description of changes to equity investment of the taxpayer, such as changes in the
registered capital, etc.;
Nature and objectives of debt investment from related parties, and the market
conditions at the time the debt investment was obtained;
Currency, amount, interest rate, term and fnancing terms of the debt investment
from related parties;
Collaterals provided by the enterprise and the relevant terms;
Details of the guarantor and the terms of guarantee;
Interest rate and fnancing terms of similar loans contemporaneous to the debt
investment from related parties;
Terms of conversion of convertible bonds; and
Other information that can support the conformity with the arms-length principle.
2118. General anti-avoidance rules (GAAR)
For the frst time, the new CIT law introduced GAAR, which formally authorises
Chinese tax authorities to make an adjustment if a taxpayer enters into an arrangement
without reasonable commercial purpose. This is a strong indication of the Chinese
tax authorities growing scrutiny of business structures.
Pursuant to Circular 2, a general anti-avoidance investigation should focus on the
following transactions/structures:
Abuse of preferential tax treatments;
Abuse of tax treaties;
Abuse of organisational structures;
Use of tax havens for tax avoidance purposes; and
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Other arrangements without reasonable commercial purposes.
Circular 2 places a special focus on the principle of substance over form and also
provides details about the various procedures for conducting a general anti-avoidance
investigation and making a general anti-avoidance adjustment, including the
requirement that all general anti-avoidance investigations and adjustments be
submitted to the SAT for fnal approval. In addition, Circular 2 provides that the
Chinese tax authorities will disregard entities that lack adequate business substance
(especially those in tax haven countries).
The introduction of Chapter 6 under Chinas new CIT law and the DIR, along with
the promulgation of Circular 2, marks a signifcant shift in Chinas transfer pricing
regime. Given that Chinese transfer pricing legislation is relatively new and untested,
it can be expected that further tax circulars will be issued by the SAT over time in
order to clarify various matters concerning transfer pricing administration and special
taxadjustments.
In addition, with the unifcation of the tax system, some tax offcials formerly
practicing in other areas are being redirected into the area of transfer pricing and
tax avoidance. This suggests that audit activity will increase in the near future. As
mentioned earlier, the guidance from the SAT to the local-level tax authorities under
Circular 85 has brought the issues of royalty and service fee remittance (as well as
certain industries such as pharmaceuticals, automobiles, retail, etc.) on the radar
screen in terms of transfer pricing and tax investigation. In addition, the SAT has been
requiring local-level tax authorities to build up transfer pricing auditor resources
to undertake feldwork and to negotiate with taxpayers during investigations. It is
expected that a core team of about 200 transfer pricing specialists across China is being
formed to enhance consistency and technical competency.
2120. OECD issues
While China has observer status with the OECD, it has modelled its transfer pricing
legislation after the OECD Guidelines. In general, Chinas transfer pricing regulations
refect the same arms-length principle and support the same type of transfer pricing
methodologies that are being adopted in the OECD member countries. However, a
transfer pricing policy or practice that is acceptable in an OECD member country will
not necessarily be followed in China (e.g. collaboration between the customs and tax
authorities in determining the transfer price/import value of related party tangible
goods transactions).
China would not usually join another country in undertaking a joint investigation of a
multinational group for transfer pricing purposes. However, the Chinese tax treaties
generally contain an Exchange of Information article that provides the cooperation
between the competent authorities in the form of exchanges of information necessary
for carrying out the provisions of the treaty (including transfer pricing investigations).
In practice, the methods of exchanging information include exchange on request,
spontaneous exchanges and automatic exchanges.
China
There are intra-country transfer pricing investigation cases in which authorities in
different locations collaborate their efforts in conducting simultaneous audits on
Chinese subsidiaries of a group corporation.
2122. Special features
Multiple audits
In general, China does not allow consolidation of CIT returns for multinational
companies. A multinational company with subsidiaries located in various parts of
China may, therefore, be subject to multiple transfer pricing audits.
Management fees
Under Article 49 of the DIR, management fees paid to related parties are not deductible
for CIT purposes. On the other hand, service fees are deductible. According to Article
8 of the CIT law, a taxpayer may deduct reasonable expenses (including service fees
paid to its related parties) that are actually incurred and are related to the generation
of income. As there is no clear guidance on how to distinguish between service fees and
management fees, tax authorities in different locations may have different views and
practices in this regard.
Business tax and other taxes
In establishing transfer pricing policies for China, it is important for foreign investors
to realise that income tax is not the only tax issue. Besides the Chinese CIT, other taxes
such as business tax, value-added tax, consumption tax and customs duties can be quite
signifcant. Therefore, in China, transfer pricing arrangements also must consider the
implications of other taxes.
Colombia
22.
C
Colombia
2201. Introduction
Colombia frst introduced transfer pricing regulations by Act 788 in 2002, and by
Act 863 in 2003 specifed and clarifed the scope. Subsequently, the Regulatory
Decree 4349 of 2004 (regulatory decree) enacted the enforcement of the formal and
substantial transfer pricing obligations.
Colombian regulations regarding transfer pricing apply from FY 2004
1
and are
consistent with the spirit of the OECD Guidelines, and they are part of a government
effort to prevent tax avoidance. The transfer pricing rules address specifc issues such
as fnancial transactions, application of the interquartile range, adjustment to the
median when the taxpayers margins or prices fall out of the interquartile range and
considerations of the industry and/or life business cycles.
Colombian tax authorities (Direccin de Impuestos y Aduanas Nacionales, or DIAN)
are entitled to assess taxpayers transactions subject to the rules as from year 2005.
Transfer pricing rules apply to taxpayers engaging in cross-border transactions with
foreign-related parties. These rules impact only the income and complementary tax
computation regarding ordinary and extraordinary income, expenses (costs and
deductions) and the determination of assets and liabilities between related parties.
Therefore, the rules will not affect the determination of other taxes under such
transactions, such as industry and trade tax, value added tax and customs.
All transactions with related parties are subject to the rules including transfer or use of
tangible and intangible property, provision of services and fnancial transactions such
as loans and investments.
Regarding the application of any of the transfer pricing methods, the rules clarify
that income, costs, gross proft, net sales, expenses, operating profts, assets and
liabilities should be determined, based on the Colombian generally accepted accounting
principles(GAAP).
Related economic party or related party
The concepts of related economic party and related party should be considered
synonyms and are basically defned by references to other rules that include situations
1
In Colombia, scal year equals calendar year.
International Transfer Pricing 2011 Colombia 323
Colombia
ranging from statutory to economic dependency and control of companies by
individuals. In this matter, Section 260-1 of the Colombian Tax Code remits to the
following regulations:
Commercial Code, which addresses the meaning of subordinated or controlled entity
(Sections 260 and 261), including branches and agencies (Sections 263 and 264);
Section 28 of Act 222 of 1995, which defnes the concept of group and the notion of
unity of management and purposes;
Sections 450 and 452 of the tax code, which apply subordination levels; and
Finally, unless otherwise proven, transactions among residents domiciled
in Colombia and residents domiciled in tax havens will be considered to be
transactions among related parties.
Following the spirit of the OECD Guidelines, the transfer pricing rules specify
the methods for the transfer pricing analysis, as well as the comparability factors
that should be taken into consideration when assessing controlled transactions in
relation to those performed by independent third parties in comparable transactions.
In Colombia, Section 260-2 of Tax Code establishes the following six transfer
pricingmethods:
Comparable uncontrolled price (CUP);
Resale price (RPM);
Cost plus (CPM);
Proft split (PSM);
Residual proft split (RPSM); and
Transactional net margin (TNMM).
Best method rule
Transfer pricing rules do not establish a ranking for selecting a transfer pricing method,
nor do they provide guidance as to the specifc cases in which the methods will have to
be used. In practice, taxpayers should select the most appropriate method applicable
to the transaction(s) under review and adequately support the rejection of the
othermethods.
The most appropriate method is the one that better refects the economic reality of the
transaction, is compatible with the companys enterprise and commercial structure,
has the best quantity and quality of information, contemplates a better degree of
comparability and requires fewer adjustments.
Tested party
For the application of transfer pricing methods that require the selection of a tested
party, the Colombian transfer pricing rules do not determine which party should be
subject to analysis. Therefore, it is permissible to choose as the tested party either the
local or the foreign-related party when conducting the transfer pricing analysis.
Formal obligations
Income taxpayers obliged to fulfl transfer pricing requirements are those that perform
transactions with related parties located abroad that at year-end exceed the established
caps of gross equity equal to or higher than 100,000 taxable units (TU
2
) or gross
2
For FY 2009, one TU is equivalent to COP23,763 (approximately USD12.51), and for FY 2010, it is equivalent to COP24,555
(approximately USD12.92). Exchange rate of COP1,900 per USD.
Colombia 324 www.pwc.com/internationaltp
C
income equal to or higher than 61,000 TU, as well as those taxpayers that engage in
transactions with residents or those domiciled in tax havens.
For the enforcement of the obligations, taxpayers should report on the informative
return all transactions entered into with foreign-related parties, regardless of the
amount. However, for supporting documentation purposes, only those transactions
exceeding 10,000 TU by type of transaction are subject to a transfer pricing analysis.
Following is a short description of the requirements in the regulatory decree
regarding the individual and consolidated informative returns as well as the
supportingdocumentation.
Individual informative return
Pursuant to the regulatory decree, the return must contain the following:
Form fully completed;
Taxpayers fscal identifcation;
Income tax ID and country of domicile of the related parties involved in the
controlled transactions;
Transfer pricing method used to determine the prices or proft margins;
Interquartile range obtained in the application of the transfer pricing methodology;
Assessment of sanctions, when necessary; and
Electronic signature of the taxpayer or its legal representative, its agents or the
special agent.
Consolidated informative return
In cases of control or holdings, when the controller or headquarters or any of its
subordinated entities must fle an individual informative return, the controller or
head offce will have to fle a consolidated informative return listing all transactions,
including those involving affliates that are not required to fle the individual
informative return. Additional considerations:
In cases of joint control, the DIAN must be informed, by a letter, which of the
controllers will fle the consolidated return;
When the controller or head offce has a branch and one or more subsidiaries in
Colombia, the branch is the one required to fle the consolidated return;
When there is no branch, the subordinate with the higher net equity at 31
December of the related FY would be responsible for complying with this formal
obligation; and
The content of the consolidated return is similar to that of the individual one.
However, all transactions performed by the related parties must be consolidated by
type of transaction.
Filing of the informative returns
The forms of the informative returns are generally due in mid-July and they should
be fled through the Electronic Media and Payment System. The forms to be used
are N 120 for the individual informative return and N130 for the consolidated
informativereturn.
Supporting documentation or transfer pricing study
The supporting documentation should be prepared and made available to the tax
authorities upon request no later than 30 June of the following year to the related
Colombia
fscal year. In practice, tax authorities have requested the supporting documentation
from all taxpayers for the last three consecutive years. In general, the supporting
documentation must contain, among other things, the following information:
General information
Description of the taxpayers organisational and functional structure;
General description of the business;
Equity composition with name, income tax ID and ownership percentage of
partners or shareholders;
General description of the industry or sector to which the company belongs,
indicating the taxpayers position in it; and
Name, income tax ID, domicile, description of the business purpose and activity of
the related parties, including ownership details and subsidiaries. The facts that give
rise to the relationship must be informed.
Specifc information:
Detailed description of each type of transaction;
For contracts or agreements, parties, purpose, terms and prices must be specifed;
For transactions with residents or those domiciled in tax havens, a copy of the
documentation that certifes that the transaction was done must be included;
Functional analysis by type of transaction, including a short description of the
activities, classifcation of used assets and inherent risks of the transactions,
amongothers;
General information about commercial strategies;
Information about the industry and description of substitute goods or services;
Politic or normative changes that could affect the result of the transaction;
Method used by the taxpayer in the transfer pricing analysis, selected in accordance
with the best method rule;
Proft level indicator used in the analysis;
Identifcation and determination of the comparable companies, information
sources, inquiry dates and indication of the rejection criteria of non-accepted
comparable companies;
Technical adjustments description and, when needed, generic description of the
principal differences between Colombian accounting practice and the accounting
practices in those countries where the comparable companies are domiciled; and
Detailed conclusions of the level of compliance with arms-length standard.
Annex information:
Financial statement (general purpose);
Balance sheet, proft and losses statement, production costs statement and sales
costs statement segmented by type of transaction;
Copy of the contracts or agreements; and
In economic or special business situations, pertinent supporting information, such
as marketing studies, projections and reports must be attached.
Related rules
The following Tax Code provisions do not apply whenever taxpayers transactions are
analysed according to transfer pricing rules:
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Determination of the gross proft in case of transfer of assets (Section 90);
Other non-deductible payments (Section 124-1);
Non-deductibility of losses in case of transfer of assets to economic related parties
(Section 151);
Non-deductibility of losses derived from the transfer of a companys assets to its
partners (Section 152); and
Cases in which occasional losses are not accepted (Section 312, paragraphs two
andthree).
The majority of the above-mentioned rules aim to control transactions between related
parties, although in a very general manner. As a result, it would not be appropriate
to apply these rules in a case in which arms-length values for controlled transactions
would be analysed through transfer pricing rules.
It is also established that transactions to which transfer pricing rules apply will not
be subject to the limitations on costs and deductions established in the Tax Code
Section260-7.
Act 1111 of 2006 established that the Ministry of Mines and Energy will set the price
of exports of minerals when they exceed USD100 million. Taxpayers obliged to fulfl
transfer pricing regulations should establish their income using at least the price set by
said Minister.
Act 1370 of 2009 modifed the frst paragraph of Section 287 of the Tax Code, which
states that for income-tax purposes, some accounts payable with related parties should
be considered as equity. The modifcation consisted of including the defnition of
related party as stated in Section 260-1.
3
Tax havens
To determine if a country or jurisdiction qualifes as a tax haven, Act 863 of 2003
specifed the criteria by which the national government can issue such qualifcation. A
country or jurisdiction will be considered a tax haven if it fulfls the frst requirement
and any one of the other three listed below:
Nonexistence of taxation or low, nominal rates as compared to those applied in
similar transactions in Colombia;
Lack of an effective information exchange, or the existence of regulations or
administrative practices that could limit the exchange of information;
Lack of transparency at a legal level, regulatory or administrative functioning; and
Absence of requirements for the development of a real economic activity that is
important or substantial to the country or territory or the simplicity by which a
jurisdiction accepts the establishment of private entities without a substantive
localpresence.
The Colombian government has the authority to issue through a decree the list of
countries and jurisdictions considered to be tax havens. However, to date such a decree
has not been issued.
3
This modication applies as from FY 2010 onwards.
Colombia
On the other hand, for foreign policy reasons, the Colombian government
has the authority to exclude a country or jurisdiction even if it fulfls the
above-mentionedcharacteristics.
2204. Legal cases
Tax authorities have started transfer pricing audits, requesting that a taxpayer amend
its income-tax return when failing to fulfl the arms-length principle. It is expected that
such requests will be brought before courts.
The transfer pricing rules shift the burden of proof to the taxpayers, allowing them to
develop their transfer pricing policies and to document all their cross-border-related
party transactions subject to the rules.
Colombian tax authorities have started audit procedures focused on 1) taxpayers
failing to fulfl transfer pricing rules, 2) informative return formal penalties (i.e. late
fling) and 3) requests for income-tax return amendments for failure to comply with
the arms-length principle.
Tax authorities use the regular or standard audit procedure, such as on-site
examinations and/or written requests. During the examination, the tax authorities
may request additional information and must be allowed to have access to the
companys accounting records. In general, the audit procedure is the following:
Ordinary tax notice; in general, tax authorities grant 15 calendar days to answer it;
Special tax notice; taxpayers have three months to answer it;
Offcial assessment; taxpayers may appeal (two months) or fle a complaint before
a tax court (four months);
If the taxpayer appeals, tax authorities have one year to issue a tax authoritys fnal
judgment. Once the tax authoritys fnal judgment is issued, the taxpayer has four
months to fle a complaint before a tax court;
Once the complaint is in a tax court, the process may take up to three and a half
years; and
If the tax courts decision is adverse to the taxpayer, it may fle a complaint before a
fnal tax court. This process may take approximately 18 months.
Formal penalties for transfer pricing rules are established in Section 260-10 of the
TaxCode.
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Summary of penalties
Supporting Documentation Informative Return
Case Inconsistent/After
deadline/Not the
requested/Mistaken/
Does not permit
Verication
Not led Late ling Amendment Not led
Rate 1% 1% 1% per month
or month
fraction
1% 20%
Base Total value of transactions with related parties
Cap 28,000 TU 39,000 TU 39,000 TU 39,000 TU 39,000 TU
Effect Rejection
of the
cost or
deduction
Could not
be used as
a proof
Other
considerations
After tax
notice,
penalty
will be
doubled
Inconsistent
information could
be amended
between the next
following 2 years
after the deadline
established
for the return
and before the
notication of
the requirement.
Section 260-2 of the Tax Code states that if the analysis of a transaction falls outside
the range, the price or margin to be considered to be at an arms-length nature will
be the median of such range. In practice, and according to the type of transaction,
taxpayers should recognise additional taxable income or reject costs and deductions
if they have failed to comply with. Income-tax amendments should take into
consideration effects on assets and liabilities between related parties.
In addition, the paragraph of Section 260-10 states that:
In accordance with transfer pricing rules, there will be sanctionable inaccuracy with
the inclusion in the income-tax return, informative returns, supporting documentation
or in reports fled to tax authorities of false, mistaken, incomplete or disfgured data
or factors, and/or the determination of income, costs, deductions, assets and liabilities
in transactions with related parties, with prices or margins that do not match those
used by independent parties in comparable transactions, which derive in a lesser tax or
payable value, or in a greater balance in favour of the taxpayer. The applicable sanction
will be the one established in Section 647 of the Tax Code, which can be up to 160% of
the additional tax.
It is important to bear in mind that amendments to the income-tax return can be
made only if such return has its statute of limitations open, which in general terms is
twoyears.
Colombia
Comparable information is required in order to determine arms-length prices
and should be included in taxpayers transfer pricing documentation. Colombian
companies are required to make their annual accounts publicly available by fling them
to the Colombian Superintendent of Societies (Superintendencia de Sociedades). This
fnancial information can be accessed through the internet and is considered reliable
data. PwC Colombia has made an important investment accruing and formatting this
information so it can be used for supporting documentation purposes as of FY 2007.
authority procedure
Where there is an agreement to avoid double taxation signed by Colombia with a
foreign jurisdiction, in case such jurisdiction adjusts the profts (as a result of a transfer
pricing audit) of the foreign-related party, the taxpayer in Colombia is allowed to
request a reciprocal adjustment, subject to approval of the Colombian tax authorities,
on its income-tax return.
Notwithstanding such an agreement, it is necessary to harmonise the statute
of limitations of the income-tax return in Colombia with what is pursued by
the agreements to avoid double taxation in order to be able to request the
reciprocaladjustment.
Currently, Colombia is part of the following treaties to avoid double taxation:
Andean Community (Bolivia, Ecuador and Peru), Spain (23 October 2008) and
Chile (1 January 2010). Treaties are in the process of approval with Canada, Mexico
andSwitzerland.
As of 1 January 2006, taxpayers can request an APA. These regulations refer to the
duration, time limits so that the APA may by authorised by the tax authorities, time
limits so that taxpayers could request an APA, modifcation of an APA and cancellation
of the agreement, among others.
Law
Changes in the transfer pricing rules or enactment of new rules is not expected in the
near future.
Practice
Tax authorities have become more aggressive and have improved their transfer pricing
knowledge. Although transfer pricing audits have focused on formalities, it is expected
that the audits will address inter-company debt, technical services fees, commission
payments, royalty payments, transfers of intangible property and management fees.
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There are no records or evidence of any direct communication between customs and
tax authorities regarding transfer pricing.
2214. OECD issues
Although Colombia is not a member of the OECD, the tax authorities have generally
adopted the Transfer Pricing Guidelines for Multinational Enterprises and Tax
Administrations, published by the OECD, as a specialised technical reference and not
as a supplementary source of bylaw interpretation.
There have been no requests to other tax authorities for specifc information
concerning transfer pricing.
Croatia
23.
International Transfer Pricing 2011 331 Croatia
2301. Introduction
Transfer pricing provisions in Croatia were introduced through the Corporate Income
Tax Act (CIT) on 1 January 2005.
Prices between a Croatian entity and its foreign-related party must be charged at
armslength.
According to the CIT Act, the following methods can be used to determine the arms-
length price:
The comparable uncontrolled price method;
The resale price method;
The cost-plus method;
The proft split method; and
The net-proft method (which is equivalent to the transactional net margin method
under the OECD Guidelines)
According to Article 41, Paragraph 2 of the General Tax Act, related entities are
legally independent companies which, in their mutual relations, fall into one of the
followingcategories:
Two or more companies, of which one company holds a majority share or majority
decision-making interest in the others;
Two or more companies, of which at least one company is dependent and one is
controlling; companies that are part of the same concern (Group);
Companies with common shareholders; and
Companies linked by special contracts in accordance with the Companies
Act or that have arrangements such that profts and losses can be transferred
betweenthem.
Transfer pricing rules are prescribed by Article 13 of the CIT Act and by Article 40 of
the Corporate Income Tax Ordinance.
Currently, detailed transfer pricing regulations are in a draft form. There is no
indication when they will be published.
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Croatia 332 www.pwc.com/internationaltp
There are no other regulations, but the OECD Guidelines can be used as a
generalguide.
2304. Legal cases
As this is a relatively new provision, there are no legal cases in Croatia related to
transfer pricing.
The burden of proof lies with the local taxpayer.
According to the transfer pricing provisions of the CIT Act and the related ordinance,
the business relations between related entities will only be recognised if a taxpayer has
and provides (at the request of the tax authority) the following information:
Identifcation of the method selected and the reasons for the selection of
suchmethod;
A description of information reviewed, the methods and analyses used to determine
the arms-length price and the rationale for selecting the specifc method;
Documentation regarding the assumptions made in the course of determining the
arms-length price;
Documentation regarding all calculations made in the course of the application
of the selected method in relation to the taxpayer and any comparables used in
theanalysis;
Information regarding adjustments for material changes in relevant facts and
circumstances when documentation is an update that relies on a prior-year
analysis; and
Any other documentation that supports the transfer pricing analysis.
2306 Tax audit procedures
In Croatia, in order to be fully recognised for tax purposes, all costs incurred between
two companies must meet the following conditions:
They should be proven as necessary and provided for the beneft of the company;
The description of the services on the invoice must correspond to the services
actually provided;
The invoice must be supported with documentation of services provided (e.g. in
case of consulting or advisory activities, this may include various correspondence,
emails, reports, projects, etc.); and
The value on the invoice should be an arms-length price.
Currently there is no special tax audit procedure specifc to transfer pricing that differs
from the regular tax audit procedure. However, the tax authority has published the
Guidebook for Surveillance of Transfer Pricing, which is designed for internal use, but
is also available to all taxpayers.
International Transfer Pricing 2011 Croatia 333
Croatia
The standard legal procedure is for the tax authority to issue a resolution at the
conclusion of the tax audit (i.e. frst instance).
Prior to the issuance of the resolution, the tax authority issues tax audit minutes.
The taxpayer has an opportunity to object to the tax audit minutes and make written
comments/remarks regarding the statements made in the minutes. Subsequently, the
tax offce issues the written resolution.
If, at the frst-instance level, the tax offce does not accept the taxpayers objection to
the resolution, the taxpayer can appeal to the Central Tax Offce (i.e. second instance).
In the second instance, the Central Tax Offce will issue a second-instance resolution.
With this second-instance resolution, the Central Tax Offce can resolve the confict
itself or prepare instructions for the frst instance as to how to resolve the confict.
In the event that the second-instance resolution is unfavourable and not acceptable to
the taxpayer, the taxpayer may next appeal the second-instance resolution.
Current Croatian legislation does not proscribe additional tax and penalties in relation
to transfer pricing. The general penalties contained in the law apply to these cases as
well. However, if the prices between related entities are different from those between
non-related resident and non-resident entities, any excess amounts will not be
recognised for taxation purposes.
Generally, no information is publicly available regarding any database that the tax
authority uses for transfer pricing purposes. However, there are indications that
the tax authority has access to the Amadeus database. The tax authority is known
to use publicly available, relevant data from other companies that operate in the
Croatianmarket.
See previous section.
Inter-company management services usually draw the attention of the tax authority
and may trigger an inspection.
The tax offce is not organised on an industry-specifc basis.
While mutual agreement provisions exist in Croatian tax treaties, there is currently
little practical experience in this area.
Croatia 334 www.pwc.com/internationaltp
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Croatia does not have an APA programme in place.
See section 2302.
Yes.
2316. OECD issues
No.
We are not aware of joint investigations at this time.
Thin capitalisation provisions were introduced on 1 January 2005. These provisions
state that interest payments made in respect of loans from a shareholder of a company
holding at least 25% of shares or voting power of the taxpayer will not be recognised
for tax purposes if the amount of the loan exceeds four times the amount of the
shareholders share in the capital or their voting power.
A third-party loan will be considered to be given by a shareholder if it is guaranteed by
the shareholder.
These services consist of various consulting and business services, which are attracting
the attention of the tax authority. The tax authority is very aggressive in challenging
the deductibility of this type of expense. Therefore, in order to prove these services
are tax-deductible, the taxpayers must satisfy the terms stated under the tax audit
procedures section (i.e. have suffcient support or evidence for the provision of
theservices).
The Czech Republic
24.
International Transfer Pricing 2011 335 The Czech Republic
2401. Introduction
The Czech tax authorities have begun to recognise the importance of transfer
pricing, resulting in an increase in the number of tax audits that focus on related
partytransactions.
Acceptance of OECD Guidelines
The Czech Republic has been a member of the OECD since 1 January 1996. OECD
Guidelines on transfer pricing were translated into the Czech language and published
by the Czech Ministry of Finance in 1997 and 1999. Although the OECD Guidelines are
not legally binding, they are generally accepted by the Czech tax authorities.
Arms-length principle in Czech tax legislation
Czech transfer pricing legislation covers transactions between companies as well
as individuals and applies equally to domestic and cross-border transactions. The
legislation contains a general defnition of the arms-length principle, which basically
refects the arms-length principle in the OECD Guidelines.
The legislation states that a taxpayers tax base will be adjusted for any related party
transaction undertaken by the taxpayer in which the price differs from what would
have been agreed between unrelated parties in current business relationships under
the same or similar terms (conditions).
Based on Czech tax legislation, parties are regarded to be related if one party
participates directly or indirectly in the management, control or capital of the other,
or where a third party participates directly or indirectly in the management, control or
capital of both of them, or where the same persons or their close relatives participate
in management or control of the other (excluding situations where one person is the
member of supervisory boards of both parties). Participation in management suffces
to assume a relationship, even without equity ownership. Participation in control or
capital means ownership of at least 25% of a companys registered capital or voting
rights. Individuals are related if they are close relatives. Parties are also deemed to be
related if they enter into a commercial relationship mainly for the purpose of reduction
of the tax base (or increase of a tax loss).
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The Czech Republic 336 www.pwc.com/internationaltp
Methods for determination of the arms-length price
In general, there are no provisions in the Czech tax legislation on how an arms-length
price should be determined in related party transactions. However, as mentioned
above, the OECD Guidelines generally are accepted by the Czech tax authorities. It is
therefore recommended to apply the methods described in the OECD Guidelines.
Czech transfer pricing guidelines and documentation rules
In accordance with the guideline of the Czech Ministry of Finance D-258 (regarding
use of the international standards for taxation of transactions between related
parties), followed by the guidelines of the Czech Ministry of Finance D-292 (regarding
the transfer pricing advanced pricing agreement) and D-293 (regarding transfer
pricing documentation), Czech companies should follow the principles of the
OECDGuidelines.
The Czech tax legislation does not prescribe any obligation to maintain any transfer
pricing documentation (including preparation of a benchmarking study or a functional
and risk analysis). Nevertheless, documentation proving that the arms-length
principle was followed in related party transactions might be required by the Czech
tax authorities during a potential tax audit. It is, therefore, highly recommended that
such documentation be prepared in advance and that the transfer pricing methodology
applied in transactions with related parties be properly documented.
In addition, as a member of the European Union, the Czech Republic has adopted the
EU Transfer Pricing Documentation Code (master fle approach). However, it is at the
taxpayers discretion to follow the code.
Based on the legally nonbinding guideline D-293 on transfer pricing documentation
issued by the Czech Ministry of Finance, documentation for transfer pricing should
contain at least the following information:
a. Master fle:
Information about the group (business description, organisational structure,
inter-company transactions, functional and risk profle of companies within the
group, etc.).
b. Local fle:
Information about the group;
Information about the companies involved;
Information about the transactions;
Information about the transfer pricing policy and the selection of the method;
Information about other relevant circumstances;
Functional and risk analysis; and
Benchmarking analysis.
The above contents should be suffcient for the tax administrator to determine whether
the company acts in compliance with the arms-length principle.
Advanced pricing agreement (APA)
Based on the Czech Income Taxes Act, if a company is in doubt as to whether the prices
applied in existing or future transactions are in compliance with the arms-length
principle, it can submit a written request to the Czech tax authorities for an APA ( i.e. a
binding transfer pricing ruling).
International Transfer Pricing 2011 The Czech Republic 337
The Czech Republic
Practical experience shows that the average time needed for processing an APA in the
Czech Republic is approximately eight months. So far, only unilateral APA requests
have been fled. However, the Czech Ministry of Finance expressed that it is also
prepared to deal with a bilateral or multilateral APA, if required.
Customs
According to customs legislation, the base on which customs duty is calculated may be
amended when the seller and buyer are related. There is a description of how an arms-
length price will be determined for customs duty purposes through available data on
comparable goods and services.
2403. Reporting under the commercial code
Starting in 2001, the Czech commercial code introduced new rules and regulations
relating to groups of companies, including reporting requirements. Group companies
may conclude a controlling agreement listing the companies that are subject to
common management by the controlling company. In the absence of such an
agreement, the new reporting requirements impose an obligation on companies having
a common majority shareholder to report intragroup transactions.
The information on intragroup transactions is to be prepared as part of the annual
report, and is to be fled with the relevant commercial court. This document must
outline all transactions carried out in the fscal year between the subsidiary company
and the majority shareholder, and also with any sister company. There are no
guidelines in the legislation as to what level of detail is required. The document is
available to the public, including the Czech tax authorities and minority shareholders,
which increases the risk of transfer pricing investigations. The report on intragroup
transactions is also subject to statutory audit review.
2404. Penalties and interest on late payments
If there is a successful challenge of a companys transfer prices by the tax authorities,
then additional tax, penalties and interest on late payments may be due.
With effect from 1 January 2007 (for tax due after 1 January 2007), the penalties and
interest on late payments are calculated as follows:
A penalty in the amount of 20% applies if tax is increased or a tax deduction
isdecreased.; and
A penalty in the amount of 5% applies if a tax loss is decreased.
In addition to the penalty, interest on late payments applies. Interest is calculated as
the National Banks repo-rate increased by 14%. This interest charge is applicable for a
maximum period of fve years.
No penalty applies if the taxpayer reassessed the tax base voluntarily in an additional
tax return (only interest on late payment applies in that case).
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Obligations of the taxpayers
Based on the Taxes and Fees Administration Act, which governs tax audit procedures,
the taxpayer has two main obligations:
To declare the tax liability to the tax authorities in a tax return; and
To be able to substantiate the liability declared.
In principle, the tax authorities may request that the taxpayer provide evidence to
substantiate all facts relevant to the tax return. This also applies to documentation on
the taxpayers approach to transfer pricing.
Approach of the tax authorities
In practice, rather than requesting general information, the authorities will specify
their requirements. They must grant the taxpayer suffcient time to compile the
required information (although practice shows that in a transfer pricing inquiry
situation, this might be an issue, given the complexity of transfer pricing and the
documentation required).
In cases where the tax authorities have requested evidence to substantiate items
included in the tax return, it is the tax authorities themselves that decide whether
that evidence is adequate. Where it is considered inadequate, the tax authorities
may reassess the taxpayers liability on the basis of their own sources of information,
such as third-party valuations or information obtained from other taxpayers returns
orinvestigations.
However, in order to be able to make an assessment, the tax authorities should have
a reasonable basis for the challenge of the declared tax liability. In transfer pricing
disputes, they should primarily:
Provide suffcient evidence that the arms-length principle was not followed; and
Demonstrate that, as a consequence of non-compliance with the arms-length
principle, the taxpayer has declared an incorrect low tax liability.
Negotiations are rare on the tax liability between the taxpayer and the tax authorities
(e.g. when the taxpayer cannot substantiate the declared liability and the tax
authorities cannot obtain adequate evidence from their own sources to issue
areassessment).
Burden of proof
The burden of proof effectively lies with the taxpayer because in order to mount
a challenge, the tax authorities must only demonstrate that there is some basis
for that challenge. It is the taxpayer who must then provide the evidence to refute
thechallenge.
2406. Transfer pricing practice
Transfer pricing inquiries
The number of transfer pricing inquiries has increased in recent years, and the Czech
tax authorities are becoming more confdent in this area. The practical knowledge
International Transfer Pricing 2011 The Czech Republic 339
The Czech Republic
of transfer pricing and the level of detail to which the tax offces go when reviewing
transfer prices vary across the country from tax offce to tax offce. However, the
level of sophistication of the tax authorities constantly increases, and the Czech tax
authorities have established specialised audit teams focused on transfer pricing. These
developments prove that the Czech tax administration recognises the importance
of transfer pricing, resulting in a number of tax audits that focus on related party
transactions, particularly those involving services, low-risk functions and losses.
Further, there is a growing trend in relying on the APA process with the Czech tax
authorities to resolve transfer pricing uncertainties.
Investment incentives
Currently, the Czech government gives the opportunity for companies investing in the
Czech Republic to participate in an investment incentives programme. The investment
incentives package contains various benefts such as a 10-year tax holiday.
Czech tax legislation contains a specifc provision on the interplay between a tax
incentive and transfer pricing. Based on this provision, if a company that was granted
investment incentives does not comply with the arms-length principle, it may lose the
granted tax incentive. This may result in suspension of the tax relief and assessment
of severe penalties. Therefore, the Czech tax authorities are highly focused on transfer
pricing when examining companies that participate in investment incentives.
2407. Anticipated developments
Because many of the neighbouring countries (e.g. Poland, Hungary and Slovakia) have
introduced transfer pricing documentation rules, the Czech Republic likely will follow
this trend.
Thin capitalisation rules in Czech tax legislation
Thin capitalisation provision also is included in the Czech tax legislation.
The main rules are outlined below:
The debt-to-equity ratio for related party loans to equity is 4:1 (6:1 for banks and
insurance companies). Unrelated party loans (e.g. bank loans) are not subject to
thin capitalisation;
The tax deductibility test applies to interest as well as to other fnancial costs on
loans (i.e. interest plus other related costs such as bank fees, etc.);
Financial costs paid on proft participating loans are fully tax non-deductible; and
Back-to-back fnancing (i.e. credits and loans between related parties provided
through an unrelated intermediary, such as a bank) is also subject to thin
capitalisation rules.
Denmark
25.
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Denmark
2501. Introduction
The Danish transfer pricing rules, which are based on the 1995 Organisation for
Economic Co-operation and Development (OECD) Transfer Pricing Guidelines, have
evolved considerably since their implementation in 1998. The implementation of
transfer pricing rules was partially infused by two notable court cases that had made
it diffcult for the Danish Tax Authority (DTA) to achieve tax adjustments for transfer
pricing reasons. The Danish transfer pricing rules can be found in Section 2 of the
Danish Tax Assessment Act (DTAA), and Section 3B and Section 17 of the Danish Tax
Control Act (DTCA).
Since 1998, the Danish Parliament has passed a comprehensive set of rules on
documentation requirements and tax returns. In December 2002, the DTA issued a
guideline on transfer pricing documentation requirements. Based on a study completed
in 2003, it was determined that approximately half of the 233 companies surveyed had
provided inadequate documentation. Consequently, transfer pricing has been declared
a tax audit theme.
In 2005, the Danish government suggested introducing various measures in order
to increase the focus on tax assessment and control of transfer pricing issues. The
various measures include extending and tightening transfer pricing documentation
requirements in order to ensure that the Danish transfer pricing rules are not in
confict with EU anti-discrimination law and are in alignment with the EUs Code of
Conduct, and encouraging businesses to prepare quality and adequate transfer pricing
documentation.
In February 2006, in addition to formalising the new 2006 Danish Transfer Pricing
Guidelines, the DTA also announced new statutory rules for documenting controlled
transactions. The main aim of tightening the rules is to ensure that all the requirements
in the statutory rules are observed when documenting controlled transactions, truly
demonstrating the adoption of the arms-length principle.
In August 2009, the DTA introduced a valuation guideline in relation to the valuation
of businesses, parts of businesses and intangible assets. The valuation guidelines are
not binding for the taxpayer but express the best practice that the DTA should follow
for the valuation of companies and part of companies, including valuation of goodwill
and other intangible assets.
International Transfer Pricing 2011 Denmark 341
Denmark
The guidelines consider intragroup controlled transactions as well as independent
party transactions where the independent parties do not have opposite interests.
Moreover, the guidelines describe three overall types of valuation methods, namely the
income-based models, the market-based models and the cost-based models. Further,
the guidelines offer recommendations in the application of valuation models as well as
recommendations to the content of documentation in relation to a valuation.
The valuation guidelines should be considered a supplement to an established practice,
and the existing goodwill note and established legal practice still apply.
In 2008, the DTA announced adjustments of DKK8.7 billion. The adjustment for
subsequent years has not yet been released but is expected to amount to or even exceed
the 2008 fgures.
2502. Statutory rules arms-length principle
Section 2 of the DTAA does not address only cross-border transactions, but all
transactions between related parties. Section 2 of the DTAA provides that the arms-
length principle applies to taxable Danish entities that:
Are controlled by an individual or legal entities;
Control legal entities (i.e. directly or indirectly own more than 50% of the share
capital or control more than 50% of the votes in another entity);
Are related to a legal entity (i.e. are controlled by the same group of shareholders);
Have a permanent establishment situated abroad; and
Are a foreign individual or a foreign legal entity with a permanent establishment
inDenmark.
The arms-length principle applies to transactions with all of the above-mentioned
persons, legal entities and permanent establishments.
Disclosure
The following entities are required to prepare and keep transfer pricing
documentation:
Danish legal entities that are controlled by foreign individuals or legal entities;
Danish individuals and Danish legal entities that control foreign legal entities;
Danish legal entities that are related to a foreign legal entity through ownership or
voting rights;
Danish individuals and Danish legal entities that have a permanent establishment
outside Denmark; and
Foreign entities that have a permanent establishment in Denmark.
In this context the term control means that an entity directly or indirectly
owns more than 50% of the share capital or controls more than 50% of the votes in
another entity. Related parties are parties that are controlled by the same (group of)
shareholder(s), and the term controlled transactions means commercial or fnancial
cross-border transactions between parties, where one party either controls or is
controlled by the other party or between related parties.
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A foreign legal entity included in a Danish joint taxation also falls under the Danish
documentation requirements with respect to controlled transactions with other foreign
entities or foreign individuals.
Entities that fall under the transfer pricing documentation rules must supply certain
information on their tax return regarding the nature and the scope of controlled
commercial and fnancial transactions with foreign-related parties. In short, all entities
falling within the scope of the transfer pricing documentation rules must complete
the balance sheet section. In addition, entities that have controlled transactions in
the proft and loss account exceeding DKK5 million must complete the proft and
losssection.
Companies with cross-border-related party transactions exceeding DKK5 million must
state for each individually defned group of transactions whether all transactions
amount to:
Less than DKK10 million;
Between DKK10 million and DKK100 million; and
More than DKK100 million.
Companies should state whether the controlled transaction exceeds 25% of total
transactions within each individual group of transactions. In addition, certain
transactions must be disclosed in a companys income-tax return, such as a sale of fxed
assets and an inter-company fnancial transaction.
At the same time, the DTA has eased the documentation requirements for small and
medium enterprises (SME), which are defned as having:
Less than an average of 250 full-time employees during the year; and
Total assets of less than DKK125 million or net sales of less than DKK250 million.
There is a box in the annual tax return information requirement form that may be
checked by the enterprise eligible for SME status. However, this SME exemption
does not apply to inter-company transactions with enterprises and permanent
establishments in states outside of the EU and the European Economic Area (EEA),
which have not concluded a tax treaty with Denmark.
Danish transfer pricing documentation (DTPD)
From 1 January 1999, documentation supporting transfer prices has been
required. The documentation has to be suffcient for the tax authorities to evaluate
transfer pricing policies and to assess whether prices are consistent with the
arms-lengthprinciple.
In December 2002, the DTA issued a guideline on transfer pricing documentation
requirements, but the taxpayers are not obligated to strictly follow the documentation
guideline provided that the principles contained in the OECD Guidelines on transfer
pricing are applied. If the documentation upon evaluation is judged insuffcient, the
DTA may estimate transfer pricing adjustments.
In 2005, the Minister of Taxation proposed a new bill regarding the tightening of the
transfer pricing documentation rules. The extended and tightened DTPD rules took
effect from January 2005 and include the following four elements:
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Expansion of rules on documentation requirements to domestic transactions
Prior to the proposed bill, the rules on documentation applied only to cross-border
transactions. DTPD requirements now also apply to intragroup transactions between
domestic companies to satisfy non-discrimination principles of EU law (i.e. the arms-
length principle is to be applied to both domestic and cross-bordertransactions).
Part exemption to small and medium sized enterprises (SME)
SMEs with fewer than 250 employees at group level and which either have assets of
less than DKK125 million or turnover of less than DKK250 million are granted partial
exemption from documentation requirements.
Penalties for nonfulflment
Signifcant penalties apply for non-compliance with the DTPD rules. Section 14 of the
DTCA provides that the DTA may impose penalties on enterprises for fling incorrect
information regarding their eligibility for SME status. The DTCA Section 17 provides
that penalties may be imposed for not preparing transfer pricing documentation
and applies to controlled transactions carried out in income years starting 2 April
2006, or later. In summary, to impose penalties, it must be a matter of intent or
grossnegligence.

The DTA must fx rules with respect to the content of the transfer pricing
documentation, and the rules must be approved by the Board of Assessment before
they may be enforced. The fnes that may be imposed must be evaluated according to
the rules fxed by the DTA, whether it is lacking of transfer pricing documentation or
inadequate documentation.

From a practical perspective, penalties shall apply if the DTPD does not exist or if the
documentation is inadequate. The two-tier penalties are proposed according to the
following principles:
For the lack of documentation or inadequate documentation, a minimum penalty
must be paid in the amount equal to twice the cost saved by not preparing the
documentation or by preparing only inadequate documentation. However, if
suffcient documentation is prepared subsequently and submitted, the penalty
is then reduced by 50%. There is no guidance as to how the cost saving is to
be measured, but rumours indicate that the penalty amount will be between
DKK100,000 and DKK250,000. Also, interest of 1% per month applies to
thisamount.
In addition to the lack of documentation or inadequate documentation, if an
adjustment is issued after a tax assessment (i.e. the arms-length principle has not
been observed), the minimum penalty will be increased with an amount of 10% of
the proft adjustment.
The penalties have not yet been imposed in practice.
Tightening of documentation requirements
The quality of the documentation must correspond to the principles and descriptions
included in the documentation guidelines prepared by the DTA and the Danish transfer
pricing regulations based on the OECD Guidelines.
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Benchmarking as one of the requirements in DTPD
There is no compulsory requirement to do comparable databases searches.
However, in the case of a transfer pricing audit, the DTA can explicitly require that a
comparable database search using commercial databases be completed within 60 days
uponrequest.
Statutory rules for documentation of controlled transactions
The DTA has issued explanatory notes regarding the extent of documentation required.
The explanatory notes are binding on the DTA but not necessarily on the taxpayers.
The 2002 guidelines on transfer pricing documentation requirements issued by the
DTA sets forth an applicable and operational model for the preparation of transfer
pricing documentation. The explanatory notes and the guideline on documentation
take up the position that taxpayers are generally better at deciding what information
could be relevant as transfer pricing documentation. Hence, the recommendations in
the guideline on documentation requirements are of an overall nature only, and useful
as inspiration for the preparation of taxpayer-specifc transfer pricing documentation.
Effective February 2006, the new Danish statutory rules for documentation of
controlled transactions are applicable to all controlled transactions. The DTPD, as a
whole, forms the foundation for an estimation of the prices and terms and conditions
fxed in an agreement that could be obtained between independent parties.
The new statutory rules imply specifcally that taxpaying companies must observe all
the requirements when documenting controlled transactions.
In accordance with the new statutory rules, a DTPD must include the following:
A description of the company concerned;
A description of the controlled transactions;
A comparability analysis;
A description of the implementation of the price-setting methods;
A list of inter-company contracts; and
A description of the database searches (if performed).
The DTA must make their analysis in accordance with the OECD Guidelines and,
consequently, take the situation as a whole into consideration when auditing.
The DTPD may be prepared in one of the following languages: Danish, English,
Norwegian, or Swedish.
Insurance companies per January 2010 are no longer subject to special transfer
pricing regulations. They are subject to the general transfer pricing documentation
requirements and must prepare transfer pricing documentation for the income year
2010 and onwards.
Statute of limitation concerning transfer pricing adjustments
As a general rule, the DTA is not allowed to reopen a tax assessment detrimental
to the taxpayer later than the end of April in the fourth year after the income year
hasexpired.
According to the transfer pricing rules, this time limit may be extended by two years in
respect of transfer pricing adjustments. The notifcation of an adjustment of the taxable
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income in transfer pricing cases, therefore, must be made prior to 1 May in the sixth
year after the expiry of the income year under audit.
2503. Legal cases
To date, few cases concerning transfer pricing issues have been taken to court, and no
cases under the new legislation have yet been litigated.
There have been two important decisions of the court in the feld of transfer pricing,
the so-called oil decisions, both of which were tried under the previous legislation.
These two cases have had a signifcant infuence on the development of transfer pricing
rules in Denmark and are described below. In the early 1970s, political attention
focused on the non-payment of taxes by oil companies, and the Ombudsman was asked
to examine the extent to which the DTA applied Section 12 of the Company Tax Act
to the oil industry. Following his report, the DTA audited and then raised additional
assessments against the Danish subsidiaries of Exxon, Chevron, Texaco, and BP for the
tax year 197778.
These companies appealed against the assessments, and the appeal was heard by the
National Income Tax Tribunal. The decision of the tribunal was in favour of the oil
companies and allowed only a small assessment against Texaco Denmark. The tax
authorities then brought two additional cases before the courts.
In the Texaco case, the appeal concerned an additional tax assessment for 197778
made by the authorities based on a comparison of the net proft of the company with
the net profts of other Danish subsidiaries in the oil industry.
The court affrmed the principle that it was for the DTA to substantiate or prove a
violation of the arms-length principle. The court found that Texaco Denmark could be
required to disclose information regarding price and gross proft of the parent company
when dealing with other group companies and with unrelated customers. This
information was not available to Texaco Denmark, but only to the foreign management
of Texaco. Because this was not disclosed, the court concluded that the burden of proof
on the DTA should be reduced.
Nevertheless, the High Court ruled in favour of Texaco Denmark, allowing no increase
in its taxable income. The court found that the companys reduced proftability
could be accounted for by factors other than that of control by the foreign parent.
Texaco had entered the Danish market by acquiring 71 companies, resulting in high
implementation costs. Also, several differences in products (oil versus petrol) and
customers (no retail sales) disqualifed comparison with other Danish subsidiaries in
the oil industry. Finally, prices were not found to differ materially from those identifed
on the Rotterdam Spot Market.
The case of BP Denmark also concerned an additional tax assessment for 197778.
The High Court upheld a minor increase in BP Denmarks taxable income. Based
on a similar premise to Texaco Denmark, the court found that the prices paid by
BP Denmark were approximately 9% higher than the Rotterdam Spot Market and
concluded that this justifed an increase in BP Denmarks income. The company
appealed to the Supreme Court.
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The Supreme Court repeated that the burden of proof rested on the DTA, but that a
taxpayers failure or refusal to disclose evidence will reduce this burden. However,
because BP Denmarks purchases were on long-term contracts, this fact could explain
the deviation from the Rotterdam Spot Market rates. Hence the authorities had failed
to show that the deviation was due to the company being controlled and not to other
factors. BPs failure to disclose information was considered to be of less importance,
and the Supreme Court ruled in favour of BP Denmark.
The most recent Danish ruling on transfer pricing was made by the National Income
Tax Tribunal and concerns transfer prices for royalties. This case also addresses the
years before the new Danish transfer pricing legislation came into force. The National
Income Tax Tribunal ruled that it is crucial whether the royalty charges are reasonable
compared with the value of what is received in return, and it accepted tax deductibility
for royalties paid by a Danish branch to a foreign group company based on a fxed
percentage of the branches sales to third parties. However, the National Income Tax
Tribunal did not accept royalties paid on sales related to products for which the branch
owned the patents.
Although there have been no major cases on transfer pricing in Denmark since the
oil decisions above, the development in transfer pricing audit cases will increase the
number of cases brought before the Danish courts in the near future. These cases will,
without a doubt, emphasise the signifcant importance of transfer pricing issues placed
by the DTA in Denmark.
The question of burden of proof has been one of the most important issues in relation
to the development of transfer pricing in Denmark.
In the Texaco and BP Denmark court cases, the High Court and Supreme Court
confrmed that the burden of proof lies with the tax authorities and that the taxpayer
is required to disclose information relevant to the question of whether the arms-length
principle has been violated. This information would include items such as prices and
gross proft earned by the parent company when dealing with other group companies
and with unrelated customers. Where this information is not disclosed, the court
concludes that the burden of proof on the DTA is reduced.
In the explanatory notes to the new statutes on disclosure and documentation it is,
however, said explicitly that the DTA probably has interpreted the court decisions
too pessimistically and the attitude towards the burden of proof question is going to
change in the future so that the burden of proof situation in transfer pricing cases will
not be different from other tax cases.
The fact that the DTA may estimate transfer pricing adjustments if documentation is
inadequate represents a signifcant shift in the balance of the burden of proof between
the tax authorities and taxpayers. Furthermore, the conduct of the taxpayer during the
investigation may infuence the outcome because a refusal to provide documentation
can reduce or even reverse the burden of proof of the DTA.
Denmark
2505. Tax audits
As transfer pricing has been a tax audit theme since 2004 and with the new tightened
and expanded Danish transfer pricing regulations, the DTAs attitude has changed (i.e.
the DTA frequently questions transfer pricing policies of Danish companies).
The Danish government has introduced various measures since 2007 in order to
increase focus on tax assessment and control of transfer pricing issues. Among the
measures are establishment of a unit dedicated to transfer pricing issues, centrally led
by the tax authorities in Copenhagen and assisted by eight centres of excellence, which
are responsible for tax assessment of the largest and most complex transfer pricing
cases. In addition, more sophisticated information technology systems have been
introduced to enable selection of relevant companies for control. A model company has
not yet been formally defned; however, in general it is expected that a model company
is a company that fulfls all legislative requirements and delivers reliable, transparent
and informative fnancial information. Under such circumstances a model company
will only be subject to reduced control by the public authorities.
For 2010 and 2011, the central focus areas in tax audits are expected to be a repetition
of the 2008-09 areas, including, for example, the transfer of intangibles, royalties
in relation to intangibles and defcits. Additionally, new focus areas are expected to
include outsourcing to low-cost countries, as well as a focus on transactions between
certain developed transfer pricing jurisdictions. Moreover, the DTA has disclosed that
tax audits focused on whole sectors of industries will be a centre of attention.
There are no standard rules as to how a company or group might be selected for a
transfer pricing audit. In the previous oil cases, the investigation was triggered by an
apparent lack of taxes paid in Denmark. The DTA has recently announced that Danish
multinationals will be subject to audits in the upcoming years, especially where there is
an apparent lack of taxes paid to Denmark. In the future, the other most signifcant risk
factor will be the preparation or lack of the documentation both in relation to general
transfer pricing documentation and also in relation to valuations. In general, the DTA
are allowed to request any information of relevance for the tax assessment and has the
authority to make an estimated adjustment of the taxable income if information is not
provided. In addition, the conduct of the taxpayer during an audit may infuence the
outcome because a refusal to provide documentation can reduce or even reverse the
burden of proof of the DTA. While it is possible to negotiate with the DTA before the
adjustment is fnalised, it is not likely that the outcome of the audit will be a result of
either negotiation or litigation, but rather an assessment raised by the DTA based on its
audit fndings.
Simultaneous examinations
Denmark will cooperate with other countries in undertaking simultaneous
examinations of multinational groups. Indeed, this has already been practiced with the
Nordic countries, and it is conceivable that it will occur with respect to other countries
as well.
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It is possible to appeal after an assessment has been raised. There is one level of
administrative appeal, after which it is possible to continue the appeal in the courts.
As mentioned above, a unit dedicated to transfer pricing issues has been established
with the central tax authorities in Copenhagen. The unit is supported by eight centres
of excellence, which are responsible for tax assessment of the largest and most complex
transfer pricing cases.
In order to secure unifed assessments of the transfer pricing cases throughout the
entire country, the tax assessment authorities must obtain prior authorisation from the
central transfer pricing unit to make adjustments to the transfer pricing.
This offce is also the competent authority in relation to transfer pricing issues and is
expected to spend an equal amount of time on mutual agreement work and Danish
transfer pricing cases.
2508. Comparability analysis
Under the previous statutory transfer pricing documentation requirements, a
comparability analysis was not explicitly required to be part of the transfer pricing
documentation. Although a comparability analysis is not required, taxpayers were,
nonetheless, required to explain the prices in their inter-company transactions and to
provide the explanation and reasoning for proving that the prices were in accordance
with the arms-length principle.
As a result, the DTA has had diffculty in accessing whether the prices set by the
taxpayers were consistent with the arms-length principle. Therefore, one of the basic
requirements emphasised through the tightening of the rules in 2006 is with regard to
comparability analysis.
The requirements of comparability analysis
Following the tightening of the transfer pricing documentation requirements, the DTA
is now allowed to request for a comparability analysis as part of a taxpayers transfer
pricing documentation for one or more controlled transactions.
The comparability analysis is to provide, primarily, a basis for assessing whether the
principles used by the taxpayers group to determine prices in respect to its controlled
transactions are in conformity with the arms-length principle and secondly, the
reasoning for the benchmarks used and the method chosen.
Criteria to consider for comparability analysis
Consistent with the OECD Guidelines, the Danish guidelines connect the concept of
comparability analysis to the concept of functional analysis. The conditions concerning
an inter-company transaction must be examined in order to determine whether the
transaction or the company is comparable. The criteria set out in the Danish guidelines
to assess a comparability analysis are:
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Characteristics of the products or services;
A functional analysis;
Contractual terms;
Economic circumstances; and
Business strategies.
In practice, the retrieval of comparable data related directly to transactions between
independent companies operating under similar conditions remain infrequent as
this type of direct observation implies access to detailed information that generally
is confdential. Furthermore, even if the information is available, it would still
be necessary for the transactions to be comparable, which also is seldom found
inpractice.
Conducting a suffciently thorough comparability analysis that produces satisfactory
and reliable results requires the databases used by the taxpayers to be publicly
available and the data to be comparatively numerous and suffcient to build an
argument justifying that the selected independent companies are comparable with the
tested company. Practical experiences show that no two transactions are identical. It
is, therefore, necessary for the taxpayers to examine the results thoroughly on whether
the differences found are signifcant enough to affect the comparability of the selected
independent companies.
Type of database
The Danish guidelines have set out a list of examples of databases that could be used
by taxpayers for their comparability analysis. In practice, the most commonly used
database for comparability analysis in Denmark is the Bureau Van Dijks Amadeus
database, which is listed in the Danish guidelines. It is presumed that comparability
analysis using public domain sources of information also would qualify. This is
provided that the comparability analysis prepared based on these public domain
sources of information is clarifed clearly and is prepared in a transparent manner to
allow validation of the information source.
Elements of the comparability analysis write-up
In addition to the preparation of the comparability analysis, the comparability analysis
must be described as part of the transfer pricing documentation. The descriptions must
contain the following four elements:
Identifcation of the tested transaction(s) and the pricing methods;
Detailed written descriptions of the comparability searches providing the
arguments and reasons for the qualitative and quantitative search steps;
Explanation of the justifcation and range; and
Materials for the documentation from the database.
Although the Danish guidelines provide an example of the presentation of the elements
described above, it is stated that taxpayers may prepare the descriptions of their
comparability analysis differently as long as the elements above are taken into account
and references are provided thoroughly.
Quantitative and qualitative search steps
According to the Danish guidelines, the following search criteria are suggested, but not
compulsory, to be included in a comparability search process:
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Identify the activity of the tested company: branch code(s), keywords related to the
industry, key accounting data;
Identify the economic circumstances: geographic boundary, size of the tested
companys activity, number of years with activity;
Identify the key accounting data to justify the pricing and qualifcation of the arms-
length principle; and
Verify the data available through additional qualitative steps through: internet,
websites of companies and other possible methods.
It is pointed out that the selection of comparable companies must, nonetheless, be
consistent. This section of the Danish guidelines implied the need to avoid any cherry-
picking of proftable companies among the independent companies available as
comparables by both the taxpayers, when preparing a comparability analysis, and by
the tax authorities during tax audits.
Like many European countries that use the OECD Guidelines as the model for the
local transfer pricing guidelines, Denmark recognises the use of average data of the
past few years for the purpose of comparability analysis. Furthermore, the range of
data available for multiple years might disclose facts that may have infuenced the
determination of the transfer prices.
It is a common practice in Denmark for the data from the database to be measured
using median as the statistical tool to determine the representative result of a sample
set. The interquartile range also is used to determine the range of acceptable transfer
prices. An interquartile range is advantageous because, by excluding outlying or
extreme data point, which may be unrepresentative, the range frequently provides a
good indication of representative values.
The DTA generally accepts the transfer prices used by taxpayers if such prices are
known to be within normally acceptable market range and if such prices fall within a
broader range of comparable prices. Such prices could either be the interquartile range
of the comparable results or the complete range of results.
Request for the preparation of documentation and penalties
Following the tightening of Danish rules, taxpayers are now obliged to prepare
comparability analysis if the DTA requests it. The taxpayers must be given a 60-day
period to prepare the comparability analysis upon request with the possibility to extend
to a maximum of 90 days with authorisation from the DTA.
It is not possible at this stage to identify specifc transactions or industries where
transfer pricing adjustments are more likely than others. Income regulations on this
subject are often not appealed and therefore not published. However, we see that there
has not been much focus on more complicated transfer pricing issues by the authorities
since the oil cases (see section 2503 above). More straightforward cases, such as
management fees and interest on inter-company loans, are frequently taken up during
tax audits. However, this situation is changing as the tax authorities have become
more experienced in transfer pricing matters and more resources have been dedicated
to this area. Another new focus area is inter-company fnancing, as well as valuation
ofintangibles.
Denmark
The DTA is, without any limitations in time, obliged to reopen a tax assessment on
request by a taxpayer if there has been a transfer pricing adjustment abroad.
It should be noted, however, that the DTA is still entitled to form its own opinion
on the transfer pricing issue in question. The authorities may disagree with an
adjustment made by a foreign tax authority and consequently refuse to make a
correspondingadjustment.
The risk of a secondary adjustment in connection to the corresponding adjustment
exists in Denmark. The consequence of a secondary adjustment is a neutralisation of
the corresponding adjustment. According to Section 2 of the DTAA, a taxpayer has a
favourable position to avoid a secondary adjustment on transfer pricing adjustments
compared with other tax adjustments.
The Danish competent authority on transfer pricing matters is the special central
transfer pricing unit. Danish administrative principles, while not permitting the mutual
agreement procedure to become a process of litigation, grant the taxpayer the right
to comment on and discuss the position taken by the authorities. If a corresponding
adjustment is refused by the authorities, it is possible to appeal to the courts.
The Convention on the elimination of double taxation in connection with the
adjustments of profts of associated enterprises (Convention of 23 July 1990, 90/436/
EEC) became effective in Denmark during the period commencing 1 January 1995,
until 31 December 1999. The Convention was applicable in relation to all EU Member
States. Denmark has ratifed the extension of the Convention as have some of the other
EU Member States. However, the extension of the Convention will not come into force
until all EU Member States have ratifed it.
2511. Advance pricing agreements (APA) and binding
statements
Practice has shown that it is impossible to obtain a unilateral APA on continuing
transactions. So far it has been possible to obtain an advanced ruling only on single
transactions (i.e. the transfer of assets). The ability for the authorities to agree on
unilateral APAs requires new legislation. The guidelines issued by the Joint Transfer
Pricing Forum under the EU Commission likely will accelerate the inclusion of a
regulatory framework for APAs in Denmark.
The DTA is planning to issue Danish APA guidelines during 2010 (these guidelines have
been under way since 2008). These guidelines will largely follow the recommendations
from the Joint Transfer Pricing Forum under the EU Commission issued 26 February
2007. The Danish APA guidelines also will present the possibility of unilateral APAs.
Currently, it is possible to apply for bilateral APAs with countries with which Denmark
has tax treaties, by reference to the mutual agreement article. The possibilities of
obtaining a bilateral APA have never been better for the taxpayers. However, preparing
an APA demands considerable resources and is therefore most useful in more
complicated cases in which trade patterns are changed.
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In addition, taxpaying companies have the possibility of applying for a binding
statement with the DTA concerning the tax treatment and consequences for their
actions either before or after any action taken by the companies. The request for a
binding statement applies to questions on tax and indirect tax consequences, and fees
will apply for each request.
In general, a binding statement normally is provided by the DTA, and the response
will be provided within one month of the request. In the event of a request concerning
principle contents of the tax regulations, the binding statement will be provided by
the Danish Tax Assessment Committee, Skatterdet, and the response will be provided
within three months. However, if upon the request for a binding statement by the
taxpaying companies it is found that insuffcient documentation has been provided to
the DTA in order to provide a response or if the request is complicated, the DTA may
extend its response time. A binding statement provided by the DTA is only binding for a
maximum of fve years.
As part of the Danish transfer pricing guidelines, it states that APAs concluded by
Danish companies with foreign tax administrations must be disclosed towards the DTA
as an important part of the transfer pricing documentation.
The Danish Parliament has passed rules on thin capitalisation in Denmark. The thin
capitalisation rules apply to the income year 1999 and onwards.
Thin capitalisation rules exist when a Danish company or a Danish permanent
establishment has debt (controlled debt) to foreign companies or individuals who:
Directly or indirectly own more than 50% of the share capital or 50% of the votes in
the Danish company; and
The debt to equity ratio of the Danish company exceeds the ratio 4:1.
If these conditions are met, the interest on controlled debt, which exceeds the debt
equity ratio of 4:1, is disallowed. The interest will not be recharacterised as a dividend
and will still be treated as an interest with respect to withholding tax, etc.
If the Danish taxpayer can prove that the debt is at arms length, there will be no
limitation on the right of deduction.
The term controlled debt includes both debt directly provided by a related foreign
company and debt where a related party has provided a guarantee to the third party in
order to obtain the loan.
There are further amendments to the thin capitalisation rules that were effective from
April 2004, and the principle amendments are as follows:
The thin capitalisation rules also will apply to Danish shareholders;
The thin capitalisation rules will apply only if the controlled debt exceeds
DKK10million;
The limitation of interest deductibility will apply only to the part of the controlled
debt that should be converted into equity in order to meet the 4:1 debt/equity ratio
(which remains the same);
Denmark
The consolidation rule now only applies to Danish companies that are still
considered part of the same group when the foreign shareholders or an ultimate
Danish parent company of the group is excluded; and
A Danish company/group of an EU or EEA parent company that has been taxed in
accordance with the existing rules between 1999 and 1 January 2004, may have its
tax return(s) reopened upon application.
The 4:1 ratio is still calculated, based on the fair market value of the companys assets.
Furthermore, the thin capitalisation rules will still not apply if the loan is on arms-
length terms.
Additional amendments apply form June 2007, which include, but are not limited to,
the following change of regulations:
The corporate tax rate
The corporate tax rate in Denmark is 25%, which has been applicable from fscal
year2007.
Limitation on net fnancial expenses
Interest expenses are limited in the following way and in the following priority:
The current thin capitalisation rules will still apply. The new limit of DKK20 million
(see below) will not apply to this current rule;
As of 1 July 2007, it is only possible to deduct net fnancial expenses in a Danish
jointly taxed group equal to 6.5% (5% for 2010) of the tax value of qualifying assets
at year-end. However, it is possible to deduct net fnancial expenses of DKK20
million; and
In addition, as of 1 July 2007, the taxable income before interest deduction may
not be reduced by more than 80% as a result of net fnancial expenses. Any unused
allowed net fnancial expenses may be carried forward. The DKK20 million
limitation also applies to this rule (i.e. it is always possible to deduct DKK20 million
in a year).
2513. Recent developments in Danish law
In April 2008, the Danish Parliament was presented with bill L181, which includes
a proposal to introduce unlimited tax liability for certain branches and transparent
entities (i.e. reverse hybrids).
The proposal included, but was not limited to, the following change of regulations,
which have been enacted.
The entities
The Danish government aims to include certain foreign-owned Danish transparent
entities under Danish taxation, as if these transparent entities were companies. A
transparent entity will be considered Danish if it:
Is registered in Denmark;
Has its place of residency in Denmark according to the articles of association or
similar; and
Has its effective place of management in Denmark.
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Transparent entities often will take the form of a registered branch, limited partnership
(K/S or P/S) or interessentskab (I/S), often broadly referred to as partnerships.
However, the list is not exhaustive, and the defnition can comprise any entity
regardless of name, as long as it is a legal entity.
There are two main conditions for transparent entities to be comprised by the proposed
rules. The entity must be owned more than 50% (i.e. ownership share or votes) by one
or more foreign non-transparent entities in countries:
Where the Danish entity is treated as a non-transparent entity for tax purposes; and
That do not have an agreement to exchange information with the Danish
taxauthorities.
The timing
The rules are in effect for income years starting on or later than 15 April 2008 (i.e. for
entities with the calendar year as fnancial year) and applies from 2009. However, if an
election to treat a transparent entity as non-transparent is made after 15 April 2008,
the rules will apply from the date it is effective in the participants jurisdiction (or from
15 April 2008, if with retroactive effect to a date before that).
The applications
The main aim of the rules is to avoid double non-taxation of certain aggressive US/
Danish IP ownership structures, but it is likely to have a much broader impact. All
existing branches and partnership structures with majority owners as described above
will be comprised, regardless of the reason for their existence. This likely will include
some corporate structures as well as some private equity structures.
The tax and customs authorities dealing with transfer pricing are part of the same unit
(SKAT) and, therefore, information is exchanged between them. In fact, it is common
for a group of offcials to audit a company at the same time, considering all aspects of
taxation (i.e. income tax, value added tax, customs duty, etc.).
2515. OECD issues
Denmark is an OECD member and has a representative on the Transfer Pricing Task
Force. Denmark is considered an OECD-compliant country and generally applies the
OECD Guidelines.
Dominican Republic
26.
International Transfer Pricing 2011 355 Dominican Republic
2601. Introduction
With the enactment of Fiscal Rectifcation Law No. 495-06 (Tax Reform) of 28
December 2006, the Dominican Republic became the frst country in the Caribbean to
introduce the transfer pricing concept through the modifcations made to Article 281 of
the Dominican Tax Code.
The Tax Reform Law establishes that transactions between related parties should be
made at arms length or market value, meaning that the prices paid between related
parties should be similar to those that should have been paid by independent third
parties. The law stipulates that if this criterion is not met, the Tax Administration
may challenge the values involved in the transactions. Furthermore, if the accounting
methods do not allow the assessment of the actual results of a local related party, then
the taxing authority may impute a result based on the ratio of gross income in the local
subsidiary relative to the total income generated by the headquarter company and its
total assets.
The new transfer rules are based on the internationally accepted arms-length
standard. This legislation does not specify any methods that make reference to the
Organisation for Economic Co-operation and Development (OECD) standards.
The following related party transactions are expressly subject to this law:
Inter-company payments made or received on goods and services;
Allocation of corporate expenses which must be deemed necessary to maintain and
preserve the taxable income of the subsidiary; and
Financial or credit operations.
The Tax Administration will be able to assess:
Prices that the branch or permanent establishment collects from its parent
company or another branch or related company when these prices do not refect
the amounts that independent entities collect for similar operations;
Prices paid or owed for goods or services rendered by the parent company, its
agencies or related companies when these prices do not refect normal market
prices between unrelated parties; and
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Dominican Republic 356 www.pwc.com/internationaltp
Corporate expenses distributed by the parent company to the branch or
establishment in the country when these expenses do not correspond with the
amount or price that independent entities collect for similar services. These
expenses will have to be necessary for maintaining and conservation of the income
of the permanent establishment in the country.
2603. Legal cases
No transfer pricing court cases have been introduced.
The burden of proof lies with the taxpayer to demonstrate that the transfer policy
complies with the general rules and the transactions have been conducted in
accordance with the arms-length standards.
The Dominican legislation does not specify any methods for transfer pricing audits.
There are no indications that certain types or particular industries are at higher risk
than others. All multinationals are in risk or assertion.
2607. Advanced pricing agreements (APA)
The Tax Administration enters into APAs with taxpayers in the all-inclusive hotel
industry, which are represented by the National Hotel and Restaurants Association.
The APAs incorporate prices based on a standard parameter by zones, cost analysis and
other variables that impact the tourism industry. These prices apply for 18 months,
with subsequent APAs being in force for up to 36 months. Such agreements are subject
to renewal. In addition, the Tax Administration may challenge the prices included in
the APA and, consequently, impose penalties stipulated in the Tax Code on taxpayers
who do not meet the terms and requirements of the agreed APA. APAs may also be
obtained in other industries with foreign involvement, such as the pharmaceutical,
power and insurance industries.
2608. OECD rules
The Dominican Republic is not a member of the OECD; nonetheless, the Dominican
Republic does generally follow the OECD Guidelines and models. Transfer pricing
legislation in the Dominican Republic does not make allusion to the Organisation for
Economic Co-operation and Development (OECD) standards.
Ecuador
27.
International Transfer Pricing 2011 357 Ecuador
2701. Introduction
Ecuadorian transfer pricing rules apply to taxpayers undertaking cross-border
operations from fscal year 2005 onwards. The regulations expressly recognise the
guidelines established by the OECD as technical reference in transfer pricing matters.
Ecuadorian taxpayers should be able to demonstrate that their transactions with
foreign-related parties are conducted in accordance with the arms-length standard.
Transfer pricing rules are applicable to all types of transactions (covering, among
others, transfers of tangible and intangible property, services, fnancial transactions,
reimbursement of expenses and licensing of intangible property). Transfer pricing rules
apply to cross-border transactions with foreign-related parties in the followingmanner:
Taxpayers with cross-border transactions with foreign-related parties for
cumulative amounts between USD1 million and USD3 million must fle a transfer
pricing annex within two months after the fling date of the tax return when the
sum of the transactions is more than 50% of the total taxable income of a company;
Taxpayers with cross-border operations with foreign-related parties for cumulative
amounts between USD3 million and USD5 million during any given fscal year must
fle a transfer pricing annex within two months after the fling of the income tax
return (which normally occurs in April of the following year); and
Taxpayers with cross-border operations with foreign-related parties for cumulative
amounts greater than USD5 million must fle a comprehensive transfer pricing
report as well as the transfer pricing annex within two months after the fling date
of the tax return.
Any adjustments arising from the application of transfer pricing regulations must be
included in the tax return and affect taxable income.
Related parties
Related parties are defned as individuals or entities in which one directly or indirectly
participates in the direction, control or capital of the other, or in which a third party,
individual or entity participates in the direction, control or capital of the others.
In order to establish any relationship among entities, the tax administration will
consider, in general terms, the participation in the companies shares or capital (more
than 25%), the holders of the capital, the entitys administration, the distribution of
dividends, the proportion of transactions carried out between entities (more than 50%
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of total sales, or purchases, among others) and the pricing mechanisms used in such
operations. Specifcally, the regulations list the following situations as related parties:
Head offces and their subsidiaries, affliates and permanent establishments;
Subsidiaries, affliates and permanent establishments among themselves;
The parties that share the same individual or entity directly or indirectly in the
direction, administration, control or capital of such parties;
The parties that maintain common directive bodies with a majority of the
samemembers;
The parties with the same group of shareholders participating directly or indirectly
in the direction, administration, control or capital of such parties;
The members of the directive bodies of the entity with respect to the entity, as long
as the relationships between them are different to those inherent to their positions;
The administrator and statutory auditors of the entity with respect to the entity,
as long as the relationships among them are different to those inherent to
theirpositions;
The entity with respect to the spouses and relatives (fourth degree of consanguinity
and second degree of affnity) of the directing shareholders, administrators and
statutory auditors; and
The entity or individual with respect to the trusts in which it has rights.
The Ecuadorian law also deems transactions as being carried out by related parties
when such transactions are not carried out at arms length or when they take place
with individuals or entities located in tax-haven countries or jurisdictions.
Comparability
Operations are deemed comparable if no differences exist between their relevant
economic characteristics that signifcantly affect the price or value of the goods and
services or the arms-length margin; or, in instances where these differences exist, they
can be eliminated through reasonable technical adjustments.
In order to verify whether the operations are comparable or if there are signifcant
differences between them, the following factors should be considered when assessing
the comparability of a transaction:
The specifc characteristics of the goods or services;
The functions that each taxpayer performs, including the assets used and the
risksundertaken;
The terms and conditions (contractual or not) that exist between related and
nonrelated parties;
The economic circumstances of different markets, such as geographical location,
market size, wholesale or retail, level of competition, among others; and
Business strategies, including those related to market penetration, permanence
andexpansion.
Methods
According to transfer pricing regulations, the following methods should be used when
assessing the arms-length principle in transactions with related parties:
Resale price method (RPM);
Cost-plus (CP) method;
International Transfer Pricing 2011 Ecuador 359
Ecuador
Proft split method (PSM);
Residual proft split method (RPSM); and
Transactional net margin method (TNMM).
Ecuadors transfer pricing regulations contain a best method rule. They also indicate
that the methods must be applied beginning from the CUP method through the TNMM
method, along with an explanation of why each method has been discarded. Transfer
pricing regulations state that the application of the methods should be interpreted
based on the OECD Guidelines, when they are not contrary to local legislation.
Transfer pricing regulations include the use of the interquartile range and the
adjustment to the median if the taxpayers result falls outside the range.
Transfer pricing annex
As previously stated, taxpayers undertaking cross-border operations with foreign-
related parties under certain amounts during the fscal year must present a transfer
pricing annex. The annex must include:
Identifcation of the taxpayer, including taxpayer identifcation number and
fscalyear;
Identifcation of foreign-related parties, including name, address, fscal residence,
taxpayer identifcation number in the country of fscal residence;
Operations with foreign-related parties, including type of operation, amount of
operation, and method used to determine arms-length compliance; and
Transfer pricing adjustment if applicable.
Transfer pricing report
The transfer pricing report should include the following information:
The activities and functions performed by the taxpayer;
The risks assumed and the assets used by the taxpayer to carry out such activities
and functions;
An explanation of the elements, documentation, circumstances and facts valued for
the transfer pricing analysis or study;
Details and amounts of the performed transactions, subject to analysis;
Details of the related entities abroad which the company performed the
transactions subject to analysis;
Method used to support the transfer pricing, stating the reasons and fundamentals
which led to considering it as the best method for the transaction under test;
The identifcation of every selected comparable to justify transfer pricing;
The identifcation of the information sources used to obtain the comparable;
Listing of selected comparables that were discharged, stating the reasons for
suchconsideration;
Listing quantifcation and methodology used to practice adjustments necessary on
selected comparable;
Median and the interquartile range;
Proft and loss statement of the comparable entities corresponding to the
commercial years considered for the comparability analysis, indicating the source
of information;
Description of the activities and characteristics of the business of the comparable
companies; and
Conclusions.
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The Servicio de Rentas Internas (SRI) enacted resolutions establishing the contents
of the transfer pricing annex and the integral transfer pricing report, as described
previously.
2704. Legal cases
Transfer pricing rules were introduced as part of the Income Tax Law in January 2008.
Currently, there are transfer pricing cases at the tax court level.
In practice, the burden of proof lies with the taxpayer for fling the transfer pricing
annex and the transfer pricing report.
There are no specifc tax audit procedures established for transfer pricing purposes.
Transfer pricing obligations are audited as part of regular tax audits conducted by
theSRI.
Tax audit-related inspections are carried out frst as desk reviews based on detailed
information provided by the taxpayers and, subsequently, at the taxpayers offce.
Taxpayers must make available all basic accounting records, auxiliary records as well
as all sources of information supporting the fnancial statements, the tax returns and
the transfer pricing annex and report.
Once the tax audit has been completed, inspectors prepare an assessment that
either confrms the declared taxable income and the tax paid or requests payment of
additional taxes arising from the objections resulting from the audit. Among these
objections, the administration could challenge the adequacy of the transfer pricing
study and establish different transfer pricing adjustments for income-tax purposes.
Taxpayers have the right to fle objections with the SRI against additional tax
assessments established because of tax audits within 20 days of receipt of the
notifcation of assessment. The SRI must issue its resolution within 120 days of the
appeal. The lack of response of the SRI within 120 days is considered a tacit acceptance
of the claim presented by the taxpayer.
If the appeal to the SRI is unsuccessful, the taxpayer can appeal before the Fiscal Court,
which is organised into three chambers of three judges each. Each chamber processes
claims and issues judgments independently from the others. In the event that taxpayers
do not agree with the judgment made by a particular chamber of the court, they have
the right to appeal before the entire tribunal (i.e. all three chambers). Only legal issues
are discussed before the full court.
International Transfer Pricing 2011 Ecuador 361
Ecuador
Failure to fle the transfer pricing annex or the comprehensive transfer pricing report
on the established dates can result in a fne up to USD15,000. The same fne may apply
to cases where the information presented in the annex and the report is incorrect or
differs from the information provided in the income-tax return.
There is a unit within the SRI that deals specifcally with transfer pricing issues.
Comparable information is required in order to determine arms-length prices and
should be included in the taxpayers transfer pricing documentation. Ecuadorian
companies are required to make their annual accounts publicly available by fling
a copy with the local authority (e.g. the superintendence of companies). However,
these accounts do not necessarily provide enough or suffcient information on
potentially comparable transactions or operations since they do not contain much
detailed or segmented fnancial information. Therefore, reliance is often placed on
foreign comparables. This practice would be acceptable under Ecuadorian transfer
pricingregulations.
The domestic legislation is supplemented by the provisions of the double taxation
treaties that Ecuador has signed with several countries (Brazil, Belgium, Chile, France,
Germany, Italy, Romania, Spain, Canada, Mexico, Switzerland and the nations of the
Andean Community: Colombia, Peru and Bolivia). These agreements generally include
provisions on mutual agreement procedures, related parties and business profts.
Ecuadorian legislation establishes the possibility of advance pricing agreements(APA).
Law
According to changes in tax legislation in force since 1 January 2010, taxpayers are
excluded from applying transfer pricing rules if they comply with the following:
Income tax due is higher than 3% of total sales;
There are no transactions with tax-haven countries; and
There is no contract for the exploitation of natural resources.
Practice
It is expected that tax authorities will become more skilled and aggressive in handling
transfer pricing issues. Transfer pricing knowledge of tax inspectors is expected
to increase signifcantly, as training improves and they gain experience in transfer
pricingaudits.
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Tax authorities and customs authorities may exchange information. Experience
suggests, however, that the authorities do not deal very closely with each other where
transfer prices are concerned.
2715. OECD issues
Ecuador is not part of the OECD, but according to transfer pricing rules the OECDs
transfer pricing guidelines for multinational enterprises and tax administrations are
used as technical references for transfer pricing purposes.
Transfer pricing regulations do not establish specifc procedures for joint investigations.
As of 1 January 2008, thin capitalisation provisions must be considered by taxpayers.
In effect, if the amount of a foreign loan exceeds three times the amount of the paid
capital, the interest expense will not be considered as a deductible expense for income-
tax purposes.
In instances where the amount of a management charge has been calculated on an
arms-length basis, the management fee would normally be tax-deductible.
Egypt
28.
International Transfer Pricing 2011 363 Egypt
2801. Introduction
Egypt was one of the frst countries in the Middle East and North Africa to introduce
specifc transfer pricing rules in its tax code. Transfer pricing laws were enacted in
2005 through Egyptian tax law No. 91 and related Executive Regulations (the TP law).
The TP law introduced many fundamental transfer pricing concepts, including the
arms-length principle, defnition of related parties and transfer pricing methods. The
Egyptian Tax Authority (ETA) has since developed draft transfer pricing guidelines (the
Guidelines) that are likely to be released in 2010. The Guidelines, which are largely
consistent with OECD Guidelines, were developed to provide Egyptian taxpayers
with detailed guidance on how to prepare documentation to support the arms-length
nature of their transactions. The ETA is in the process of hiring and training a team of
specialty auditors to undertake transfer pricing investigations. The ETA, together with
the Ministry of Finance, views transfer pricing as a key legislative trench to raising
revenues in 2010 and beyond.
Transfer pricing legislation
Transfer pricing in Egypt is governed by Income Tax Law, Article (30) and its Executive
Regulations, Articles (39), (40). The TP law defnes the arms-length principle, related
parties and the transfer pricing methods together with the priority in which they
can be applied. The TP law is applicable to international and domestic transactions
between related parties. The scope of these rules is applied to transactions carried
out with parties in low- or nil-tax jurisdictions or regimes (international or domestic).
Domestic transactions with Egyptian free zones or local related parties with incentive
to shift profts among them also fall under this category.
Related parties
A related party is defned as any person who has a relationship with a taxpayer that
may lead to an effect on the taxpayers taxable proft. Based on the Egyptian tax law,
related parties include:
A husband, wife, ancestors and descendents (family members);
Capital associations and a person that holds at least 50% of the value of shares or
voting rights, whether directly or indirectly;
Partnerships, the joint partners and silent partners of those partnerships; and
Any two or more companies where a third party holds 50% or more of the value of
shares or of the voting rights in each company.
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Egypt 364 www.pwc.com/internationaltp
Article (39) defnes the methods of determining the neutral price (i.e. arms-length
price) which include, in order of priority:
Cost-plus (CP) method; and
Resale price (RP) method.
In case all three methods are not applicable, then any of the other methods stated by
the OECD Guidelines can be used. Other methods can be used upon prior agreement
between the taxpayer and the ETA.
Other regulations
Since 2006, the Egyptian corporate tax return has required that taxpayers disclose
related party transactions (including the nature and quantity of the transaction
together with the transfer pricing method). The 2008 and 2009 corporate tax returns
further required that taxpayers collate certain documents to support the disclosures in
the tax return. The ETA may request the following documents in the event of an audit:
Group structure, identifying the counterparties to related party transactions and
the nature of the relationship;
The nature of the entitys business activity and the goods or services it provides;
An analysis of the legal and economic factors affecting the pricing of the related
party transactions;
The steps and procedures performed in order to choose the appropriate method to
determine the arms-length price;
For each type of transaction, the reasons for the choice of transfer pricing method
and the basis for calculating the price(s);
A description of the independent parties used for establishing comparability;
Contracts and agreements with related parties; and
In the case of multinational enterprises, the parent companys transfer
pricingstudy.
Legal cases
There have been no specifc transfer pricing cases in Egyptian courts. However, the ETA
has had a tendency to challenge structures/transactions where there is inconsistency
between the legal form and the economic substance of arrangements. Where such
inconsistencies have been apparent, tax authorities have historically sought to adjust
transactions such that it tests the outcome of the transaction based on the economic
substance. This has been done many times before on an arbitrary basis.
The burden of proof lies with the taxpayer.
The income-tax law is based on a self-assessment system. The law does not determine
separate audit procedures for transfer pricing transactions. Corporate tax returns
from 2004 are only now being audited by the ETA. Accordingly, there has been a very
International Transfer Pricing 2011 Egypt 365
Egypt
limited practical application of transfer pricing audits under the TP law. It is therefore
anticipated that, for transfer pricing, the audits will be done as part of the corporate
tax audit with the involvement of a specialised tax inspector from the ETAs newly
established transfer pricing team. It is anticipated that the ETA will provide further
advice on the Egyptian audit programme once the Guidelines are released.
2805. Penalties
ETA penalties, which are provided under the general corporate tax provisions in Article
(136), can be relatively harsh, with penalties up to 80% of the income adjustment. The
specifc penalty provisions state that if the tax payable (stated in the tax return) by the
taxpayer is less than the fnal assessed tax, then the taxpayer will be liable to a fne
based on the percentage of the unincluded tax amount:
5% of the tax payable on the unincluded amount if such amount is equivalent to
10% up to 20% of the due tax;
more than 20% up to 50% of the due tax; and
more than 50% of the due tax.
The authorities have not yet issued guidance on comparable data. We anticipate that
the guidelines will shed some light on this subject. For the time being, however, it is
anticipated that, in the absence of local comparable information, information available
in other regions (e.g. Europe, the Middle East and Africa (EMEA)) may be acceptable.
2807. Tax treaty network
Egypt has double tax treaties with approximately 50 countries. Most, if not all,
Egyptian double tax treaties have been drafted according to the OECD model
convention. With regard to application, treaty provisions are honoured by the ETA in
most cases; however, recently some limitations have been placed on their application.
Competent authority proceedings are not regularly used in Egypt.
Article 30 of the Egyptian tax law as well as Article 39 of the Executive Regulations
contain a provision stating that the head of the ETA may conclude agreements
with related parties in respect to one of the available transfer pricing methods for
determining an arms length. In theory, this provision potential enables APAs to take
place; although, to date, no formal APA application process has been established.
Egypt 366 www.pwc.com/internationaltp
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As stated, it is anticipated that there will be an amendment to the Egyptian tax law that
will introduce an obligation on taxpayers undertaking related party transactions to
prepare a transfer pricing study to be available to support the related party transactions
declared in the tax return. The ETA has also announced that the Guidelines will be
issued in three parts and will provide taxpayers with further guidance on fundamental
transfer pricing issues, including the application of the arms-length principle,
comparability and pricing methods. It is understood that the Guidelines are consistent
with the OECD Guidelines. The extent to which the Guidelines will incorporate
some or all of the proposed amendments to Chapters IIII of the OECD Guidelines
remainsunclear.
Estonia
29.
International Transfer Pricing 2011 367 Estonia
2901. Introduction
The signifcantly amended Estonian Transfer Pricing Regulation became effective on
1 January 2007. It relies strongly on the principles stated in the OECD Guidelines and
overcomes several signifcant shortcomings of the previous guidelines, consequently
stipulating solid rules for implementing the regulation in practice.
The arms-length standard for cross-border controlled transactions concluded between
an Estonian company and an associated non-resident entity was frst introduced in
1998. However, because of relatively vague tax legislation and the absence of formal
transfer pricing documentation requirements, the tax authorities have not actively
challenged the inter-company transfer pricing policies in the past.
It is expected that transfer pricing will become an increasingly important tax issue in
Estonia in the near future. However, the Estonian transfer pricing practice is currently
not very sophisticated, as both taxpayers and tax authorities are building their transfer
pricing expertise.
Application of the regulation
Estonian transfer pricing rules are stipulated in the Income Tax Act and in Regulation
no. 53 issued by the Estonian Ministry of Finance on 10 November 2006. As of 1
January 2007, Estonian taxpayers are required to be able to demonstrate that both
domestic as well as cross-border transactions with related parties were conducted at
arms length. Transfer pricing rules are applicable to all types of transactions.
Transfer pricing rules are applicable to inter-company transactions concluded between
the following parties:
An Estonian company and its related party;
An Estonian sole proprietorship and its related party;
An Estonian permanent establishment and its foreign head offce;
An Estonian permanent establishment and a party related to its foreign offce; and
An Estonian company and its foreign permanent establishment.
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Related parties
Estonian tax legislation provides a rather broad and formal defnition of related
parties. The following companies and individuals qualify as related parties:
An Estonian company and its group company;
An Estonian company and a direct shareholder that owns more than 10% of the
share capital, number of votes or rights to the profts of the company;
An Estonian company and two or more direct shareholders, which qualify as related
parties to each other and own (on a combined basis) more than 50% of the share
capital, number of votes or rights to the profts of the Estonian company;
An Estonian company and another company that has a common shareholder, which
owns more than 50% of the share capital, number of votes or rights to the profts of
both of these companies;
An Estonian company and another party that each separately own more than 25%
of the share capital, number of votes or rights to the profts of the same legal entity;
An Estonian company and another legal entity that has exactly the same members
of their respective management boards; and
An Estonian company and its employees, members of management and supervisory
board and direct relatives of these persons.
This list of the related parties cannot currently be expanded further by tax authorities
and as a result, the transfer pricing regulation cannot be applied to transactions
between formally unrelated parties, even if in practice an economic relationship
between them is obvious. However, the draft amendments to the Income Tax Act
are expected to supplement the current (formal) defnition of related parties with
an economic defnition. As a result, companies not covered by the existing formal
defnition may be regarded as related parties if they have a common economic interest
or if one company has control over another. Enforcement of the draft is expected to be
enforced as of 1 January 2011; however, the wording of the amendments is subject to
change as it has not yet been adopted by the Estonian parliament.
Transfer pricing principles
The Estonian regulation is based on the arms-length principle that requires the prices
charged between related parties be equivalent to those that would have been charged
between independent parties in the same circumstances. Should the transfer prices
applied in the inter-company transactions not follow the arms-length principle, any
hidden distribution of profts is subject to Estonian corporate income tax.
The Estonian transfer pricing regulation should generally be in line with the principles
laid down in the OECD Guidelines. However, there are some Estonia-specifc issues
(e.g. preference of local comparables) that should be considered when applying
the OECD Guidelines. Furthermore, suffcient attention should be paid to the
present Estonian corporate income-tax system, which taxes only direct and deemed
proftdistributions.
Under the present Estonian corporate income-tax system, transfer pricing adjustments
are treated as deemed dividend distributions subject to corporate income tax.
Consequently, transfer pricing adjustments do not increase the taxable income of the
taxpayer and are not treated as non-deductible for corporate income-tax purposes.
International Transfer Pricing 2011 Estonia 369
Estonia
The Estonian transfer pricing regulation provides guidelines regarding comparability
of the transactions with respect to the functional analysis and contractual terms of the
transaction as well as economic circumstances and business strategies. The Estonian
regulation also establishes guidelines for intellectual property, provision of intragroup
services and cost-contribution agreements.
The Estonian regulation introduces fve transfer pricing methods that are the same as
those in the OECD Guidelines:
Cost-plus method;
Transactional net margin method.
In addition, the taxpayer is entitled to apply its own method provided that it achieves a
more reliable result.
The Estonian regulation recognises the best method rule for selecting the applicable
transfer pricing method. As a result, each transaction or group of transactions must
be analysed separately in order to determine the most appropriate method and that
there is no priority of the methods. Furthermore, the regulation does not prescribe
any obligatory method for certain types of transactions, and the taxpayer is entitled to
apply only one method for calculating transfer price for a transaction.
Estonian corporate income-tax system
Estonia has a rather exceptional corporate income-tax regime that should be
considered while applying the transfer pricing regulation. Under the Estonian
corporate income-tax regime, all undistributed corporate profts are tax-exempt.
This exemption covers both active (e.g. trading) and passive (e.g. dividends, interest,
royalties) types of income, as well as capital gains from sale of all types of assets,
including shares, securities and immovable property. This tax regime is applicable
to Estonian companies and permanent establishments of foreign companies that are
registered in Estonia.
In Estonia, corporate profts are not taxed until the profts are distributed as dividends
or deemed proft distributions, such as transfer pricing adjustments, expenses and
payments that do not have a business purpose, fringe benefts, gifts, donations and
representation expenses. Registered permanent establishments (including branches)
are subject to corporate income tax only in respect of proft distributions, both actual
and deemed, as defned in domestic law.
Distributed profts are generally subject to 21% corporate income tax (21/79 on the net
amount of proft distribution).
The period of taxation is a calendar month. The combined corporate income tax and
payroll tax return (form TSD with appendices) must be submitted to the local tax
authorities and the tax must be paid by the tenth day of the month following a taxable
distribution or payment.
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Documentation
The Estonian transfer pricing regulation introduces documentation requirements
applicable starting from 1 January 2007. As a general rule, all Estonian group
companies and permanent establishments are obliged to prepare transfer pricing
documentation to prove the arms-length nature of the inter-company transactions.
An exemption applies to small and medium-size enterprises (SME) unless they
have conducted transactions with entities located in low-tax territories. A company
or permanent establishment is deemed to be an SME, provided that the previous
fnancial year consolidated results of an Estonian company or a permanent
establishment together with its associated enterprises or head offce are below all of
the followingcriteria:
Annual sales below EUR50 million;
Balance sheet below EUR43 million; and
The number of employees below 250.
Although the formal transfer pricing documentation requirements do not apply
to SMEs, they may still be required to prove the arms-length nature of their inter-
company transactions to the tax authorities in the course of a tax audit. There are
generally no limitations and restrictions in relation to the form or type of evidence the
taxpayer can submit to defend transfer prices.
The Estonian documentation requirements should generally follow the principles
stipulated in the EU Council Code of Conduct on Transfer Pricing Documentation for
Associated Enterprises in the EU. The master fle and country-specifc fles, including
supporting documentation, should be prepared by the taxpayer with due diligence
considering the nature and extent of the controlled transactions.
The master fle should contain a business profle of the group, a list of related parties
with business profle descriptions, details of controlled transactions, a functional
analysis, a list of intellectual property owned by the group, a description of the transfer
pricing policy and a list of any applicable cost contribution and advance pricing
agreements. Country-specifc fles should include a business profle of the taxpayer,
description of intragroup transactions, comparability analysis, and the selection of
transfer pricing method and identifed comparables.
Transfer pricing documentation should be submitted to the tax authorities within
60 days of the request. The transfer pricing documentation does not have to be in
Estonian, but the tax authorities may ask the taxpayer for a translation.
Other than the formal transfer pricing documentation and general requirement to
disclose the transactions with the related parties in the annual reports, there are
no additional reporting requirements related to transfer pricing in relation to inter-
company transactions.
Taxpayers and tax authorities are encouraged expressis verbis to apply the OECD
Guidelines for interpreting and implementing the Estonian regulation except where
they are not in agreement with the Estonian regulation.
Estonia
In addition, the tax authorities have also issued guidelines of a general nature for the
purposes of explaining the application of the regulation.
2904. Legal cases
Due to the novelty of the Estonian Transfer Pricing Regulation, there is currently no
existing case law.
As a general rule, burden of proof lies with the taxpayer, as the taxpayer is required
to prove the arms-length nature of the inter-company dealings. If the taxpayer has
submitted proper documentation, the burden of proof is shifted to the tax authorities,
who must demonstrate why the taxpayers transfer prices are not arms length and
support it with adequate documentary evidence in order to challenge the transfer
prices of the taxpayer. Once the tax authorities have proposed an alternative transfer
pricing method or comparables, the burden of proof again shifts to the taxpayer to
defend the arms-length nature of its transfer prices.
Estonian tax authorities have tax inspectors who specialise in transfer pricing. As a
general rule, tax authorities do not perform special transfer pricing audits but the
pricing of inter-company dealings is reviewed in the course of a general tax audit where
transfer pricing is audited simultaneously with other types of taxes.
The transfer pricing audit procedures must follow the general tax procedures
established for tax audits. The tax authorities may request all relevant data such as
accounting records and other supportive documentation and have interviews with the
management and employees. Information may also be requested from third parties,
including credit institutions.
The tax audit is usually fnalised with the submission of a written report of the tax
fndings to the taxpayer. The taxpayer is entitled to fle a written response accompanied
by additional documentary evidence, if necessary. Any resulting transfer pricing
adjustment is imposed by the appropriate local tax offce of the tax authorities.
Additional assessments and any penalties imposed by the tax authorities can be
appealed by the taxpayer within 30 days of receipt of the tax verdict. The appeal may
be submitted to the tax authorities, with review of the appeal occurring generally
within 30 days. If the appeal is unsuccessful, the taxpayer is entitled to submit a new
appeal to the court within 30 days of receiving the decision from the tax authorities.
As an alternative, the taxpayer may submit their appeal directly to the court; appealing
frst to the tax authorities is not obligatory.
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As a general rule, regardless of whether an appeal has been submitted, the taxpayer
is required to pay the imposed tax within 30 days of receipt of the tax verdict. Under
certain circumstances, the tax authorities or court may postpone the payment of tax
until the tax dispute is resolved. Should the appeal be successful after the tax has
been deposited by the tax authorities, overpayment of tax bears late payment interest
amounting to 0.06% per day payable to the taxpayer.
Taxpayers are liable to self-assess the arms-length nature of inter-company
transactions. Any transfer pricing adjustment must be declared and the tax remitted on
a monthly basis, as the period of taxation is a calendar month. The combined corporate
income tax and payroll tax return (form TSD with appendices) must be submitted
to the local tax authorities and the tax must be paid by the tenth day of the month
following a taxable distribution or payment.
Tax arrears bear late payment interest (0.06% per day) and 21/79 corporate income
tax will be levied on late payments interest paid. In certain circumstances transfer
pricing adjustments may also trigger double taxation. There are no special transfer
pricing penalties.
Tax returns are open for investigation generally for three years from the dates of
submission. This statute of limitation can be extended for another three years if the
authorities discover intentional non-payment of tax.
For the purposes of improving their transfer pricing expertise, transfer pricing trainings
have been held for the tax inspectors. It is also understood that the tax authorities are
entitled to use international databases for performing benchmarking studies.
Comparable information is required in order to substantiate the arms-length nature
of the inter-company dealings and should be included in the taxpayers transfer
pricingdocumentation.
Estonian companies are required to make their annual reports publicly available
by fling the copy with the local authority (Estonian Commercial Register). These
annual reports can be used as comparables. In addition, taxpayers are entitled to use
international comparables.
As a general rule, internal comparables are preferred to external comparables. In
addition, local comparables are preferred to foreign comparables (e.g. pan-European
or global). The use of secret comparables is prohibited.
Estonia
Although administrative practice is inconsistent, sensitive areas are emerging such as
loss-making companies, management services and fnancing.
There is no special regulation to provide relief from double taxation of domestic inter-
company transactions. The general procedure of refunding overpayments of tax may be
insuffcient for some cases and may trigger double taxation.
Relief from double taxation in cross-border inter-company transactions can be sought
through the tax treaties concluded by Estonia that, in most cases, include provisions
for a mutual agreement procedure. Estonia has also ratifed the Arbitration Convention
(90/436/ECC) that should provide relief from double taxation related to tax disputes
inside Europe.
Currently, there are no provisions enabling taxpayers to negotiate APAs with the
taxauthorities.
It is expected that the tax authorities will issue additional guidelines and
interpretations for the purposes of applying the transfer pricing regulation. In addition,
it is expected that an option to conclude APAs will become available within the next
few years.
In Estonia, both tax and customs authorities are within the authority of the Estonian
Tax and Customs Board. It is assumed that there is exchange of information
between these departments but there is no prescribed approach for the use of
certain information of one area in the other area (i.e. transfer pricing analysis for
customspurposes).
2916. OECD issues
Estonia is not a member of the OECD. Nevertheless, the taxpayers and Estonian Tax
and Customs Board are expressis verbis encouraged to apply OECD Guidelines for
interpreting and implementing the Estonian Regulation in situations where OECD
Guidelines do not contradict the Estonian Regulation.
In Estonia, the tax authorities have conducted joint investigations covering both
taxation and customs of a taxpayer.
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At this stage, we are not aware of any joint international transfer pricing tax audits
conducted in cooperation with foreign tax authorities.
There are no thin capitalisation rules in Estonia.
Estonia has not established any special transfer pricing regulation in relation to inter-
company management services. As a result, the taxpayers are entitled to follow the
principles introduced in the OECD Guidelines for the purposes of establishing the
arms-length nature of inter-company management fees charged.
Finland
30.
International Transfer Pricing 2011 375 Finland
3001. Introduction
The bill containing legislation on transfer pricing documentation rules has been in
effect from 1 January 2007. This has signifcantly increased the number of transfer
pricing audits in Finland. In fact, transfer pricing is one of the key areas of a tax
audit and applies to both Finnish multinationals and Finnish subsidiaries of foreign
multinationals. As the amounts of related party transactions have to be reported in the
tax return from 2009 tax year onwards, even more Finnish subsidiaries will probably
experience a Finnish transfer pricing audit during the next few years.
Transfer pricing adjustment
Article 31 of the Assessment Procedure Act (VML) prescribes the arms-length principle
for related party transactions. According to Art 31 VML, in the event a taxpayer and a
related party have agreed upon terms or defned terms that differ from the terms that
would have been agreed upon between independent parties and, as a consequence, the
taxable income of the taxpayer falls below, or the taxpayers loss increases, compared
to the amount that the taxable income would otherwise have been, the taxable
income may be increased to the amount that would have accrued in case the terms
had followed those that would have been agreed upon between independent parties.
Related party transactions are defned on the basis of direct or indirect control. The
arms-length requirement also applies to transactions between the company and its
permanent establishment.
Documentation
The documentation rules are contained in Articles 14a14c of the Assessment
Procedure Act and provide that documentation establishing the arms-length nature of
transactions between related parties should be drafted on cross-border transactions.
According to the rules, the Finnish transfer pricing documentation should include
thefollowing:
Description of the business;
Description of related party relationships;
Details of controlled transactions;
Functional analysis;
Comparability analysis including information on comparables if available; and
Description of the pricing method and its application.
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The description of the business should contain a general description of the business
of the taxpayer and the group the taxpayer belongs to. The description could include
recent history of the group, a description of the taxpayers position on the market,
and information on business environment and the taxpayer, any of which can be used
to evaluate circumstances affecting the transfer pricing. It is separately stated in the
government proposal concerning the transfer pricing legislation that it is important
to describe the business strategy and changes to the business strategy. It should also
be noted that the business description needs to be relevant to the transfer pricing of
thecompany.
The description of the related parties should include information on related parties
with whom the taxpayer has had business activities during the tax year, or whose
business activities affect directly or indirectly the pricing of the transactions between
the taxpayer and a related party. The information should include the basis for the
related party relationship and the organisational structure of the group.
Details of controlled transactions should include the following information on
intragroup transactions:
Type;
Parties;
Value in euros;
Invoicing fow;
Contractual terms; and
Relationship to other transactions with related parties.
In addition, a list of relevant agreements (including copies of the most important
agreements) should be included along with a list of cost allocation agreements,
advance pricing agreements (APAs) and advance rulings, and any rulings issued by the
tax authorities to the other party of the transaction.
The aim of the functional analysis is to analyse the transactions between related
parties by taking into account the functions, assets and risks involved. Identifying
the intangible property is extremely important. In addition, the risks of each party
should be carefully analysed. It is stated in the tax authorities guidance that a detailed
description of both parties is required, as well as a characterisation of the entities.
The comparability analysis compares the related party transactions to unrelated party
transactions. The analysis should include the factors affecting the comparability,
including the functional analysis, the nature of the transferred assets or services, the
terms and condition and economical factors affecting the parties. Information on
the search for comparables should also be included (i.e. information on the selection
criteria, arguments, factors affecting the comparability and any adjustments made).
The description of the pricing method and its application should include the reasoning
for the selection of the method, as well as a clarifcation of the method applied. The
clarifcation should include any calculations used to verify the arms-length nature and
details on any adjustments made. Assumptions made and conclusions drawn should
also be described.
International Transfer Pricing 2011 Finland 377
Finland
Transfer pricing documentation should be submitted to the tax authorities within 60
days from a request. However, a taxpayer would not be required to submit transfer
pricing documentation earlier than six months after the end of the accounting period
in question. Any additional information requests should be complied with within 90
days of the request.
Based on the above, no contemporaneous documentation during the tax year would
be required. However, it is stated in the legislative proposal that a taxpayer should
monitor its transfer prices during the tax year, as it is not possible to amend the taxable
income downward on a tax return in Finland. During the tax year it is possible to
make an adjustment to bring pricing into line with the arms-length principle; such an
adjustment would be included in the calculation of taxable income.
A relief from the documentation requirement is being applied to small and medium-
sized enterprises. These enterprises do not need to prepare transfer pricing
documentation. The defnition of small and medium-sized enterprises follows the
European Commission recommendation 2003/361/EC. Consequently, the relief will,
in principle, apply to companies belonging to a group with turnover of no more than
EUR50 million or balance sheet of no more than EUR43 million and less than 250
employees. Employees include those employed in a group or company, full- or part-
time workers, seasonal workers and owners who participate in managing the company.
The number of employees is expressed in annual working units, where a full-time
worker is one unit, and the other workers are divided in partial units.
If the requirements of an small and medium-sized enterprise are exceeded during a
year, the documentation requirements will not be imposed during that year.
According to the Finnish tax authorities, the requirements for transfer pricing
documentation can be fulflled with an EU TPD.
In terms of the language to be used in the documentation, the proposal for legislation
states that a transfer pricing documentation should be accepted in Finland, even if it
was drafted in English. A translation to Finnish or Swedish should only be required
when it is necessary for the purposes of conducting the taxation of the entity
inquestion.
Disclosure on tax return
Taxpayers are required to disclose on their annual tax return whether they have
had related party transactions during the tax year in question and whether they are
obliged to maintain transfer pricing documentation provided in 14a of the Assessment
Procedure Act. Beginning from the tax year 2009, taxpayers who have the obligation
to maintain the transfer pricing documentation are also required to fle an additional
tax return form (Form 78) describing the intragroup cross-border transactions
and their volumes. However, Form 78 is not intended for explanations of transfer
pricingmethodology.
On 19 October 2007, the tax authorities published guidelines dealing specifcally with
documentation. The OECD Guidelines on transfer pricing, while not legally binding
in Finland, are important in practice. Decisions of the Finnish courts, although they
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do not specifcally refer to the OECD Guidelines, are compatible with them and
furthermore, Finnish legal commentary also follows the principles in the Guidelines.
Non-deductibility of economic support
It should also be noted that economic support given by a Finnish parent company to a
loss-making foreign subsidiary has previously been deductible for tax purposes under
certain conditions. An amendment to the business income tax act has abolished this
opportunity. The amendment is applied to accounting periods ending on or after 19
May 2004.
According to the amended rules, any costs incurred in improving the economic status
of the related party company without counter-performance are non-deductible for tax
purposes. According to the provision in the tax law, support given to a company is not
deductible for tax purposes if the company giving the support or other companies in
the same group or the above-mentioned companies together own at least 10% of the
share capital of the company receiving the support.
As only support without counterperformance from the other party is non-deductible,
our view is that, for example, market penetration support that fulfls the arms-length
criteria should be deductible for tax purposes. However, even though some tax
authorities share our view there are no published court rulings on the issue.
3004. Legal cases
There have been several cases brought to court, which establish some principles for
dealing with transfer pricing and illustrate how the arms-length rule can be applied in
practice. Some of the rulings of the Finnish Supreme Administrative Court are set out
below. There has not yet been any published legal case dealing with transfer pricing
documentation.
Case 1990/483
A Finnish company paid penalty interest to its Swedish parent company in respect of
payments made after the due date. The parent company had not paid penalty interest
on similar late payments to the Finnish subsidiary. In these particular circumstances,
the penalty interest was held to be a hidden distribution of proft as defned in Section
73 of the Assessment Act.
Case 1986/3441
A Finnish company that manufactured and marketed lures sold 90% of its products by
exporting the majority to North America. In 1981 it established an Irish subsidiary. Two
models in the product range were exported incomplete to Ireland, where they were
fnished and sold to the North American market. The Irish company benefted from
favourable tax rates in the frst ten years of its activities.
In the next tax year, the parent company sold blanks to Ireland for FMK916,488 and,
after production costs of FMK724,856, made a proft of FMK191,632 or a gross proft
margin of 20.9%. The Irish company fnished these blanks and sold them in the North
American market for FMK4.3 million and, with associated costs of FMK1.9 million, the
Irish company made a proft of FMK2.4 million or a gross proft margin of 55.8%.
The court held that the transfer price was different from what would have been
agreed between two parties acting on an arms-length basis. The taxable proft of the
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Finnish parent was increased by FMK291,605 to take into account the hidden proft
distribution to the subsidiary.
Case 1993/3009
A Finnish company, whose main activities were photographic development and
wholesaling of photographic products, entered into a marketing services agreement
with its US-resident parent company under which it received technical and marketing
assistance in return for an annual fee. The fee was based on an apportionment of the
parent companys marketing budget, split between the US and Finnish companies on
the basis of their respective turnover. The agreement contained a clause limiting the
maximum payment by the Finnish company to 1.5% of turnover.
In three consecutive years, the Finnish company paid marketing service charges
equivalent to 0.59%, 0.44% and 0.33% of turnover. In return, it had received from the
US parent access to a computerised quality control system, advice on the recovery of
silver, various services for eliminating equipment defects and functional problems, and
training planning services.
Based on the documentation presented, the Supreme Court found that it was necessary
to have regard to the price that would have been paid to receive all of the services
provided, if they could be obtained, and that it had not been proven that the agreement
was on terms different from those that would have been agreed between independent
parties. Consequently, the court overturned the additional assessments that were
submitted by the tax authorities.
Case 1994/1847
A global group operated in 15 European countries in the business of manufacturing
electrical fttings and special tools for computer-controlled automated systems. Its
Finnish subsidiary imported wholesale products and distributed them in the local
market. Under a licensing agreement, the company paid a royalty based on turnover to
the US resident parent company. The tax authorities took the view that the activities
of distributor and wholesaler did not justify paying a royalty. The company argued
that the transfer price charged for goods did not take into account the research
and development (R&D) costs that the parent incurred and therefore a royalty was
justifed. The company produced evidence that the lowest price paid by an unrelated
dealer for the same products was signifcantly higher than the intragroup price
plusroyalty.
The court considered all of the services, rights and other benefts enjoyed by the
Finnish company under the licensing agreement and the evidence provided by the
company. It concluded that the authorities had not proved that the amount paid by
way of royalties based on the principle of cost distribution between group companies
was higher than it would have been between unrelated parties, or that the licence
agreement contained terms that were not at arms length. The additional assessments
were rejected.
Case 1999/4219
A Finnish parent company had granted its Dutch subsidiary a licence to use its
trademark. Under the licensing agreement, the Dutch subsidiary paid the Finnish
parent a royalty of 2% of the net income of the group. The Finnish parent also received
dividends from the Dutch subsidiary. The Dutch subsidiary had sublicensed the
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trademark to other group companies and received a royalty of 5% of the companys
netincome.
The tax authorities took the view that the terms of the licensing agreement between
the Finnish parent company and the Dutch subsidiary were not at arms length. Their
view was that other Finnish group companies had paid a royalty of 5% to the Dutch
company in order to enable the Dutch company to pay tax-exempt dividends to the
Finnish parent company.
Since the company could not present adequate reasons for the difference between the
level of the royalties paid from the Dutch subsidiary to the Finnish parent company and
the royalties paid from the other group companies to the Dutch company, the court
held that the Finnish parent company and the Dutch subsidiary had in their licensing
agreement agreed on terms that differed from the terms used between unrelated
parties. The taxable proft of the Finnish parent was increased by FIM5 million of the
dividends paid by the Dutch subsidiary.
The burden of proof is said to reside with the party that can best provide the
required evidence. Generally, however, the burden of proof rests with the taxpayer.
Consequently, where the authorities have questioned whether transactions between
related parties have taken place at arms-length prices, the taxpayer, who in any event
is the party best able to provide the evidence required, must prove his or her case.
Transfer pricing may be just one of the topics considered in the course of an ordinary
tax audit, or the tax authorities may just perform a transfer pricing audit. As a general
rule, the authorities try to audit the largest companies at least once every fve years.
Also as a general rule, the companies are selected to be audited based on their line of
business or specifc tax risk criteria developed by the tax authorities. However, the tax
authorities do not disclose information concerning their tax risk analysis process.
As of the 2009 tax year, taxpayers are required to fle a tax return form (Form 78)
describing the intragroup cross-border transactions and their volumes. This form 78
will be used as background information for audit selections.
the tax authorities
The tax authorities may request all data, material and property that they believe is
necessary to audit the tax return or to agree on an assessment or appeal, such as books
and records, other documents, etc. Information may also be requested from third
parties, and certain entities, such as banks, investment and insurance companies, must
disclose information on request.
The audit procedure
A tax audit would usually include a visit to the companys business premises and
interviews with personnel, including examination of correspondence on issues arising
during the investigation.
Finland
While the taxpayer has a right to be heard in the audit process, this does not amount
to actual negotiation. The tax investigators make a decision as to the amount of the
assessment, based upon the facts they have gathered from the taxpayer and other
sources. The tax investigators would normally present a preliminary report, against
which the taxpayer may give a written response, after which the report is fnalised.
The fnal report, against which the taxpayer may also give a written response, may
include a proposal for an adjustment. An adjustment is imposed by the local tax offce
as appropriate.
3007. Assessments and the appeals procedure
An appeal may be lodged against any adjustment in the same way as against an
ordinary assessment. A taxpayer has the right of appeal to the Assessment Adjustment
Board in the frst instance. The appeal must be made no later than the end of the ffth
year following the year of assessment, but in every case, however, within 60 days of
receiving notifcation of the assessment. An appeal against a decision of the Assessment
Adjustment Board may be made to the administrative court and must be made within
similar time limits. Appeals against the decision of the administrative court must be
made to the Supreme Administrative Court within 60 days of the decision and only if
the court grants permission to do so. Leave to appeal to the Supreme Administrative
Court would be granted on the basis of the following criteria:
The appeal has an important bearing on similar cases or would secure uniformity of
legal practice;
An error in procedure or other error has taken place in the case, which by virtue of
law requires the decision to be reversed; and
There are other weighty grounds for granting permission to appeal.
A failure to comply with the documentation requirements could result in a tax penalty
being applied. In case the required documentation or additional information is not
submitted in a timely manner, or if the information submitted is essentially incomplete
or incorrect, a tax penalty of a maximum EUR25,000 could be imposed.
Penalties may be charged where an additional assessment is made. They are charged
either by way of administrative fnes or by imposition by the criminal courts.
Administrative fnes are levied in cases of deliberate or negligent returns and for failure
to fle returns on time. The administrative fnes may amount up to 40% of the increase
of the taxable income, usually being between 5% and 10%. Penalty interest is charged
at the market rate on any unpaid tax. Penalties, tax increases and penal interest on
income tax paid in Finland are not tax-deductible.
No comprehensive Finnish databases containing third-party comparable information
are available. However, the tax authorities have subscribed to a commercial European
database (AMADEUS), which is used for the purposes of obtaining comparable third-
party data. This data is regularly used as a basis for suggested assessments.
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According to the transfer pricing legislation, a comparability analysis should include
the factors affecting the comparability; for example, the functional analysis, the
nature of the transferred assets or services, the terms and conditions and economical
factors affecting the parties. Finnish transfer pricing documentation need not
include a benchmark study for external comparables. In practice, this means that no
documentation penalties are levied, even though the transfer pricing documentation
does not include a benchmark study. However, unless the company provides
comparables to support its transfer pricing, the tax authorities are likely to perform a
search during their audit.
It is stated in the legislative proposal that, in accordance with the EU Code of Conduct
on European transfer pricing documentation, pan-European comparables searches
should not be disregarded offhand. However, in practice European-wide comparable
searches are regularly challenged in cases where the tax authorities have succeeded in
fnding comparable data on Finnish or Nordic companies.
There is no tendency to single out any one business sector. It is clear, however, that in
the past there has been a tendency to examine management service fees and royalties,
rather than the transfer price of goods.
For the moment, royalty payments and business restructuring, especially, seem to be
scrutinised by the Finnish tax auditors.
Finland has created a reservation to the OECD Guidelines concerning the use of the
competent authority process. This does not mean that the process will not be used at
all, but rather that it will not automatically be used. In fact, Finland has concluded
several tax treaties that include competent authority clauses.
In practice, competent authority cases have been rare. The most common source
of complaint is the question of whether or not a permanent establishment exists in
Finland; there have been only a few issues concerning transfer pricing. It is diffcult
to estimate the probability of obtaining relief in transfer pricing issues through the
competent authority process and there have been cases where relief has been refused.
In practice it has been diffcult to obtain relief and the process has been very slow.
Since 1 January 1997, amendments to the Assessment Procedure Act came into force,
introducing a new system of advance-notice available to the taxpayer from the tax
offce. This procedure will also cover transfer pricing matters, valuation issues and
questions relating to tax avoidance legislation.
At present, in accordance with Section 84 of the Assessment Procedure Act, advance
rulings on the tax consequences of proposed transactions can be given by the Central
Tax Board. An advance ruling is given only on application by the taxpayer and in cases
where the board fnds there is a point of importance either to the taxpayer personally
or as a precedent. The Board may indicate the tax consequences of the proposed action
Finland
but it will not issue advice as to the best way to minimise tax. In practice, the Board
does not give advance rulings on valuation issues or tax avoidance legislation, both of
which are relevant for transfer pricing.
The tax authorities are developing guidance notes on the new transfer pricing
legislation. However, the exact contents and the publication date of the notes are
currently unknown. It is likely, however, that guidance notes will include practical
guidance on the application of the new legislation aimed at the tax authorities.
It is likely that additional details on matters such as what will be considered and
appropriate documentation will be included in the notes.
There has been no general exchange of information between the income tax and
customs authorities to date, although particular information may be exchanged at the
specifc request of the other party.
3015. OECD issues
Finland as an OECD member has approved the OECD Guidelines. The tax authorities
follow the OECD Guidelines and other guidance approved by the OECD very carefully.
However, issues may arise as to how to interpret the OECD guidance.
It is possible that Finland could join with another country to undertake a transfer
pricing investigation. This has happened before, especially with other Nordic countries.
France
31.
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France
3101. Introduction
Statutory rules on transfer pricing adopt the arms-length principle for cross-border-
related party transactions. In addition, a considerable number of court cases are on
issues relevant to transfer pricing, which aids in the interpretation and application
of the legislation. In parallel with increased resources within the tax administration,
recent legislative developments emphasise the focus of the French Tax Administration
(FTA) on transfer pricing issues through new rules for documentation and advance
pricing agreement (APA) procedures. In February 2006, the French Revenue
introduced administrative guidance relating to mutual agreement procedures
(MAP). A transfer pricing guide dedicated to small and medium enterprises also was
released in November 2006. In addition, the FTA recently issued new transfer pricing
documentation requirements.
The following main statutory rules address transfer pricing:
Section 57 of the French tax code (Code Gneral des Impts);
The concept of acte anormal de gestion (an abnormal act of management)
the courts decide whether this concept applies by comparing the commercial
practices of the company under review with what they judge to be normal acts
ofmanagement;
Section L 13 B of the tax procedure code;
Section L 13 AA of the tax procedure code;
Section L 13 AB of the tax procedure code; and
Section L 188 A of the tax procedure code.
In theory, the tax authorities may choose whether to apply Section 57 or the concept
of acte anormal de gestion when questioning a transfer pricing policy. In reality, this
element of choice is likely to be removed by the limitations of each regulation. Section
L 13 B reinforces the French Revenue powers of investigation by imposing information
requirements in case of a tax audit involving transfer pricing. This law facilitates the
application by the French Revenue of Section 57. Section L 188 A extends the statute of
limitations when the French Revenue requests information from another state under
the exchange of information clause of the applicable tax treaty.
International Transfer Pricing 2011 France 385
France
Section 57
Section 57 was introduced into the French tax code on 31 May 1933, and has been
regularly updated since this date. It was most recently updated on 13 April 1996. It
may be applied only in relation to cross-border transfer pricing issues. Enforcement of
Section 57 requires the tax authorities to prove that a dependent relationship existed
between the parties involved in the transaction under review and that a transfer of
profts occurred. However, it is not necessary to prove dependency when applying
Section 57 to transfers between entities in France and related entities operating out of
tax havens.
Dependency can either be legal or de facto. Legal dependency is relatively easy for the
tax authorities to prove. It is defned as direct control by a foreign entity of the share
capital or voting rights of the French entity under review. It can also mean dependency
through indirect control, such as through common management. De facto control
results from the commercial relationship that exists between two or more enterprises.
For example, where the prices of goods sold by A are fxed by B, or where A and B use
the same trade names or produce the same product, there does not have to be any
direct common ownership. However, the fact that a large proportion of two or more
companies turnover results from transactions conducted between themselves does
not necessarily mean that there is de facto dependency. The Tax Administrative Court
of Paris ruled on 13 February 1997, that there was de facto control in the following
situation: One French company, in charge of the distribution of books published by a
Swiss corporation, was using personnel and equipment provided by a subsidiary of the
Swiss entity, had the same management as the Swiss entity, and had authority on the
choice of books to be distributed.
A transfer of profts may be inferred where, for example, transactions occur at prices
higher or lower than prevailing market prices. This includes all types of transactions,
including commodities, services, royalties, management services, or fnancing.
Acte anormal de gestion
This concept was developed by the Conseil dEtat (CE), the French supreme tax court in
charge of corporate income tax issues.
To invoke the concept of an acte anormal de gestion, it is necessary to prove that a
transfer of profts has taken place and that there was a deliberate intention to move
profts or losses from one taxpayer to another. It may be applied to both domestic and
international transfer prices as well as to corporations or branches.
Under this concept, a tax deduction may be refused for charges not incurred for the
beneft of the business or not arising from normal commercial operations.
Section L 13 AA
The Amended Finance Act for 2009 passed on 31 December 2009, introduced into
French law new requirements for transfer pricing documentation. An administrative
regulation commenting on the provisions of Section L 13 AA is expected. The new
general transfer pricing documentation requirements apply to tax years beginning on
or after 1 January 2010, to any one of the following types of entities located in France:
a. With turnover or gross assets on the balance sheet exceeding EUR400 million;
b. That hold directly or indirectly more than 50% of capital or voting rights of a legal
entity mentioned in (a);
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c. With more than 50% of their capital or voting rights held directly or indirectly by a
legal entity mentioned in (a);
d. That beneft from a ruling granting a worldwide tax consolidation regime; and
e. That are part of a French tax group in which at least one legal entity of the tax
group meets one of the requirements mentioned under (a), (b), (c) or (d).
The new law requires formal and compulsory transfer pricing documentation,
including the following information:
1. General information on the group:
General description of the activity, including changes occurred during the
audited years;
General description of the legal and operational structures forming the group
identifying the related companies engaged in the intragroup transactions;
Description of the functions performed and of the risks borne by the related
companies to the extent they have an impact in the audited company;
Identifcation of main intangible assets having a link to the audited company
(i.e. patents, trademarks, trade names, know-how, etc.); and
Broad description of the transfer pricing policy.
2. Specifc information on the audited company and on the transfer pricing policy. In
particular, the following elements should be provided:
Description of its activities, including changes that took place during the
audited period;
Information on operations carried out with related parties, including nature
and amount of fows (global fows per category of transactions; this covers
royalties in particular);
List of cost-sharing agreements, advance pricing agreements (APAs and rulings
obtained having an impact on the results of the company;
Description of the transfer pricing policy with an explanation on the selection
and application of the retained method, in compliance with the arms-length
principle and with the analysis of the functions performed, of the risks borne
and of the assets used by the audited company; and
Where relevant, an analysis of the comparability elements taken into account in
the application of the retained transfer pricing method.
The complete set of documentation should be maintained and provided immediately
upon request (which could be the frst day of a tax audit). The regulations, however,
provide for a 30-day extension if the documentation is not available. The FTA may
assess a maximum penalty of 5% on the transfer pricing adjustment in the case of
missing or incomplete documentation, with a minimum of EUR10,000 per audited
year. If there is no transfer pricing adjustment, the penalty imposed is EUR10,000 per
audited year, for missing or incomplete documentation.
Therefore, it is advisable for companies within the scope of the new regulations to
maintain contemporaneous documentation in anticipation of tax audits considering
the stricter deadlines and penalties.
Companies outside the scope would remain subject to documentation requests during
tax audits. Even if penalties are lower and deadlines not so strict, these companies
would still be at risk of arbitrary reassessments for not having a transfer pricing
documentation in place.
France
Section L 13 AB
Operations that are conducted by French companies with an associated entity situated
in a non-cooperative state or territory are subject to an additional documentation
obligation. The French company must provide the fnancial statements of the
associated entity.
Section L 13 B
Because of the new documentation requirements, section L13 B is now applied only to
small and medium businesses (SMBs). The Economic and Financial Act, published on
13 April 1996, contains procedures for transfer pricing examinations. This legislation
gives the FTA a clear right to request information on the taxpayers transfer pricing
policy in the course of a tax examination when it has evidence upon which to presume
that an indirect transfer of profts abroad has occurred, as defned by Section 57 of the
French tax code. This procedure only applies in the course of a normal examination.
Four types of information may be requested under this procedure:
1. The nature of the inter-company transactions;
2. The method for determining prices for transactions;
3. The activities of the foreign enterprises, companies, or joint ventures; and
4. The tax treatment of the inter-company transactions.
With this legislation, in the event of an insuffcient response within 60 days from
Revenue request, the FTA will grant the taxpayer an additional 30 days notice.
Thereafter, the sanctions imposed on the taxpayer will be twofold:
1. A EUR10,000 fne for each period under audit; and
2. The right for the FTA to reassess the taxpayers profts on the basis of the
information at its disposal (this procedure, however, remains controversial. The
burden of proof of the dependence and of the non-arms-length character of the
transactions rests with the FTA).
On 23 July 1998, the FTA published a regulation commenting on the provisions of
Section L 13 B. This regulation specifes in particular that resorting to Section L 13 B is
neither obligatory nor systematic it takes place only if the tax inspector has not been
provided with suffcient explanations during the tax audit.
Regarding the transfer pricing method used, any method invoked by the enterprise
can be considered acceptable, provided that it is justifed by: contracts or internal
memos describing the method; extracts of the general or analytical accounts; economic
analyses (notably on the markets), the functions fulflled, the risks assumed and the
comparables retained. The FTA still broadly interprets elements required to justify the
transfer pricing method.
Section L 188 A
Section L 188 A provides for an extension of the statute of limitations, and is open to
the authorities when they request information from foreign tax administrations before
the end of the initial statute of limitations. The new statute of limitations expires
either at the end of the year following the year when the information requested is
obtained or failing response, at the end of the ffth year following the year that is
audited. For example, if the fnancial year corresponds to the calendar year, intragroup
transactions conducted in 2001 may, in principle, be investigated within the framework
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of the authorities investigating a company, up to 31 December 2004. If a request for
information is put to a foreign tax authority in December 2005, these transactions may
remain open to reassessment for the years 2006 and 2007.
The extension of the statute of limitation applies if there is a request for information
bearing on intragroup transactions or on entities established in countries with
favourable tax regimes (French tax code Section 209 B), but also in cases of requests
for information with relevance to the foreign assets, credits, income, or activities of a
French taxpayer.
In addition to the legislation specifc to transfer pricing described above, the following
authorities are also relevant to the issue:
The terms of various tax treaties; and
Sections of the French tax code that deal with related issues such as transactions
with entities in tax havens.
Section 238 A limits the deductibility in France of commissions and other payments
paid to entities located in tax havens. As of 1 January 2006, a company is deemed to
beneft from a privileged tax regime when the difference between the foreign corporate
tax and the tax that would have been paid in France exceeds 50%. Section 209 B allows
consolidation in France of profts and losses realised through enterprises located in
low-tax jurisdictions. This anti-tax haven regulation was amended in the Finance Bill
for 2005 and was commented upon in a new administrative regulation on 16 January
2007. The scope of Section 238 A has been reduced. For instance, the French controlled
foreign company (CFC) rules may not be applied if the foreign company is located in
a member state of the European Union, and if the arrangement in question is not an
artifcial arrangement set up only to obtain a tax advantage. In this new regulation,
the FTA makes a reference to the ICI and Cadbury Schweppes ECJ cases to explain
the meaning of artifcial arrangements mentioned in the EU safeguard clause
(Administrative regulation: 4 H-1-07).
Sections of the French tax code that deal with specifc measures against states or
territories considered to be non-cooperative:
As from 1 January 2010, new Section 238 0-A defnes, from a French perspective, non-
cooperative countries or territories (NCST) as a country or territory that:
a. Is not a member of the EU;
b. Has been reviewed and monitored by the OECD Global Forum on Transparency and
Exchange of Information;
c. Has not concluded at least 12 administrative assistance agreements/treaties that
allow a complete exchange of information for tax purposes; and
d. Has not concluded such an agreement/treaty with France.
Withholding tax on passive income is increased to 50% for operations with an NCST
(general application is effective beginning 1 January 2010, and 1 March 2010,
depending on type of income):
France
The frst pure transfer pricing regulation was issued on 4 May 1973, in the form of
a note (This regulation is the main element of the FTA doctrine, and in April 1983
the tax authorities fnalised and published this commentary on their interpretation
of the transfer pricing legislation once the Section 57 was amended to cover
transactions with tax havens.);
A new regulation published on 23 February 2006, on bilateral and EU mutual
agreement procedures;
Regulations published on 7 September 1999, on bilateral advance pricing
agreements and 24 June 2005, on unilateral advance pricing agreements; and
The tax authorities commentary on legal cases involving transfer pricing, which
has been issued over the years in the form of directives (A directive is an indication
of how the tax authorities will interpret and apply legal decisions.).
3105. Legal cases
There have been several cases over the years that establish important principles for
dealing with transfer pricing issues. These are summarised below:
Parent-subsidiary relations: expenses invoiced by a foreign parent
company
SA Borsumij Whery France, CAA (Cour Administrative dAppel) Paris 11 February 1998
The administration considered that the reimbursement of such a charge represented
a transfer of profts abroad insofar as the French company has not substantiated
the reality of the services, invoiced in a vague manner for services which the French
company could perform itself. The submission of incomplete documents of a general
nature was deemed to be insuffcient. This analysis was then confrmed by the French
supreme tax court.
Parent-subsidiary relations: partnership
SA Cogedac, CE 23 November 2001
A parent company and its subsidiary incorporated a partnership in which the
subsidiary contributed its purchasing platform. Ninety percent of the benefts were
attributed to the parent company. The CE ruled that the administration is entitled to
reincorporate to the tax base of a French subsidiary the revenue allocated to the parent
company. The important contribution of the subsidiary and its absence of interest are
considered by the French Supreme Court as an abnormal act of management (acte
anormal de gestion).
Reality of services
SA Bossard Consultants, CAA Paris 17 March 1998
A subsidiary company, which paid royalties for a licence of a trademark to its parent
company, could not deduct part of the sums paid as a temporary increase of the
royalties by one point because it could not justify the reality of the public relations
and promotion activities in respect of the trademark that the temporary increase was
purported to cover.
Date to use when appraising a transfer pricing transaction
CE (Conseil dEtat) Ford France and CAA Paris 4 October 1994
The transaction must be appraised on the basis of facts known (or facts that could have
reasonably been known in the circumstances) at the time the contract was made. The
use of hindsight is not permitted.
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Comparable searches
Pharma Industrie, CAA Paris 12 July 1994; CE Galerie Vercel 28 September1998; SARL
Solodet, CE, 21 February 1990; Reynolds Tobacco, CAA Paris, 20 November 1990;
SARL les fermiers de lAisne, CE, 12 February 1993; Lindt et Sprungli CE, 4 December
2002; Novartis Groupe France SA ,CAA Paris, 25 June 2008; Man Camions et Bus, CAA
Versailles, 5 May 2009.
The Pharma Industrie case illustrates the type of comparison that the courts require
from the FTA and taxpayers. The tax authorities used fve products of similar
commercial reputation, distributed by three companies operating in the same
pharmaceutical sector with comparable turnovers, as comparable evidence in a
transfer pricing dispute.
The CE is very careful when examining comparable situations. For example, the CE
on 28 September 1998, refused to consider that situations were comparable when the
FTA was relying on isolated French-based transactions when the situation under audit
involved a long-lasting relationship between a French entity and its US subsidiary.
In Solodet, the comparison was rejected because the comparable products were sold
in Germany rather than in France. It was judged that both the prevailing market
conditions and the end use of the products in Germany were different, and that
therefore the companies identifed by the tax authorities were, in fact, comparable to
the French company under review.
In Reynolds Tobacco, the 2%3% commission received by the French entity was
deemed by the courts to be an arms-length amount, even though competitors were
receiving about 8% for providing similar services. This was decided on the basis
that the services provided by the French company were suffciently, if only slightly,
different, and this justifed the lower rate charged.
The Tax Administrative Court of Paris decision in 1990, referred to above, is in line
with the courts approach to comparables. The tax court decided not to accept the
position of the FTA as the data provided to support its approach was too vague. In
particular, the transfer of ownership did not take place in the same manner in the
various comparable situations as it did in the taxpayers situation.
In Lindt & Sprungli, the CE approved the position taken by the FTA, even though the
FTA did not support its position by reference to independent comparable data, but
rather through facts and circumstances of the case at stake.
In the Novartis Groupe France SA case, the court stated that if the FTA intends to use
prices existing between other companies or a proft split approach by considering the
global margin realised on one product at group level to reassess the French entity, it
must demonstrate that the price invoiced to the French entity by a related company
does not comply with the arms-length principle with a relevant and exhaustive
economical analysis.
In Man Camion et Bus the Court of Appeals stated that a comparability study
performed by the FTA has to be based on independent comparable acting in similar
conditions and markets. In this particular case, the FTA did not establish that foreign
European markets were similar to the French market and therefore rejected the pan-
European comparable study performed by the FTA. The fact that the French entity
France
has been loss-making for years is not, in isolation, suffcient to prove the existence of a
transfer of beneft out of France.
Concept of group interest
N 2372, CE, 24 February 1978; Sovifram, CE 3 June 1992; Socit Nord Eclair,
CAA Nancy, 6 March 1996; CAA Lyon 24 February 1998; SA Rocadis, CE 26
September2001.
The French courts consistently have supported the tax authorities in refusing to accept
the idea of the interests of the group as a whole serving as suffcient justifcation for a
particular intragroup transfer pricing policy. However, charges at cost were accepted by
the courts when the charges were invoiced by a parent entity to a subsidiary, according
to the 24 April 1978, CE decision.
The CE accepted the same approach on 26 June 1996, where the charges were
invoiced by a subsidiary to a parent company. In a 6 March 1996 decision, the Nancy
appeal court expressly accepted an invoicing of charges at cost between two sister
entities. This conclusion may derive from the fact that the FTA was challenging the
fow of invoices and suggested that the invoicing should have gone through the parent
company, so that the loss was incurred by the parent entity rather than one of the
sisterentities.
In a decision in 1992, the CE mentioned that an offset could also be a valid justifcation
for a loss made by the subsidiary when selling products acquired from its parent entity.
In a recent decision, the Lyon Appeal Court denied the group concept approach
because the tax administration was able to demonstrate that margins were signifcantly
higher on third-party transactions than on transactions entered into with the parent
company, despite both groups of transactions being of similar size. The subsidiary was
unable to provide evidence of services that had been provided by the parent company,
which may have allowed the subsidiary to justify this difference in margins.
In the Rocadis decision in 2001, the CE accepted the concept of group of interest
between the members of a distribution network. The CE did not adhere to the general
group concept approach, but the French court reckoned with the specifcity of
functioning of this specifc distribution network.
Economic or commercial beneft
Boutique 2 M, CE 27 July 1988
In a number of cases over the years, the courts have accepted taxpayers arguments
that their transfer prices did not satisfy the arms-length principle because they
resulted in some economic or commercial beneft. For example, their prices increased
marketshare.
In all instances where this argument is put forward, the deemed beneft must be
specifc and reasonable in relation to the loss or reduced revenue recognised by the
French company. Where the taxpayer has only been able to prove a potential beneft,
the transfer pricing policy has been adjusted.
In such cases the burden of proof lies with the taxpayer. Various court decisions have
established that this applies whether the tax authorities are attempting to enforce
Section 57 of the tax code or the concept of acte anormal de gestion.
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Legal protection of the intangible licensed as royalty payment
Bentone Sud, CAA Paris 15 June 1999
Despite the fact that the patents were no longer protected and there was a lack of
actual transfer of know-how, the Appeal Court of Paris accepted the deductibility of a
licence fee covering patents and know-how, in addition to a trademark and a regular
supply of equipment. The court judged that the access to the trademark and the right
to access products made by the licensor were a valid justifcation for the payment of
royalty. This decision is unique.
Decisions such as Outinord, or the above-mentioned Lindt & Sprungli court decisions,
confrm that the lack of legal protection is a critical factor for the courts in appraising
the arms-length nature of a royalty fow.
Existence of a written agreement
Electrolux, CE 21 October1991; Barassi, CAA Lyon 11 February 1995
The court was able to rule in Electrolux that the lack of a written agreement signed
prior to transactions taking place was not relevant to the transfer pricing policy under
dispute because the ongoing trade between the related companies under review
supported the transfer price as described to the tax authorities. This decision was based
on the provisions of the Code de Commerce, which recognises oral trade agreements
as valid and binding.
Once an agreement has been signed, the parties must abide by it. If circumstances
change and the terms no longer apply, it must be amended.
Despite the above court decision, a contemporaneous written agreement is advisable in
all instances.
Sale of assets
N17055, CE 21 November 1980; Berri Ponthieu, CE 21 June 1995
In Berri Ponthieu, the court decided that the sale of shares in a listed entity at book
value, which was lower than the prevailing market value, was a non-arms-length
transaction, even though the sale was a group reorganisation.
Similarly, the acquisition of shares at a price exceeding the market value is also a non-
arms-length transaction, unless there are special circumstances.
Sale of goods or services
SARL Rougier Hornitex, CE 26 June 1996; SNAT, CE 31 July 1992 Rouleau, CAA
Bordeaux 27 December 2001
The sale of products or services to related parties at a price below prevailing domestic
or international prices is not considered an arms-length transaction.
In Rougier Hornitex, the court decided that a sale at a loss of services and goods
invoiced by a subsidiary to a parent company, during the subsidiarys frst two fnancial
years, was not an acte anormal de gestion. The price of the goods and services, even
though generating operating losses, was not below the market price, and therefore was
considered an arms-length transaction.
In the Rouleau case, the court ruled that the tax authorities did not establish an acte
anormal de gestion by only referencing that the sales of goods and services were below
the market price.
France
Commission
Vansthal France, CAA 11 March 1993
A number of court decisions address situations where companies used related
intermediaries whose activities did not justify the level of commission or remuneration
paid to them. For example, the decision of the Court of Appeal in Nancy on 11 March
1993, disallowed a transfer pricing policy under which a 20%40% markup was added
to payments to a Swiss entity because in its capacity as a billing centre it bore no risk.
However, where taxpayers have been able to justify the nature and value of the services
provided, the courts have invariably accepted the commission paid. For example, a 5%
commission was found to be acceptable between A and B, where B was assisting A with
promoting its exports to Italy (CE 26 June 1985).
Royalties
Caterpillar, CE 25 October 1989
In Caterpillar, a 5% royalty was judged to be an arms-length rate for both
manufacturing and assembling operations. In this particular case, the court refused to
accept that there should be different rates for the two different activities.
Cap Gemini CE 7 November 2005
In Cap Gemini, the French tax Supreme Court stated that the FTA did not demonstrate
the indirect transfer of beneft in the absence of a comparability study. The criticised
transaction consisted of a royalty-free licence of the Cap Gemini trademark and logo.
The court considered that the fact that French subsidiaries were charged with a 4%
royalty, whereas European and American subsidiaries were charged no or lower
royalty, was not relevant. The court considered that the value of a trademark and logo
may differ depending of each situation and market. Different situations may request
different royalty rates. In its ruling, the Conseil dEtat reaffrmed that a transfer pricing
reassessment must be based on solid evidence.
Commissionaire and permanent establishment (dependent agent)
Zimmer Limited, CAA Paris 2 February 2007
In Zimmer Limited, the Administrative Court of Paris stated that a commissionaire
of a UK principal company constituted a permanent establishment of that company
in France. The French company, Zimmer SAS, distributes in France the products for
Zimmer Limited and was converted into a commissionaire (acting in its own name but
on behalf of Zimmer Ltd.) in 1995. The FTA considered that Zimmer SAS constituted
a permanent establishment of Zimmer Limited in France because the French entity
had the power to bind its UK principal in commercial transactions related to its own
activities. Zimmer Limited should, therefore, be taxed on the profts generated in
France according to Section 209 of the FTC and Article 4 of the double tax convention
between France and the UK.
The court concluded that Zimmer SAS constituted a permanent establishment of
Zimmer Limited in France and that, accordingly, the taxation in France of the profts
attributed to such permanent establishment for the years under audit was fully
justifed.
Following the conclusions of the Rapporteur public, Ms. Julie Burguburu, the
High Court (CE 31March 2010) nullifed the earlier decision of the Paris Court
and agreed with the taxpayer. The High Court reconfrmed that a company has a
permanent establishment in a state if it employs a person who has the authority
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to bind the company in a business relationship and that person is not independent
vis--vis the company. Two criteria, therefore, need to be met in order to be qualifed
as a permanent establishment. The two criteria are dependence and the authority
toengage:
The High Court does not address the issue of dependence, which was not debated
in this case as the dependency was already established; and
Concerning the authority to engage, the High Court quotes article 94 of the
Commerce Code included in article L-132-1 of the new code and notes that the
commissionaire acts in its own name and cannot conclude contracts in the name
of its principal. It underlines that the commissionaire does not legally bind its
principal because of the nature of the contract. The High Court concludes that a
commissionaire cannot constitute a permanent establishment of the principal.
However, the High Court also sets certain limits by stating that when it derives from
either the terms and conditions of the commissionaires contract or any element
identifed during the examination of the case that the principal is personally bound
by the contract agreement concluded by the commissionaire with third parties, and
the commissionaire then constitutes a permanent establishment of the principal.
Financial charges and revenue
Interest charges
N 75420 and n 77533, CE, 16 November 1988; Socit Arthur Loyd, CAA Paris 1
February 1994; Montlaur Sakakini, CAA Lyon, 25 October 1995; France Immobilier
Groupe, CAA Paris, 29 September 2009.
The interest rate charged to a subsidiary by a French entity must be comparable with
the interest rate the French entity would receive from a French bank for an investment
similar in terms and risk. The interest rate used by the courts as a reference in Montlaur
Sakakini is the Banque de Frances loan rate.
In the France Immobilier Group decision, the Court of Appeal considered that the level
of the interest rate should not be assessed by reference to the debts of the lender, but
rather based on the compensation that the lender could have obtained if it invested
under the same conditions using investment banking.
Deferral of payments
Baker International, CAA Bordeaux 6 April 1994
If interest is not charged on outstanding loans to a related company, this is considered
either an acte anormal de gestion or is subject to Section 57 of the tax code.
Absence of charges for guarantees
Soladi, CAA Nancy 30 April 1998; Carrefour, CE, 17 February 1992
It is deemed to be an abnormal act of management to provide a fnancial guarantee,
free of charge, unless direct actual beneft for the entity providing this support can be
justifed. In a decision of 17 February 1992, the French Supreme Court suggested a rate
of 0.25% for this service while the FTA was seeking 1%. The remuneration asked for
this service should be commensurate with the risk incurred, as well as with the market
value of this service, irrespective of the actual cost.
France
Debt waivers
SA Les Editions JC, CE 11 February 1994; Tlcoise, CE, 16 May 2003; Guerlain, CE, 23
April 2008
The arms-length principle also applies to debt waivers. France-based entities may
waive all or part of outstanding loans to related foreign entities to the extent that they
can justify some economic or commercial beneft as a result of this fnancial assistance.
In Tlcoise, the High Tax Court determined that a French company is allowed to
deduct a provision for bad debt in relation to its foreign branch whenever the debt is
related to its foreign business operations carried out through the branch. However, the
French company must establish that the operation has a direct commercial beneft on
the business activities carried out in France.
In the Guerlain decision, a French company waived its receivables towards two foreign
branches in Australia and Singapore of its Hong Kong subsidiary. The judge made
a reference to the consolidated results of the subsidiary (including those of the two
branches), which were positive despite the fnancial diffculties of the branches; this
was one of the arguments put forward by the judge to reject the deductibility of the
waiver of the receivables in France.
Choice of the fnancing mode of a companys operations
SA Andritz, CE 30 dcembre, 2003, n 23-3894
The terms of Article 57 of the French Tax Code (FTC) do not have the purpose, nor
the effect, of allowing the administration to assess the normal nature of the choice
made by a foreign company to fnance through a loan, rather than equity, the activity
of an owned or controlled French company, and to deduce, if the need arises, tax
consequences (cf. Article 212 of the FTC thin capitalisation).
Management charges
Allocation of charges, N 2372, CE 24 February 1978
Management charges must be shared among all of the group entities benefting
from the corresponding services. Not allocating charges among all receiving group
companies is considered to be an acte anormal de gestion. Management charges should
generally be allocated on the basis of a detailed analysis, taking into account which
of the services the company received. However, when such a breakdown would be a
cumbersome exercise unlikely to result in an accurate allocation, the charges may be
allocated on the basis of a less detailed calculation, such as turnover.
Justifying the services
Gibert-Marine, CAA Bordeaux 12 December 1995; n 26241 CE 22 June 1983; SA Mat
transport, CAA Nancy 5 July 2001
The basis of fees paid for management services will be examined in a tax audit. The
taxpayer will have to provide evidence about the nature, content, and value of the
services rendered by the supplier to justify the fees paid and to receive a tax deduction
for them. In this context, an invoice alone is not suffcient proof.
Payments for seconded executives
Oudot, CE, 30 March 1987; Ministerial commentary, 7 September 1987
In Oudot case law, it was considered that the costs of an executive seconded from a
French company to a Swiss subsidiary should be charged to the Swiss company, unless
the French entity could demonstrate a commercial or economic beneft from not
doingso.
F
As a rule, the burden of proof lies with the tax authorities, unless the transfer of profts
concerns a tax haven, in which case the burden of proof is transferred to the taxpayer.
However, there is now a legal requirement for taxpayers to provide documentation
supporting their transfer pricing policies. Though in theory the burden of proof lies
with the tax administration, in practical terms the burden of proof has always fallen on
the taxpayer where the tax authorities have deemed a proft shift to have taken place or
inappropriate transfer pricing to exist.
Generally speaking, transfer prices are audited as part of a formal tax audit on all
issues. There are no rules as to which companies come under investigation. Major
companies are audited every three to four years, unless in a loss-making situation in
which the statute bar limitation rules for corporate income tax are less crucial to the
tax administration. Nowadays, almost all sectors are audited, including French wholly
owned entities and subsidiaries of non-France-based groups.
3108 The audit procedure
Tax audits are generally carried out through the following procedure:
Written notice is sent to the taxpayer informing of the date of the auditors frst
visit and the particular taxes and years under investigation. The taxpayer may use a
professional adviser to assist during the investigation;
The auditors site visits take place at the taxpayers main premises, either the
registered offces or the main place of operations. The auditors on-site presence
can last from a few days to several months, depending on the size of the taxpayers
business and the number and complexity of issues under review. There is no
maximum limit to the time the auditor may spend on-site. The auditor may be
assisted by information systems or specialists taken from a dedicated group within
the tax administration, as well as by FTA transfer pricing experts;
Throughout the auditors visit(s), regular dialogue takes place between the
taxpayer and the tax inspector;
On-site investigations by the tax inspector cease when the inspector is satisfed that
all outstanding questions have been answered. At this point, written notice of any
underpayment is sent to the taxpayer;
The taxpayer must provide a written response to the notice within 30 days of
receipt. In the response, the taxpayer must either accept or reject the proposed
adjustment. If s/he choose to contest the reassessment, the taxpayer must set
out detailed and convincing arguments to support his/her case. At this point, the
taxpayer may ask to meet the tax inspectors superior. Such a request is generally
not denied. After this meeting the taxpayer may then also request a meeting with
the local head of the tax audit division (i.e. the appeals offcer or Interlocuteur
dpartemental);
After considering the written arguments of the taxpayer (and generally only after
the meetings described above have taken place), the tax authorities will either
reaffrm or amend their initial position in a letter. There is no time limit within
which the tax authorities must provide their response;
France
In their fnal response, the tax authorities are obliged to offer the taxpayer the
opportunity to take his/her case to the Commission Dpartmentale. This body
consists of representatives of the taxpayer and the tax authorities and is responsible
for reviewing technical, as opposed to legal, tax issues. Both parties are entitled to
submit reports to the commission, which hears both arguments before issuing a
decision. The decision, however, is not binding on the FTA; and
The tax authorities are allowed to raise an assessment to collect the tax only once
the Commission has reached its fnal decision, at the latest within three years from
the date of the assessment notice (unless an application for MAP has been fled see
below under paragraph 2415).
If the taxpayer still wants to appeal against the revised assessment, then s/he may
submit a rclamation pr-contentieuse, a claim prior to court action, to the tax
authorities. If there is no response from the tax authorities within six months of the
claim submittal, then the taxpayer may elect to take his/her case to court. Otherwise,
s/he can wait for the tax authorities to release their decision, after which the taxpayer
has two months from that date to take his/her case to court.
The frst court in which the case may be heard is the Tribunal Administratif (TA).
Arguments are submitted in writing, although either or both parties may be called
to the actual court hearing. Like the Cour Administrative dAppel (CAA), the TA may
appoint an independent expert to review the facts presented by both parties before
giving its judgment.
Either party may appeal the TAs decision; this appeal would be heard by the CAA. The
plaintiff has two months from the announcement of the TAs decision in which to make
an application to the CAA.
In very limited circumstances, either party may ask the CE to hear the case. The CE
is the supreme corporate and income-tax court, and once it has heard the case it will
either issue its own fnal ruling or instruct the CAA to review the initial ruling decision
reached by the TA.
Depending on the provisions of the particular tax treaty that applies, a taxpayer may
at any time decide to pursue a competent authority claim instead of litigation. It is also
possible to pursue both routes at the same time.
Interest at the rate of 0.40% per month, or 4.8% per year, is charged for late payment
or underpayment of corporate income tax. These amounts are not deductible for the
corporate income-tax basis.
If the good faith of the entity is challenged, which tends to be frequent when transfer
pricing issues are scrutinised, a penalty of 40% or even 80% of the tax avoided is levied
(pnalits pour manquement dlibr). This extra charge is obviously not deductible
from the corporate income-tax basis.
F
In addition, a transfer pricing adjustment may lead to VAT and taxe profesionnelle,
or local tax on business activity, as well as a deemed dividend issue, depending on
treatyprovisions.
The resources available to the tax authorities to devote to transfer pricing
investigations are increasing. Major multinational entities are audited by the Direction
des Vrifcations Nationales et Internationales (DVNI or National and International
AuditAdministration).
The DVNI is responsible for auditing all companies with a turnover in excess of
EUR152.4 million for industrial companies or in excess of EUR76.2 million for
servicecompanies.
The DVNI is composed of 30 auditing teams divided by sectors. Therefore, the level
of industry-specifc knowledge is high. General tax auditors may be assisted by tax
inspectors specialised in transfer pricing (30me Brigade). They can also use dedicated
teams in charge of computer-assisted audit or audit of tax credits for research and
development expenses.
Various databases are available that contain the fnancial accounts of most of the
companies, whether or not listed. These include InfoGreffe, Diane and Amadeus
databases.
The FTA has extensive access to Diane and Amadeus. The inspectors specialised in
transfer pricing commonly use these tools to check taxpayers benchmarks or produce
their own alternative comparable studies. The DVNI is increasingly inclined to accept
or even perform pan-European benchmarks.
Although no public announcements are made with respect to the targeting of
particular industries for transfer pricing investigations, currently companies in the
pharmaceutical, computer (hardware and software manufacturers and distributors),
and chemical business sectors are more likely to be examined. Conversion schemes
with a transfer pricing element are closely scrutinised in audit situations.
The legal cases listed above illustrate that other sectors, such as retail, may also
occasionally be investigated. In addition, it is worth noting that the DVNIs transfer
pricing and fnancial inspectors recently have been put together on the same team to
enhance effciency in transfer pricing audits involving valuation issues.
The FTA does not publish data on competent authority proceedings.
France
French tax regulations provide for offcial APA procedures. Between 1999 and 2004,
only bilateral APAs were accepted. The rectifying Finance Bill for 2004 (Article 20)
codifes the legal basis for APAs and extends their scope to unilateral APAs. The APA
procedure is now included in the tax procedures code (see Article L. 80 B 7 of the Livre
des procdures fscales). Previously, the only domestic authorisation was through a 1999
FTA regulation. In addition, an APA procedure requesting limited documentation and
simplifed monitoring is now available to small- and medium-size enterprises.
Bilateral APAs
In a regulation issued on 7 September1999, the tax administration defnes the
conditions under which it would be willing to grant a bilateral APA. This may be
initiated only with states that have signed a treaty with France containing a section
equivalent to Section 25.3 of the OECD model treaty. This regulation is a fundamental
change from prior opinion expressed by the central tax administration, where they saw
an APA procedure as a breach of the principle of equality. Under this regulation, the
application process can be initiated in France or in the other state. The application may
cover all transactions or only certain transactions, covering all or part of the companies
operations (a product, a function, a type of transaction, or a business line). Through
preliminary meetings with the FTA, the exact scope of the information (tax, fnancial,
legal, industrial, commercial, etc.) to be provided will be defned. A formal request
may then be addressed to the FTA. Within two months of this application, the same
application must be submitted to the other tax administration. An indicative list of
information to be provided is included in this regulation, but the basic idea behind this
list is to establish constant debate and exchange of information with the FTA as part of
the review of the application. Once the review is completed, a draft ruling is issued for
fnal approval by the taxpayer.
The ruling will defne the parties, the transactions, the transfer pricing method(s)
elected, the assumptions used, the revision formula, the date of application of the
ruling and its duration (three to fve years), and fnally the contents of the annual
report to be issued by the taxpayer. The ruling may not have a retroactive effect, except
within the limit of the fnancial year during which the application is made.
Unilateral APAs
Unilateral APAs, which until the rectifying Finance Bill for 2004 were not authorised in
France, may now be accepted by the French administration. However, in a regulation
issued on 24 June 2005, the FTA made it clear that it would still favour the conclusion
of bilateral APAs. Unilateral APAs could be granted in cases such as:
If the bilateral tax treaty does not provide for a MAP;
If, despite the MAP provided in the bilateral tax treaty, the foreign competent
authority refuses to conclude an APA; and
For simple issues such as management fees and allocation key issues.
Small- and medium-size (SME) enterprises: simplifed APA procedure
As the standard APA procedure can be burdensome, a simplifed APA procedure for
SMEs is available as from 28 November 2006. The simplifed procedure proposed by
the FTA includes the following:
F
Fewer transfer pricing documentation is required for the APA request. The
documentation is limited to a legal chart of the group, the list of transactions and
prices between related parties, functional analysis, description and justifcation of
the transfer pricing method, and the fnancial statements of the foreign companies
involved in the transactions;
The FTA assists in the preparation of the functional analysis and in the choice of the
appropriate transfer pricing method;
An economic analysis is also requested. During an experimental period, the FTA
may perform the benchmarking analysis at the request of the SME; and
Simplifed content of the annual compliance report requested in the follow-up years
of the APA (i.e. details of the computation of the remuneration and a statement on
the substantial changes to the activity conditions described in the APA request such
as activities, functions performed, risks borne, legal/de facto dependence, assets
used, accounting methods, etc.).
Only SMEs that meet the following two criteria are eligible for the simplifed
APAprocedure:
SMEs with (1) fewer than 250 employees, and (2) a net turnover of less than
EUR50 million or with assets that do not exceed EUR43 million; and
Twenty-fve percent or more of the capital or voting rights are not owned by one
enterprise, or jointly by several enterprises that do not meet the conditions of the
previous paragraph.
To determine whether the criteria are met, reference should be made to the fnancial
year preceding that in which the request to initiate the procedure is submitted.
3116. Mutual agreement procedure (MAP)
The rectifying Finance Bill for 2004 (Article 21) suspends the collection of taxes when,
following a notice of reassessment, a competent authority procedure is undertaken
by the taxpayer to eliminate double taxation (see Article L. 189 A of the Tax Procedures
Code, Livre des procdures fscales). Prior to this amendment, after issuing a notice of
reassessment the FTA had three years to issue a notice of collection, notwithstanding
the taxpayers undertaking of a competent authority procedure. In this situation, given
the average length of a competent authority procedure in France (three years and
seven months), the FTA had to collect the taxes before the outcome of the competent
authority procedure. After receipt of the notice of collection, the taxpayer could, and
still may, request to beneft from deferral of payment of taxes if appealing to domestic
remedies. However, under the deferral of payment procedure, the taxpayer incurs
interest for late payment from the date stated in the notice of collection.
Under the new tax collection regime, the three-year statute of limitation (relating to
issuance of the notice of collection) is suspended starting from the opening date of the
competent authority procedure. The suspension holds until the end of the third month
following the date of the notice given to the taxpayer, which states the outcome of the
competent authority procedure. Suspension of tax collection applies to competent
authority procedures pursuant to the relevant tax treaty and the European Arbitration
Convention.
The suspension of tax collection is applicable to competent authority procedures
opened as from 1 January 2005.
France
In February 2006, the French revenue issued a new regulation regarding MAP.
This detailed regulation provides guidance pertaining to the scope, conditions and
implementation of the MAP in France. It also aims at applying the recommendations
encapsulated in the code of conduct elaborated by the EU Joint Transfer Pricing Forum
with respect to the implementation on the EU Arbitration Convention.
3117. Binding PE ruling
The rectifying Finance Bill for 2004 (Article 19) extends the tax ruling procedure
to permanent establishments (PE) (Article L. 80 B 6 of the Tax Procedures Code,
Livre des procdures fscales). Under the extended procedure, foreign companies
may request a ruling from the FTA stating whether their business activity in France
constitutes a PE or a fxed place of business, according to the bilateral tax treaty
between France and the parent companys country of residence. Not only may the
ruling apply to subsidiaries, but also it can relate to agents, whether or not they are
independent (see Article 5 6 OECD Model Convention), or branches, whether or not its
only purpose is to hold and deliver the parent companys goods (see Article 5 4 OECD
Model Convention). When a request for a ruling is sent, the FTA has three months to
reply. An absence of reply within that time period will be considered an automatic
approval of the request. The French subsidiary of the foreign company will, therefore,
not be deemed a PE in France, and the group will not be liable for corporate income tax
in France, consequently avoiding double taxation.
The approval binds the FTA, which may not issue tax reassessments for periods prior
to the ruling. This new procedure is, however, limited exclusively to taxpayers acting
in good faith (contribuables de bonne foi), that is, taxpayers having provided all the
useful elements to decide whether a business constitutes a PE and has not provided
wrong or incomplete information. The tax authorities may change their decision
regarding periods after the ruling, as long as the taxpayer is informed of that change.
This procedure is applicable as from 1 January 2005 (see Decree of 8 September2005).
The tax authorities have the authority to use information gathered by the customs
authorities when challenging a transfer pricing policy.
3119. OECD issues
The French tax authorities have not published a formal interpretation of transfer
pricing guidelines issued by the OECD. Indeed, there has not yet been any commentary
on the guidelines issued in July 1995. At various times, however, such as at public
seminars, the tax authorities have indicated that they do refer to the OECD principles
during audits and settlement procedures.
An explicit reference to the OECD principles was made for the frst time in the
regulation of 23 July 1998. Reference to these principles is also made in the APA
regulations referred to above.
The courts tend to use the OECDs principles as guidelines (TA de Lyon, 25 April
1990,Fisons).
F
There is little information about joint investigations, although it is generally thought
that the tax authorities participate more in these now than in the past. In particular,
the French authorities tend to join forces with their counterparts in the US, Germany,
Belgium and the UK.
To counter thin capitalisation situations more effciently, the French 2006 Finance
Bill adopted a new system, applicable from January 2007. The scope of the old thin
capitalisation rule had been limited by two major decisions of the French Supreme
Court on December 2003 (Conseil dEtat, Andritz SA and Correal Gestion) and by a
regulation dated 12 January 2005.
The new provisions provide for the repeal of the existing thin capitalisation legislation,
and replacement by an entirely new set of rules, which will cover both the interest rate
charged and thin capitalisation. These new thin capitalisation rules apply to all types of
fnancing granted to a French entity by any French or foreign-related party.
Interest rate limitations
Under the revised Article 212 of the CGI, the tax deduction of interest paid to related
parties is limited to the higher of (1) the average annual interest rate charged by
lending institutions to companies for medium-term (two years or more) variable-
rates loans, or (2) the interest that the indebted company could have obtained from
independent banks under similar circumstances.
The arms-length criterion mentioned in (2) is a new feature for France. This provision
is likely to shift the burden of proof to the taxpayer, as the French tax authorities in
practice likely will seek to apply the average annual interest rate. Once companies
have passed this interest rate test, French indebted companies must pass a second test,
namely the debt ratio.
Debt ratio
In addition, the new thin capitalisation rules provide that a portion of interest paid to
related parties, which is deductible under the interest rate test, may be disqualifed
as a deduction if it exceeds all of the three following limitations during the same
fnancialyear:
Interest relating to fnancing of any kind granted by related parties within the limit
of 1.5 times the net equity of the borrower;
Twenty-fve percent of the adjusted net income before tax (rsultat courant avant
impt, defned as operating income increased by fnancial income), before related
party interest, amortisation and certain specifc lease payments; and
Interest income received from related parties (there is no limitation on thin
capitalisation grounds when the enterprise is in a net lending position vis--vis
related entities).
The portion of interest that exceeds the above three limits may not be deducted in the
accounting period, unless it amounts to less than EUR150,000.
France
Carry-forward of excess interests
That portion of the interest expense that is not immediately deductible by the French
enterprise in the accounting period in which it is incurred may be carried forward
without a time limit for relief in subsequent years, provided that there is excess
capacity in the subsequent years, based on the second limitation mentioned above.
However, the excess amount is reduced by 5% each year, from the second accounting
period following that in which the interest expense was incurred.
Exceptions
The new provisions provide for several exceptions.
These new rules do not apply to interest payable by banks and lending institutions, or
to certain specifc situations (e.g. interest in connection with intragroup cash pools, or
in connection with certain leasing transactions).
In addition, the thin capitalisation rules do not apply if the French indebted company
can demonstrate that the debt-to-equity ratio of the worldwide group to which it
belongs exceeds its own debt-to-equity ratio.
Also, deductibility of interest is facilitated within a French tax-consolidated group. The
new thin capitalisation rules apply to each enterprise member of the group taken on a
standalone basis.
However, any excess interest incurred by such an enterprise may not be carried
forward by that enterprise. Instead, it is appropriated at the group level. Subject
to certain limitations, the consolidating company may deduct extra disqualifed
interest. Any remaining excess interest may be carried forward for possible deduction
at the group level in future accounting periods, less the 5% rebate.
The FTA issued an administrative regulation regarding these new complex rules on
31 December 2007 (Administrative regulation: 4 H-8-07). The guidelines provide the
French tax authorities interpretation of Section 212 of the French tax code relating
to thin capitalisation rules. They clarify the legal provisions and provide practical
guidance on the computation of the three tests.
In particular, the guidelines state that Section 212 is applicable to permanent
establishment of foreign companies. It provides clarifcation on how the debt-to-equity
ratio would be applied in the case of permanent establishments where the entities do
not have a share capital, per se.
The guidelines also detail the exclusion of treasury centre and leasing agreements
from the scope of the thin capitalisation rules, and they describe the specifc conditions
under which the thin capitalisation rules would allow deduction at a tax group level
(Section 223B of the French tax code) for those interests that have failed the three tests
at the level of a subsidiary on a standalone basis.
Georgia
32.
G
Georgia
3201. Introduction
Certain transfer pricing concepts have been included in the Georgian tax legislation
since 1993 (Law of Georgia on Corporate Income Tax), although specifc provisions
related to transfer pricing are very limited. Further steps were taken by including some
general transfer pricing rules in the Georgian Tax Code of 13 June 1997.
Similar provisions were incorporated into the latest tax code, effective from 1 January
2005. In particular, Article 22, Principles of Determining the Price of Goods (Services)
for Taxation Purposes, and Article 23, Interrelated Parties, provide the basis for
transfer pricing control by the tax authorities.
Scope
The Georgian tax authorities may evaluate transfer pricing involving the following
types of transactions:
Between related parties;
Barter;
Import/export; and
Supply of goods/services free of charge.
Basis for transfer pricing adjustments
The tax authorities may apply transfer pricing regulations in the following cases:
Transactions between related parties, unless their relationship does not affect
results of the transaction; and
Transactions in which the tax authorities can prove that the price declared by the
transacting parties differs from the actual price.
Related parties
The defnition of related parties is found in Article 23 of the tax code. Parties are
recognised as related if their relationship could affect the conditions or economic
results of their activities. For example:
The parties are founders (participants, shareholders, stockholders) of the same
enterprise, and their total share value exceeds 20%;
One party partially owns (directly or indirectly) the other, where such ownership
exceeds 20%;
International Transfer Pricing 2011 Georgia 405
Georgia
One partys enterprise is under the control of the other party;
One individual is subordinate to another individual in terms of employment, or one
individual is directly or indirectly under the control of another individual;
Both parties are subsidiary enterprises or are under direct or indirect control of a
third party;
The parties jointly control (directly or indirectly) a third party; and
The individuals are relatives.
Pricing methods
The primary method described in the tax code is essentially the comparable
uncontrolled price method. However, the tax code also describes three additional
methods that may also be used and are broadly equivalent to the cost-plus, resale price
and comparable profts methods.
It should be noted that there is little specifc guidance or description in the legislation
as to how these methods should be applied.
Not applicable.
3204. Legal cases
In a recent case, the tax authorities imposed penalties on a company conducting
an export operation. The penalties were imposed because prices indicated on the
invoices were two to three times less than prices presented on various company-
related websites. Further, the tax authorities determined that the main vendor
of the companys product was a related party specifcally, a relative of the chief
fnancialoffcer.
The companys appeal on the frst stage was rejected by counsel for the Ministry of
Finance, with arguments that the products supply price signifcantly deviated from the
actual market price. A fnal determination of the outcome of the case was not available
at the time of this writing.
The burden of proof remains with the taxpayer to confrm acceptability of the prices
inplace.
Georgian tax authorities are allowed to conduct tax audit procedures only once a year,
unless there is reliable information for a more frequent audit because of tax evasion.
There are no specifc regulations related to transfer pricing tax audits provided in the
tax code.
Currently, the appeals procedures for any tax-related matters are slow and unlikely
to effect any change in the initial assessment. At this time, the court system is not a
viablealternative.
Georgia 406 www.pwc.com/internationaltp
G
There are no specifc penalty regulations for the violation of transfer pricing rules.
However, transfer pricing adjustments made by the tax authorities during a tax
audit that would increase the taxable revenue of the taxpayer may be subject to tax
underpayment administrative measures.
Specifc measures would include but would not be limited to any of the following:
Proft tax at 20% rate;
VAT at 18% rate; and
Possible excise tax depending on the nature of the goods.
Please note that current tax legislation also imposes fnes for the underreporting of
income and the late payment of interest.
Information on market prices is to be obtained from offcial sources, which may include
the database of government bodies, information submitted by taxpayers, or any other
reliable information. Under certain circumstances, the tax authorities have relied on
information from other outside sources.
Based on experience, the mostly common procedure used by the tax authorities is
to rely on information collected themselves from other similar taxpayers and/or
information published by the State Statistics Committee.
Currently, Georgian tax authorities try to obtain extensive information from other
similar markets worldwide.
Manufacturing and export.
No well-developed procedures.
Not currently an option.
Putting detailed transfer pricing regulations in place is not currently a priority for the
Parliament, and a time frame for such regulations is not known.
International Transfer Pricing 2011 Georgia 407
Georgia
The tax and customs authorities have recently been merged into one body, overseen
by the Ministry of State Revenues. It is too early to determine how much coordination
will take place between the departments; however, a new, unifed database was
introduced recently that makes import and export information easily available to the
tax authorities.
3216. OECD issues
Although OECD principles are not currently offcially recognised, the Georgian tax
authorities tend to follow the OECD Transfer Pricing Guidelines.
No such procedures are known to be taking place.
Thin capitalisation rules apply from 1 January 2010. Interest expense is disallowed on
any debt in excess of three times the equity of a company. The law does not indicate
how debt and equity are measured.
The rules will not apply to:
Financial institutions;
Entities that have gross income of less than GEL200,000; and
Entities with interest expense that is less than 20% of their taxable income before
deducting that interest expense.
The maximum rate for which interest may be deducted has been increased to 30% for
2009 and 2010. It will revert to 24% in 2011.
Although the Georgian Tax Code does not specify transfer pricing regulations with
regard to management services, such transactions may be scrutinised for elements
of transfer pricing, given they are provided or received in one or more of the
followingmanners:
By related parties;
On a free-of-charge basis; and
As part of a barter transaction.
The more signifcant issue with management services is that such services generally
have a source in Georgia under the tax code, so would be subject to 10% withholding
tax unless exemption is available under a relevant tax treaty.
Germany
33.
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Germany
3301. Introduction
The German legislation on transfer pricing establishes the principle of arms-length
pricing for related party transactions. Presently, transfer pricing issues are mostly dealt
with as part of routine tax audits, which are a regular event for almost every company.
The approach of the tax authorities to transfer pricing issues in particular to acceptable
pricing methodologies and competent authority proceedings, is undergoing continual
change in response to international developments in these areas.
The statutory rules on transfer pricing are not found within one integrated section of
the legislation but in several provisions in different statutes. The provisions include a
defnition of related parties and provide that where the assets or income of a German
taxpayer are reduced by means of non-arms-length transactions with related parties,
the income of the German taxpayer may be adjusted accordingly.
The statutory references, which have been in place for decades, incorporating the
above rule are as follows:
Section 1, Paragraph 1 of the Foreign Tax Act or Auensteuergesetz (AStG)
defnition of related parties and adoption of the arms-length standard; and
Section 8, Paragraph 3 of the Corporate Income Tax Act or Krperschaftsteuergesetz
(KStG) hidden proft distributions.
In 2003, additional transfer pricing legislation was passed by the German Parliament,
incorporating the following new statutory references:
Section 90, Paragraph 3 of the General Fiscal Code or Abgabenordnung (AO)
documentation requirements for cross-border transactions with related parties
including permanent establishments (PE);
Section 162, Paragraph 3 of the AO consequences of inadequate or missing
documentation (assumption of need for proft adjustment; income estimation by
use of least favourable point in a price range); and
Section 162, Paragraph 4 of the AO penalty of 5%10% of proft adjustment
(with certain ceilings/restrictions) in case of non-compliance with
documentationrequirements.
International Transfer Pricing 2011 Germany 409
Germany
With effect from 2008 onwards, the German legislation comprehensively amended
Section 1, Paragraph 3 of the Foreign Tax Act with respect to transfer pricing by
introducing specifc rules including the following:
Transfer pricing methods the statute puts an emphasis on the three traditional
transfer pricing methods, which should be primarily used;
Comparability and adjustments of transfer pricing ranges if no fully comparable
data exists, transfer pricingTP ranges need to be narrowed. When a taxpayer selects
a transfer price outside of the range, the adjustment will be made to the median of
the range;
Hypothetical arms-length test if no comparable arms-length prices can be
determined for an inter-company transaction, the taxpayer will have to apply
a hypothetical arms-length test. Under such test, the transfer pricing range
typically would be between the minimum price for one party in the transaction
and the maximum price for the other party. If no other value can be substantiated
by the taxpayer, the arithmetic mean of the range will be selected as the
arms-lengthprice;
Business restructurings regarding the treatment of cross-border transfers of
business functions the statute addresses cases where operative functions such
as production, distribution and/or R&D, etc., are shifted from a German entity
to a foreign country or are reduced (as in the case of transforming a fully fedged
production entity to a contract manufacturer). In these cases, an exit charge will
increase the taxable income. The exit charge will be calculated by taking into
account the future proft potential of the functions transferred. Under the new
rules, the lost proft potential of the German party transferring the functions and
the gained proft potential of the foreign party assuming the functions would form
the (price) range from which the exit charge would be determined. By considering
the proft potential of the foreign party, foreign location benefts such as lower costs
(including labour costs and tax savings) would increase the exit charge; and
Retroactive price adjustments if intangibles are subject to an inter-company
transaction and if the profts attributable to the intangibles after the transaction
develop differently than originally envisaged, it will be assumed that third parties
would have agreed on an adjustment mechanism. The authorities can then apply
such (assumed) adjustment mechanism for up to ten years after any transaction
and assess different transfer prices.
The 2008 legislation also revised Section 8a of the KStG regarding thin capitalisation
rules. These rules have been replaced by a general limitation on interest deductions.
In addition to the adoption of formal statutes by parliament, the authorities
are authorised to issue so-called ordinances (Rechtsverordnungen) on specifc
matters, which have statutory character in that they are binding for taxpayers and
tax courts. With respect to transfer pricing, an ordinance was published in 2003,
providing guidance and binding interpretation on the type, contents and scope of the
documentation required (Gewinnabgrenzungsaufzeichnungsverordnung GAufzV).
In addition, the 2008 amendment to Section 1, Paragraph 3 of the Foreign Tax Act
empowers the authorities to issue an ordinance specifying further details regarding
the new transfer pricing rules; the authorities have issued an ordinance on cross-
border transfer of functions (Funktionsverlagerungsverordnung - FVerlV), which was
approved by the German Upper House on 4 July 2008. The ordinance covers details on
(1) the terminology of the new Section 1, Paragraph 3 of the Foreign Tax Act, (2) the
Germany 410 www.pwc.com/internationaltp
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valuation to be used with respect to the so-called transfer package, and (3) retroactive
priceadjustments.
The tax authorities have no power to issue legally binding regulations on transfer
pricing matters unless formally empowered by explicit provisions of law. They are,
however, authorised to promulgate general regulations, decrees on special topics,
proclamations, etc., on any issue as considered appropriate, including transfer pricing
matters. All such promulgations are binding only on the tax authorities, and this tool is
used extensively by the authorities to achieve an equal interpretation and application
of statutory law and court decisions. While such promulgations have no legally binding
effect for the public, they indicate the position that the tax authorities will take on
the respective subject matter. Consequently, such promulgations have considerable
relevance in tax practice.
From a transfer pricing perspective, the regulations set out below are of
particularinterest.
Administration principles
On 23 February 1983, the Federal Minster of Finance published the Principles Relating
to the Examination of Income Allocation in the Case of Internationally Affliated
Enterprises (administration principles). These principles contain both the general
rules on the international income allocation where related parties are involved and an
extensive discussion on the rules of law governing income allocation. Also included
are positions on various types of inter-company transactions. The original version of
the administration principles also contained guidelines on cost-sharing arrangements,
methods of adjustment and related procedural aspects; but these sections have been
replaced by new regulations (see below).
The administration principles generally follow the 1979 OECD Guidelines. During
their years of use, the administration principles have become infuential in the
treatment of inter-company transactions in tax audits. The administration principles
have been accepted by the public as a reasonable basis for transfer pricing planning,
although ongoing disputes between taxpayers and the tax authorities remain in
certain areas. The administration principles have been under revision for some time,
to incorporate developments since 1979, and in particular to catch up with the 1995
OECDGuidelines.
Further guidelines
On 24 December 1999, the Principles Relating to the Examination of Income Allocation
in the Case of Permanent Establishments of Internationally Operating Companies
(administration principles on PEs) were published. On 30 December 1999, the revised
Principles on Cost-sharing Agreements were published. On 9 November 2001, a new
chapter, without precedent in the original administration principles, was issued on
international secondments. On 29 September 2004, the Federal Ministry of Finance
issued its Principles on the Attribution of Capital to Branches of International Banks to
replace the relevant section in the 1999 administration principles on PEs.
On 12 April 2005, the Federal Ministry of Finance published the Principles for the
Audit of the Income Allocation between Related Parties with Cross-Border Business
Relationships with Reference to the Obligation to Determine Transfer Prices and
Germany
Co-operate with the Tax Administration, Amendments to Transfer Prices, as well as
their implications in terms of competent authority and EU Arbitration Procedures
(Verwaltungsgrundstze-Verfahren or administration principlesprocedures). These
principles contain the tax authorities interpretation of questions regarding the
documentation of the facts and circumstances that relate to relevant transfer pricing
arrangements. Importantly, these principles refer to the requirements to document the
appropriateness of transfer prices. Taxpayers documentation of the appropriateness
of transfer prices must be exclusively oriented towards the arms-length principle
and is the core of the administration principles-procedures. In this respect, the
administration principles-procedures also contain requirements for database analyses
and benchmarking studies.
On 17 July 2009, the German Federal Ministry of Finance published on its home page
a draft of the Principles Relating to the Examination of Income Allocation between
Related Parties in case of the Cross-Border Transfer of Functions (draft administration
principles transfer of functions). These principles explain on some 72 pages
(including three examples) the view of the German tax authorities with respect to the
terms (1) function, (2) transfer of function, (3) transfer package, (4) proft potentials,
and (5) duplication of functions. In light of the latest (intended) amendment of the
German transfer pricing rules (see below), it is, however, uncertain when a fnal version
of the draft administration principles will be published and the extent to which it might
deviate from the current draft.
Transfer pricing issues historically have been settled by compromise or negotiation
long before they reach the courts; hence, there have been very few court cases on the
subject. Recently, there seems to have been a decline in settlement by compromise
and, if this trend continues, it is likely that more transfer pricing disputes will reach
thecourts.
There are two levels of courts, and any cases that are heard by the courts may
last several years before a fnal decision is reached by the Federal Tax Court or
Bundesfnanzhof (BFH) (i.e. the higher court). Decisions by the BFH establish a
binding precedent on the lower tax courts on a particular subject. However, while it
is questionable from a constitutional point of view, the German tax authorities do not
always accept BFH decisions as binding and may publish instructions that a certain
court case is not to be applied by the tax authorities to other cases.
Most published court cases on transfer pricing issues deal with the interpretation
of the arms-length principle and the tax consequences resulting from a violation of
this principle. In substance, the courts typically verify whether transactions between
affliated parties are based on upfront (written) agreements and result in an income
allocation comparable to that arising from transactions between third parties. The
test question commonly asked by the court to establish this is whether an orderly and
diligent manager (ordentlicher und gewissenhafter Geschftsleiter) in exercising the
required professional diligence would have provided a comparable advantage to a
thirdparty.
One of the most important transfer pricing cases decided by the BFH in the past
decades is the judgment on 17 February 1993 (I R 3/92), which was published in the
Federal Tax Gazette 1993 II p. 457. This case established an important principle that was
summarised by the court itself as follows:
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an orderly and diligent manager will, for the corporation managed by him,
introduce to the market and distribute a new product only if he can expect, based
on a prudent and pre-prepared economic forecast, a reasonable overall proft
within a foreseeable period of time with due consideration to the predictable
market development.
The decision covers a variety of aspects, including the treatment of marketing
expenses and the permissible scope of start-up losses. In many respects, the decision
is signifcant for German distribution affliates of international groups, which are
in a continual overall loss position. Such a loss-making affliate should anticipate
encountering diffculties in convincing tax auditors that losses incurred over several
years would have been accepted in dealing with true third parties.
This decision covered the market introduction of a new product by an already
established company and stated that typically a market introduction phase, where
losses are acceptable, should not be longer than three years. In contrast to this, a BFH
decision dated 15 May 2002, stated that a startup loss phase resulting from market
infuences of a newly founded company can be substantially longer on a case-by-case
basis. The typical startup phase of three years is consequently, regularly extended in
case of newly founded companies. As a consequence, the overall total period after
which an independent business manager would expect proftability could be assumed
to be (somewhat) longer than in the case of the above-mentioned BFH decision dated
17 February 1993.
An even higher impact on German transfer pricing practices and procedures results
from the BFH decision of 17 October 2001, (I R 103/00, published in the Federal Tax
Gazette 2004 II p. 171). Not only does this judgment refne principles established in
the case on 17 February 1993, but also it provides substantial guidance on procedural
issues such as the judicial revision of data introduced by the tax authorities, of (secret)
comparables, the burden of proof, the consequences of lacking cooperation by the
taxpayer, the scope of transfer pricing documentation requirements, as well as the
determination of arms-length transfer prices within acceptable ranges. Further
references to this judgment will be made in the following sections. It needs to be
understood that the German legislator has reacted to this decision, in particular by
introducing statutory transfer pricing documentation requirements in Section 90
Paragraph 3 of the AO and promulgating penalties in cases of non-compliance with
these obligations in Section 162 Paragraphs 3 and 4 of the AO. To this extent, the
principles of the BFH decision dated 17 October 2001, are no longer unrestrictedly
applicable to the years 2003 onwards. However, it should be emphasised that even
after the introduction of statutory documentation requirements, the burden of proof
for transfer prices not being at arms length is still with the tax authorities, and that the
other fndings of the BFH in its 17 October 2001 decision remain in force.
Within its decisions of 27 August 2008, (I R 28/07, not yet published in the Federal
Tax Gazette) reconfrmed by the decision of the BFH dated 29 April 2009 (I R 26/08,
not yet published in the Federal Tax Gazette) the BFH interpreted the term business
relationship under Section 1 of the Foreign Tax Act. A business relationship between
related parties shall not be existent if a parent company does not suffciently capitalise
its subsidiary but provides the subsidiary with free capital replacements, which a
third party would not have provided (such as an interest-free loan or a binding letter
of comfort). If the subsidiary is not able to perform its business operations without
the capital replacements, the provision of such capital replacement is not qualifed
Germany
as a business relationship between related parties and hence not subject to income
adjustments according to Section 1 Foreign Tax Act.
One of the regional tax courts, the tax court of Cologne, rendered an important
decision on 22 August 2007, on the need of upfront (written) agreements for inter-
company transactions. The court states that German national law clearly requires
having such agreements in place in order to avoid income adjustments. However,
the court also clearly acknowledges that Germany will not be able to uphold such a
formalistic position under a double-tax treaty where the emphasis is put on whether
irrespective of the fulflment of formalities such as written agreements transfer prices
are arms length. The decision is mostly read to underline the fact that the German tax
authorities generally will not be able to attack transfer prices solely for the lack of inter-
company agreements. It is interesting to note that the tax authorities have not appealed
the court decision, and seem consequently to acknowledge its fndings. Nevertheless,
in practice it remains advisable to enter into upfront agreements with respect to inter-
As a matter of principle, the taxpayer has to prove compliance with German tax law for
all business transactions, including transfer pricing. In its aforementioned decision of
17 October 2001, the BFH provides guidance on the allocation of the burden of proof.
The taxpayer only has to prove the underlying facts of a transaction, which includes
presentation of the functions and risks and a description of how the transfer price
for the transaction was determined. The tax authorities, on the one hand, have the
onus to prove that the transfer price is, or is not, arms length. If the taxpayer should
not fully comply with his/her obligation to present all facts, the tax authorities may
conclude on the other hand that the pricing has been determined by the affliation of
the parties; however, the latter does not in itself allow the tax authorities to conclude
that the transfer price is not arms length, and the authorities are left with the need
to determine the proper pricing by means of a comparability study or an appropriate
estimation.
The 2003 legislation has introduced a rebuttable assumption that, in the absence of
appropriate documentation, the actual income from inter-company transactions is
higher than the income declared. If the taxpayer is not able to refute this assumption,
the tax authorities may have to estimate the arms-length result, and if in this case
the income can be determined only within a certain price range, the authorities may
use the least favourable end of the price range; this mechanism represents one of the
penalty elements for non-compliance with documentation rules, which is a potentially
heavy detriment for a taxpayer who has not fulflled his/her legal documentation
obligation compared with a taxpayer who has done so. The latter would beneft
from the 17 October 2001 BFH decision, which still provides the right to use the
most favourable end of the price range in case of an estimation; from 2008 onwards,
however, even in these cases a correction could be made at least to the median of a
range if the taxpayer had agreed on prices outside of the appropriate range.
However, in this respect it should be mentioned that even the administration
principles-procedures dated 12 April 2005, do not allow the taxpayer to generally
choose the most favourable value in a range of transfer prices or margins in the frame
of an estimation. The tax authorities require that this exploitation of the range in
the sense of the most favourable value for the taxpayer depends on the degree of
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comparability of the respective third-party data. For this purpose, the tax authorities
may narrow the range to the detriment of the taxpayer, if an unlimited comparability of
all third-party data within the range is not given.
The above rules only apply to the regular price determination process. However, in
criminal prosecutions, it is, of course, the tax authorities who have to prove that the
conditions of tax fraud or other criminal offence are met, including the taxpayers
criminal intent.
The German tax authorities do not normally perform tax audits specifcally for transfer
pricing issues but examine transfer pricing during the normal tax feld audits, which
are performed at regular intervals. With the exception of small business entities,
German enterprises are generally subject to regular tax feld audits, which usually
cover three to fve consecutive years. An increasing number of tax audits are focusing
on transfer pricing, and tighter investigations by tax auditors into transfer pricing
issues are occurring in light of extensive new rules and a nationwide transfer pricing
programme for tax auditors; this trend is likely to strengthen.
Since the introduction of legal documentation requirements, companies should be
prepared to be asked to submit the documentation of their cross-border transfer prices
within the limits of Section 2 Paragraph 6 of the GAufzV already on receipt of the
offcial advance notice (Prfungsanordnung) of the tax audit. The time limit of 60 days
(respectively, 30 days in case of so-called extraordinary transactions) for submitting
this documentation starts in these cases with this offcial advance notice being issued.
However, an unspecifed global request for documentation is not allowed; companies
should consider objecting if confronted with such an unspecifed global request.
the tax authorities
Information
The tax authorities may request any information considered relevant to all the
transactions throughout the audit period, and the taxpayer is obliged to cooperate with
the authorities. Where the investigation concerns cross-border transactions, there is
an increased obligation on the German taxpayer to cooperate. Information on foreign-
affliated parties must be provided if requested. Where it is not provided even though
the German taxpayer would have had the possibility to obtain such information, the
tax authorities are entitled to estimate appropriate transfer prices based on simplifed
methods, which may result in an adjustment of taxable income. The authorities may
not, however, enforce the provision of information either through the imposition of
further penalties or through other similar measures.
The 2008 legislation introduced the notion that, if foreign-related parties will not
disclose information, which is relevant for the transfer prices of a German entity, the
transfer prices of the German entity can be estimated at the end of the range that is
most disadvantageous for the German taxpayer. It is, however, somewhat unclear how
far-reaching the wording of the new rule can be interpreted.
Over the years, the tax authorities have attempted to introduce additional, partly
contemporaneous documentation rules for the specifc purpose of supporting transfer
Germany
prices. As an example, the revised cost allocation principles of 30 December 1999
request unprecedented documentation of all relevant facts. In its decision of 17
October 2001, however, the BFH emphasised that German procedural law in force
at the time of judgment did not provide a legal basis for such special transfer pricing
documentation. The 2003 legislation on documentation should be seen as a direct
response of the authorities to that verdict of the court.
The 2003 legislation has brought Germany on a procedural level comparable to a
growing number of other countries and provides an effcient tool for more structured
tax audits by the authorities.
The new rules request documentation as to type, contents and scope of cross-border
transactions with related parties, including the economic and legal basis for an arms-
length determination of prices and other business conditions. Documentation must
be prepared within a reasonably short period (in German zeitnah) for extraordinary
transactions such as corporate restructurings as well as material long-term contractual
relationships, which implies that no time limit is set for the preparation of ordinary
current transactions. Within a reasonably short period in this sense means that
documentation for extraordinary transactions must be prepared within six months
after expiration of the business year in which the respective transaction took place.
Documentation for all types of transactions must be presented to the authorities upon
their request, typically in the course of a tax audit. The time limit for presentation is
60 days following the request (respectively, 30 days in case of so-called extraordinary
transactions); extensions may be granted for special reasons.
The new law is applicable for fscal years starting after 31 December 2002 (i.e. in
most cases from 1 January 2003, onwards). However, the provisions on unfavourable
estimates as well as on penalties took effect only one year later (i.e. from 1 January
2004, onwards).
3307. Field audits in practice
Field audits are in most cases carried out at the premises of the taxpayer. The tax
auditor notifes the taxpayer of the intended visit and the scope of the audit typically
some weeks before the audit commences. Depending on the size, complexity and
availability of information, an audit may take between a few days and many months.
Effective 2002, special procedures have been established to allow spontaneous VAT
audits with no warning to the taxpayer. Depending on the results, such a special
audit may be continued as a regular tax audit covering also other taxes, including
transferpricing.
As of 1 January 2002, unprecedented new legislation has taken effect with a
fundamental impact on the future conduct of tax audits. Forthwith, the tax authorities
are entitled to access the electronic records of taxpayers who have to make available
their data. At their election, the authorities may take direct access or may request the
taxpayer to process and evaluate data at their specifcation. Finally, the authorities may
also require copies of all data in a form suitable for further processing.
As a result of the feld audit, the tax auditor summarises the fndings and any tax
adjustment considered necessary in a written report. It is common tax audit practice
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that the tax auditor, before fnalising the report, continues to correspond with the
taxpayer and/or his/her advisers in order to try to settle all the issues of concern;
regularly, also a fnal meeting will be held between all parties involved to evaluate the
material fndings. It should be noted that negotiation is an important element of most
tax audits and that in most cases a fnal settlement is reached by compromise.
In case of internationally affliated companies, the examination of cross-border transfer
prices is increasingly the focus of tax audits. Hence, the tax risks resulting from transfer
prices not being at arms length should not be underestimated, in particular against
the background of respective sanctions that may apply in such cases. In this respect,
the quality of the documentation of the appropriateness of transfer prices increases
in importance, as it may result in minimising the risk of income corrections. Simply
said, the better the documentation of transfer prices with regard to their arms-
length character, the lower the risk of income corrections. In addition, it should not
be neglected that a solid transfer pricing documentation may add the advantage of
shortening the duration of a tax audit.
The tax auditor is not authorised to issue revised assessments for the years under audit.
The fnal report, including suggestions for any tax adjustment, is presented to the local
tax offce where the revised tax assessments are prepared, usually in accordance with
the recommendations of the tax auditor.
The taxpayer may appeal against the revised assessments and ultimately any appeal
would be heard frst by the regional tax court and then, if admitted, by the Federal
TaxCourt.
Any unfavourable transfer pricing adjustment will result in an increase of taxable
income, which often requires treatment as hidden dividend distribution. To the
extent that a hidden dividend could not be funded out of available tax equity, the
imputation tax system in force until the end of 2000 resulted in a gross-up with
potentially a very high tax burden. The imputation system has been substituted from
2001 onwards and, unlike in the old system, the regular new corporation tax rate
of 15% (through 2007, 25%) as well as trade taxes will now be applied to any proft
adjustment (unless balanced by tax loss carry-forwards) with no unfavourable gross-
up. To the extent a transfer pricing adjustment will indeed be treated as a hidden proft
distribution, additional withholding taxes may become due; even if double-tax treaties
or supranational law (e.g. the EU Parent-Subsidiary-Directive) provide for reduced
withholding tax rates, such reduction may be achieved only by a formal application.
Penalties other than interest charges are generally unknown under the present laws
as part of the taxation process and may be an issue in criminal proceedings only.
However, with respect to transfer pricing documentation, a penalty regime has been
implemented with effect from 2004 under the 2003 legislation. In strict legal terms,
a surcharge (no penalty for criminal misconduct) between 5% and 10% of a proft
adjustment must be raised, with a minimum of EUR5,000. In case of late presentation
of appropriate documentation, the maximum surcharge is EUR1 million, with a
minimum of EUR100 for each day after the 30/60 days time limit is exceeded.
Germany
Central authority for all international tax matters, including transfer pricing, lies with
the Federal Tax Offce (Bundeszentralamt fr Steuern). The Federal Tax Offce collects
all information and data of relevance for international taxation and transfer pricing
issues. This central extensive statistical information is confdential and is available to
the tax administration only. In local tax audits, matters of international importance
may be presented by the local tax auditor to the Federal Tax Offce for review, and
expert auditors of the Federal Tax Offce with specialisation in transfer pricing or other
international tax matters may assume responsibility for respective segments of local
tax audits. The Federal Tax Offce relies entirely on internal expertise rather than on
outside consultants or other experts.
In recent years, the German Revenue has identifed transfer pricing as a strategic area
of the highest importance, and considerable efforts are being made to strengthen
this area, both from a manpower/experience and an organisational point of view.
Internationally affliated taxpayers are being increasingly investigated by tax auditors
with special cross-border experience, and that experience includes transfer pricing.
The responsibility for larger companies (which typically have international group
affliations) also lies with special regional tax offces, which have an increasing transfer
pricing expertise.
In determining an arms-length price, Section 1 Paragraph 3 Foreign Tax Act advises to
primarily use the traditional transactional pricing methods: comparable uncontrolled
price (CUP) method; resale price method (RPM); and cost-plus (CP) method. Proft-
related transfer pricing methods have been a controversial area in the past. However,
there is a growing tendency in tax audit practice to accept the use of proft-related
pricing methods. This trend seems to be supported cautiously also by the BFH, which
has accepted in its decision of 17 October 2001, that a certain proft benchmark may be
used for the years under review.
The administration principlesprocedures also explicitly acknowledge that, under
certain conditions, the use of other methods may be appropriate. Specifcally, the
administration principlesprocedures allow the use of a proft split method (PSM)
or the transactional net margin method (TNMM) for specifc cases; the latter can
be applied if (1) no standard method is applicable, (2) an enterprise carries out
only routine functions, and (3) at least a limited comparability exists with the
comparabledata.
The administration principlesprocedures also allow companies to apply proft-
related transfer pricing methods to the extent that useful comparable data cannot be
determined on the basis of the so-called standard methods. However, the application
of the comparable proft method (CPM) is explicitly rejected (i.e. transfer pricing
methodology has to be strictly transactional to the extent possible by, e.g. using the
TNMM instead of the CPM).
The application of the transfer pricing methods depends inter alia on the structure of
the company under review. The German tax authorities differentiate between three
categories of companies:
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Companies with routine functions and no considerable contribution to the value
chain allowed methods: standard methods and TNMM; companies with an
entrepreneur-type structure (so-called strategy leaders) allowed methods:
standard methods with respect to its affliates. PSM between companies of the same
structure; and
Companies exercising more than routine functions, without having the profle of
an entrepreneur allowed methods: standard methods, determination of transfer
prices based on internal planning data with arms-length proft forecasts.
Hence, Germany follows the international trend of using proft-related transfer
pricing methods for the determination of arms-length transfer prices; however,
certain restrictive conditions must be fulflled. This happened inter alia against the
background that it is becoming more and more diffcult in competent authority or
arbitration proceedings to reject proft-related pricing methods where other countries
are applying such methods.
The 2008 legislation confrms the concept of the so-called hypothetical arms-length
test when no comparables are available. This method was established by German
courts: Applying the hypothetical arms-length test, a transfer pricing range would
typically be seen to be between the minimum price for one party in the transaction
and the maximum price for the other party; with the price expectations of the
parties based on the net present value of forecasted future income. If no other value
can be substantiated by the taxpayer, the mean of the range will be taken as the
arms-lengthprice.
Availability
With regard to the availability of published fnancial data such as company accounts,
except for publicly traded entities, few German corporations are inclined voluntarily to
publish any meaningful fnancial data, or to comply with general European publication
requirements. Owing to the lack of penalties for non-compliance, only a relatively small
percentage of German corporations fulfl the publication requirements and, where
information is published, there is not usually enough detail for it to be of real use.
However, an increasing number of German companies are prepared to publish their
fnancials in databases. Hence, databases have a larger quantitative basis, and their
meaningfulness for comparability studies has increased. At the same time, databases
contain more detailed company information so that database-supported comparability
studies are gaining importance in defending appropriate transfer prices to the tax
authorities. However, the administration principlesprocedures require that the search
process of a database analysis be comprehensible and examinable for a tax auditor. It
must not be limited to a mere database screening but requires a manual or qualitative
screening. The overall guiding principle is quality is more important than quantity of
comparables. Only under these circumstances will the tax authorities accept database-
supported comparability analyses.
In the past, the German tax authorities have relied entirely on self-collected
information. However, refective of the evident international development, they have
recently started to use information available on publicly accessible databases. Still,
to the extent the tax auditor resorts to other taxpayers data for examining the arms-
length character of transfer prices, the taxpayer is not entitled to be informed of this
data for reasons of taxpayer confdentiality. As a result, this data has a reduced value of
proof regarding income corrections in a tax audit.
Germany
Secret comparables
In its landmark decision of 17 October 2001, the BFH had also to deal with secret
and anonymous comparables. Different from the lower tax court decision on the
same subject matter, the BFH held that the use of secret or anonymous data is not
per se violating German tax procedures. The tax authorities may, therefore, use
secret data. However, the BFH imposes an important restriction on this rule. Due to
strict procedural secrecy provisions, the authorities are effectively prevented from
an unrestricted disclosure of the sources of secret data. As a result, the reliability
and quality of such data might be substantially reduced in court and other public
proceedings. As a way out of this procedural restriction, the tax authorities gradually
have moved towards a more intensive use of publicly available data and, consequently,
towards proft-based benchmarking studies.
In accordance with German law, transactions with related parties should conform to
the arms-length standard, and consequently the transfer prices of all transactions
could be challenged. In practice, they are subject to review in regular tax audits.
As part of their evaluation of functions and risks, the tax authorities will scrutinise
transactions with an increased risk profle. Although not always caused by a particular
risk profle but rather by size and importance, tax audits focus increasingly on
particular industries (e.g. automotive and pharmaceuticals).
Competent authority provisions are an integral part of the extensive German treaty
network, and proceedings normally follow the pattern of Article 25 of the OECD
Model Tax Convention. Retroactive adjustments arising from transfer pricing issues,
which may result in a reduction of German taxes, may be allowed even where tax
assessments have become fnal and would not, in accordance with domestic tax law,
otherwise be allowed. Depending on the complexity and/or importance of the subject
matter, a competent authority proceeding may take between a number of months to
severalyears.
The administration principles-procedures dated 12 April 2005, explicitly mention
that in case of an imminent double taxation caused by transfer pricing corrections of a
foreign or national tax authority, the opening of a mutual agreement or EU arbitration
procedure may help to remove this double taxation by means of corresponding
counter-income corrections. For this purpose, in case of a transfer pricing correction
intended by a national tax audit, the company must be immediately informed of this
correction so that it can turn to the foreign tax authority and discuss the possibility of
a corresponding counter-correction with them. Should the foreign tax authority not
agree to such a correction, the taxpayer may apply for a mutual agreement or to the EU
arbitration procedure.
Further details on mutual agreement and EU arbitration procedures are set out by the
tax authorities in a circular letter of 13 July 2006.
In case of an imminent transfer pricing correction intended by the foreign tax
authorities, the German taxpayer is obliged to inform the German tax authorities.
Should German transfer prices change correspondingly, such changes would have to
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be documented according to Section 5 Number 4 of the GAufzV. Should the German
tax authorities not see themselves in a position to effect the corresponding counter-
correction, the company has the opportunity to apply for a mutual agreement or EU
arbitration procedure in order to avoid double taxation. In case of a foreign transfer
pricing correction, the company has to submit all documents relevant to this correction
to the German tax authorities.
It should be noted that, although the success of competent authority proceedings
depends on the voluntary consensus of both tax authorities involved, the German
authorities are unlikely to reject a compromise. In addition, Germany has commenced
to include in the negotiation of a new tax treaty the position that mutual agreement
procedures should contain an arbitration element (i.e. that they cannot end without a
binding and fnal decision to avoid double taxation).
Like all other EU Member States, Germany has to observe the European Arbitration
Convention on Transfer Pricing Matters. The EU Arbitration Convention is based on the
Convention 90/436/EEC on the Elimination of Double Taxation in Connection with the
Adjustment of Transfers of Profts between Associated Undertakings and entered into
force on 1 January 1995, for a duration of fve years. The extending protocol of 1999
was not ratifed until 1 November 2004, and therefore the EU Arbitration Convention
was paused between 1 January 2000 and 1 November 2004. Based on the protocol, the
EU Arbitration Convention was applied retroactively, and double taxation caused by
transfer pricing adjustments in this period has been covered.
The attitude of the Federal Ministry of Finance on APAs recently changed very
positively, insofar as the Ministry actively welcomes and supports APAs for transfer
pricing purposes in Germany. This has to be seen against the background that the
determination of arms-length transfer prices in an APA serves to avoid lengthy
disputes between the participating revenue in treating cross-border transfer prices. A
further beneft of an APA is that it may considerably shorten the length of tax audits
because the transfer pricing system as such will not be challenged. In addition, APA
reporting requirements and documents of an APA can be used to fulfl German transfer
pricing documentation requirements.
However, it should be emphasised that the Federal Ministry of Finance is typically not
prepared to grant unilateral APAs in transfer pricing issues because unilateral APAs
have no binding effect on the other country concerned. Therefore, the German tax
authorities are instructed to only grant APAs on a bilateral or multilateral basis. This
necessitates the respective other country to participate in the APA procedure and
effecting APA proceedings on the legal basis of Article 25 OECD Model Tax Convention
in the sense of a (anticipated) mutual agreement procedure.
Germany has now also APA guidelines in the sense of formal regulations on how
to apply for, negotiate and grant an APA. On 5 October 2006, Germanys Finance
Ministry released a long-awaited circular on bilateral and multilateral APAs, which
was designed to facilitate the processing of APAs and to establish more certainty for
taxpayers. The circular offers taxpayers and practitioners comprehensive guidance on
obtaining an advance accord. With the new circular, the APA application process is
also expected to be shorter: tax authorities are aiming to issue within nine months a
Germany
German position paper in a bilateral APA, with a closed bilateral agreement expected
in about 18 months.
Within the Federal Ministry of Finance, the competence for APA applications and for
granting an APA has been centralised in one department and is no longer allocated
over several state-specifc departments. This centralised department is located within
the Federal Offce of Finance in Bonn. It has to be considered that in addition to the
Federal Ministry of Finance, the local tax offce (including the tax auditor) is regularly
involved in an APA procedure. In addition, expert auditors for international tax issues
from the Federal Offce of Finance may be involved in the proceedings.
In 2007, Germany introduced the following fees for its APA programme:
In general, the fee for an APA amounts to EUR20,000 (basic fee), which will also
become due if an APA will not be issued as set out in the application process. In case
of multilateral APAs, the fee will incur for each country involved;
The fee for an extension of an already existing APA amounts to EUR15,000
(extension fee);
Amendments to an APA application will give rise to a fee of EUR10,000
(amendment fee); and
Reduced fees are possible in cases concerning small enterprises.
Finally, the German tax authorities will closely examine any unilateral APA granted by
a foreign tax authority that has detrimental tax effects in Germany, unless the German
tax authorities themselves actively participated in the APA process.
Law
With respect to the concept of the transfer of functions under the new Section 1
Paragraph 3 Foreign Tax Act, the German government elected in autumn 2009,
introduced into parliament a draft law with the intention to provide taxpayers with
release from one of the most critical aspects of the German transfer of function rules
introduced in 2008. Current rules foresee that an exit charge for the transfer of a
business function from Germany abroad shall always be based on a transfer package
valuation of the function (including as a general principle the goodwill attached to the
function). The proposed change is that goodwill (and the proft potential inherent in
it) will not need to be included in the exit charge calculation if functions transferred
do not constitute a whole (or at least partial) business; then, any intangible assets
transferred may be valued on an individual basis, which should allow in most cases
not to include goodwill in the valuation. Final decision on the new law is expected for
May2010.
The German tax authorities are also continuing their work on a revision of the
administration principles following international developments. The administration
principles have been revised regarding Chapters 7, 8 and 9 via new decrees. In a next
step, Chapter 5 (intangible assets) is intended to be revised. As can already be seen
from the administration principlesprocedures dated 12 April 2005, it is expected that
in a continuing revision of the 1983 administration principles, Chapter 3 which deals
with the supply of goods and services will support the application of proft-related
methods for the determination of transfer prices under certain circumstances. Here,
German tax authorities increasingly follow international trends.
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Practice
Further changes can be observed in the approach of the German tax authorities
to transfer pricing issues. As practical training and experience of tax auditors are
increasing, the profle of transfer pricing issues in tax audits is raised. It is also expected
that taxpayers will request, and the Revenue will have to get involved in an increasing
number of competent authority, arbitration proceedings and APAs.
In the past, income tax and customs authorities normally have worked independently
of each other with little or no communication or exchange of information. However,
this is gradually changing, and it can no longer be excluded that transfer pricing
adjustments may result in a reassessment of customs duties, or vice versa.
3317. OECD issues
Germany is a member of the OECD and has approved the OECD Guidelines on transfer
pricing despite having previously expressed reservations on certain sections of the
guidelines, such as those dealing with proft-based pricing methods.
The tax treaty provisions and additional EU provisions on the exchange of information,
competent authority, arbitration and consultation proceedings provide a procedural
framework for the German tax authorities to join another country in a joint
investigation of a multinational group for transfer pricing purposes. For practical
reasons (e.g. lack of manpower and language problems), such simultaneous audits are
likely to be restricted to exceptional cases. Currently there is close communication with
other EU Member States and the US Tax Administration on issues of mutual interest,
and this will impact on alliances for joint audits.
3319. Thin capitalisation/limitations on interest deductions
The 2008 legislation revised fundamentally Section 8a KStG, which formerly dealt
with the thin capitalisation of companies. The thin-capital rules that restricted the
deduction of interest on shareholder loans are replaced with effect from 1 January
2008, by an interest deduction limitation rule. Under the new rules, the allowable
net interest expense is restricted to 30% of taxable income before interest, taxes on
income, depreciation and amortisation. There is no limitation on the deductibility of
interest in the following circumstances:
Where the net interest expense is less than EUR1 million;
Where the company is not part of a group and interest paid to any one shareholder
of more than 25% does not exceed 10% of the net interest expense; and
Where the company is a member of a group, but its borrowings do not exceed the
borrowing ratio (as shown by the fnancial statements under a common accounting
convention such as International Financial Reporting Standards or US generally
accepted accounting principles) by more than 1% and interest paid to any one
shareholder of more than 25% does not exceed 10% of the net interest expense.
Germany
Similar principles apply to corporate holdings in partnerships and there are related
party and right of recourse rules for shareholders to catch back-to-back fnancing and
other perceived abuses.
Any net interest expense that has been disallowed on a given year because it exceeds
the 30% threshold, may be carried forward for relief in future years. The net interest
expense is then treated as a net interest expense of the year concerned, with the same
conditions applying.
The interest limitations are effective for accounting years commencing after 25 May
2007 (adoption of the bill by parliament) and ending after 31 December 2007.
Prior to 2008, the thin capitalisation regulations of Section 8a of the KStG provided
for a generally available safe harbour debt to equity ratio of 1.5:1. Within this safe
harbour, interest on loans received from (or guaranteed by) shareholders or affliates
were deductible for tax purposes. However, no safe harbour was allowed where the
interest charged was based on proft or turnover rather than on a fxed percentage of
the principal. In connection with the thin capitalisation legislation, there were complex
anti-avoidance provisions, among others, on intragroup debt push-downs.
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34.
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3401. Introduction
Since 1994, provisions under the Greek tax law (Article 39 of L. 2238/1994, the
Income Tax Code) have enabled the Greek tax authorities to make adjustments to
inter-company transactions that have not been conducted on an arms-length basis.
However, this law has been rarely applied in practice, and consequently companies
operating in Greece have historically paid little attention to developing formal transfer
pricing policies or preparing documentation to support the pricing of their inter-
That situation has now changed. On 18 December 2008, a bill relating to market
control and supervision introduced by the Ministry of Development was enacted as
L. 3728/2008. Although the purpose of this legislation was ostensibly to implement
measures to control consumer prices, the legislation adopted OECD-style transfer
pricing principles as one of the tools with which to accomplish consumer price
controls. Accordingly, Article 26 of L. 3728/2008 confrms the application of the arms-
length principle to inter-company transactions and establishes a formal transfer pricing
documentation requirement for all Greek taxpayers. Subsequently, detailed regulations
in support of Article 26 of L. 3728/2008 were also promulgated by the Ministry of
Development under Decision R. 2709/2008, with further clarifcations by Decision
A2-2233.
Prompted to action by the Ministry of Developments legislative advance in transfer
pricing, the Ministry of Finance enacted its own documentation requirements for tax
purposes in mid-2009. These requirements are incorporated into the Greek tax law
under Article 1 of L. 3775/2009, which amended the existing Article 39 and added a
new Article 39A to L. 2238/1994. However, these new documentation requirements
are, to all intents and purposes, the same as those required by the Ministry of
Development. Accordingly, this chapter addresses the Greek transfer pricing
environment from both perspectives.
The provisions of Article 26 of L. 3728/2008 are effective for fscal years ending after
the date of enactment of the law (i.e. 18 December 2008), while the provisions of
Article 1 of L. 3775/2009 are effective for tax returns fled from 1 January 2011 and
thereafter. However, as the Ministry of Development has the power to refer a taxpayer
to the Ministry of Finance if it discovers evidence of non-arms-length pricing in the
course of an audit under Article 26 of L. 3728/2008, the practical position is effectively
that documentation is also required for tax purposes from fscal years ending 18
December 2008 onward.
International Transfer Pricing 2011 Greece 425
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The introduction of two pieces of transfer pricing legislation by two different
government bodies within such a short time period is a clear indication that transfer
pricing is now a key focus of the Greek government. Moreover, the Greek tax
authorities have historically been relatively aggressive in conducting tax audits, with
taxpayers rarely avoiding some level of adjustment. Given this history, it is inevitable
that audits involving transfer pricing issues are likely to become a regular feature of
Greek tax practice in the future.
Transfer pricing adjustment
The power of the Greek tax authorities to make an adjustment for transfer pricing
purposes is now contained within Articles 39 and 39A of L. 2238/1994. These articles
provide that an adjustment to net proft may be made where either the price charged
between domestic-related parties is unreasonably higher or lower than what would
have been agreed between third parties or where the price charged between cross-
border-related parties is not at arms length, and where the result of this difference
is the avoidance of either Greek direct or indirect taxes. In addition, Articles 39 and
39A also provide that an adjustment to net proft may be made where the terms of
the agreement between the related parties are such that no third party would have
entered into such a transaction. In the latter case, any profts arising out of the inter-
company transaction that would not have arisen in a transaction between third parties
shall be considered to be proft for the Greek taxpayer and taxed accordingly, without
impacting the validity of the taxpayers accounting books.
Affliated undertakings
Article 26 of L. 3728/2008 and Articles 39 and 39A of L. 2238/1994 apply to all
taxpayers engaging in transactions with companies associated with them associated
being defned as under the Greek Corporate Law, namely Article 42e of L. 2190/1920.
The latter provision states that companies associated with a taxpayer, known as
affliated undertakings, exist in the following circumstances:
In parent/subsidiary arrangements, where:
The parent owns the majority of the capital or voting rights in a subsidiary,
including securities and rights held by third parties on behalf of the parent;
The parent controls the majority of voting rights in a subsidiary through an
agreement with the other shareholders or partners of the subsidiary;
The parent participates in the capital of the subsidiary and has the right,
directly or through third parties, to appoint or remove the majority of the
members of the management of the subsidiary; and
The parent has the power to exercise (or actually exercises) dominant infuence
or control over the subsidiary, or has the power to do so through another
subsidiary under the common management of the parent.
Where a brother/sister relationship exists, defned as the subsidiaries, or
subsidiaries of subsidiaries, of the above parent/subsidiary relationships;
In cases of indirect ownership, defned as the parent/subsidiary and brother/sister
relationships above, irrespective of whether direct participation exists; and
Common management without capital participation, as defned in the Greek
Corporate Law on consolidation (Article 96(1) of L. 2190/1920).
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Documentation
Both Articles 39 and 39A of L. 2238/1992 (as amended by L. 3775/2009) and Article
26 of L. 3728/2008 provide that all Greek companies engaging in transactions with
affliated undertakings must conduct those transactions on an arms-length basis,
whether this principle is stated explicitly (for foreign transactions) or implicitly (for
domestic transactions). To monitor compliance with the arms-length principle, two
documentation obligations are imposed on all taxpayers.
First, under Article 26 of L. 3728/2008, within 4.5 months from the end of the fscal
year a taxpayer is required to submit to the Ministry of Development a list of all
transactions with affliated undertakings. As set out in Article 8 of R. 2709/2008,
the list must provide the amount and nature of each transaction (e.g. sale of goods,
provision of services), information about the counterparty (name, place of registration,
tax registration number), and all inter-company deliveries invoiced through third
parties (i.e. triangular transactions).
Second, under Articles 39 and 39A of L. 2238/1992 (as amended by Article 1
of L. 3775/2009) and Article 26 of L. 3728/2008, taxpayers are also required to
demonstrate the arms-length nature of all inter-company transactions by preparing
detailed transfer pricing documentation.
As outlined above, the Ministry of Development has issued specifc regulations under
Article 26 of L. 3728/2008, which provide further detailed guidance in relation
to application of Article 26 of L. 3728/2008 and its documentation requirements
(hereafter, MoD regulations). Although the Ministry of Finance has issued no
regulations under Article 1 of L. 3775/2009 in relation to transfer pricing at this time,
the MoD regulations are detailed and comprehensive, and are based on the principles
set out in the OECD Guidelines. Accordingly, the MoD regulations may be considered
a guide as to what is likely to be contained within any future regulations issued by the
Ministry of Finance.
Clarifcation of affliated undertakings
The following transactions are explicitly confrmed as being covered by the defnition
of affliated undertakings:
Permanent establishments; and
Triangular transactions (i.e. inter-company transactions invoiced through a
thirdparty).
Exemptions from documentation requirement
Certain transactions or entities may be exempt from the requirement to prepare
transfer pricing documentation. These include:
Transactions with an individual not acting as an entrepreneur;
Transactions between related parties with a value of EUR200,000 or less;
Companies with annual turnover of EUR1 million or less;
Transactions where the object is company shares;
Transactions for the transfer of ownership and other property rights in real
estate;and
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Special auxiliary and supporting service entities established under the provisions of
Greek tax law (Article 27 of L. 3427/2005).
Contents of documentation
For a Greek-headquartered taxpayer, Articles 39 and 39A of L. 3775/2009 and Article
26 of L. 3728/2008 require a Master Documentation File to be prepared. For a Greek
subsidiary of a foreign-owned company, both laws require a Greek Documentation
File be prepared. Detailed guidance on the contents of these two pieces of
documentation under Article 26 of L. 3728/2008 is provided by the MoD regulations
asfollows:
Information regarding the group:
Organisational, legal and operational structure (including permanent
establishments and partnerships);
Group corporate activities and strategy, including changes from the previous
fscal period;
Inter-company transfer pricing policy, if available;
Identifcation of inter-company transactions, including nature of transactions
(e.g. sale of goods, provision of services), invoice fow, transaction amount
and information about the related parties engaged in the transaction (e.g.
their objectives, duration of trading activity, annual gross income, number
ofemployees);
Functions, risks and assets of the related parties, including changes from the
previous fscal period;
Ownership of intangible assets and associated royalty payments to or from third
parties; and
Advance pricing agreements (APAs) between the companies of the group and
foreign tax authorities.
Information regarding the company:
Detailed report of the inter-company transactions covered by the
documentation, including nature of transactions (e.g. sale of goods, provision
of services), invoice fow and transaction amount;
A comparative analysis showing the characteristics of the inter-company
transactions, a functional analysis of the relevant related parties, the
contractual terms of the transactions, the economic circumstances surrounding
the transactions, and any special corporate strategies;
Description of the transfer pricing method or methods adopted for the inter-
company transactions, including the reasons why that method was considered
most appropriate;
Information related to internal or external comparables, where available; and
Other data or circumstances considered vital to the company preparing the
documentation.
Given the background behind the introduction of Article 26 of L. 3728/2008 as
described at the beginning of this chapter, the MoD regulations have a strong
emphasis on documenting and supporting commercial aspects of the inter-company
transactions, with explicit references to corporate strategy, market changes and impact
of competition, changes in product specifcations or technological advancements,
exclusivity rights, contractual deadlines for completion of transactions, and marketing
strategies (market entry, discounting, promotional, etc.). It is not yet clear whether
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future Ministry of Finance regulations providing detailed guidance on the contents of
transfer pricing documentation will have a similar focus.
The Master Documentation File and the Greek Documentation File must both be
maintained in the Greek language and retained for the entire period of the statute of
limitations (technically fve years under Article 84 of L. 2238/1994).
Transfer pricing methodologies
The MoD regulations outline the acceptable transfer pricing methodologies for Greek
taxpayers. Fundamentally, these replicate the provisions of the OECD Guidelines;
however, the MoD regulations place a priority on the comparable uncontrolled
price method over other transfer pricing methodologies. In order of the hierarchy
established by the MoD regulations, the following transfer pricing methodologies may
be used:
Other traditional methods (i.e. resale price method and cost-plus method)
available only where the comparable uncontrolled price method cannot be applied;
and
Other (non-traditional) methods (i.e. transactional net margin method and proft
split method) available only if the three traditional methods cannot be used.
To apply a method lower on the hierarchy, the taxpayer must include in the
documentation fle a clear explanation of the reasons why a higher-placed method
cannot be applied.
Calculation of the arms-length range
Pursuant to the MoD regulations, when calculating an arms-length range from
comparable company data, the average results of the past three years shall be used.
There is no mandated approach for calculating the arms-length range, and any
generally accepted calculation or statistical programmes can be used. In addition,
once a range has been established, there is a presumption that inter-company pricing
falling within this range of comparable prices is at arms length (assuming the selection
of the comparable companies is considered appropriate).
However, although the MoD regulations provide for the above presumption and also
state expressly that when conducting an audit the Ministry of Development must
bear in mind that there is no single arms-length price that should be considered
acceptable and that a range of prices may be appropriate, if a taxpayer falls outside
the interquartile range, the Ministry of Development must confrm the median of that
range as the arms-length price.
On the other hand, as the Ministry of Development does not have the power to make
an adjustment to taxable income, use of the median should not be considered binding
on the tax examiners during an audit conducted under Articles 39 and 39A of L.
3775/2009 at this time. Although, based on their own analyses, the tax examiners may
of course adopt the median as the arms-length price in specifc cases in the future.
Consequently, based on the current legislation and regulations, it is theoretically
possible that a taxpayer falling outside the range of comparable prices could fnd
themselves in the unenviable position of being assessed against two different
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arms-length prices subject to an adjustment to the median in the course of an audit
by the Ministry of Development, yet adjusted to some other point in the range by the
examiners during a tax audit.
3404. Legal cases
Given that no assessments in relation to transfer pricing issues have arisen in Greece
as yet, there are no legal precedents at this time. However, based on experience with
litigation in other areas of tax legislation, little assistance has historically been derived
from the courts. This is primarily due to the lack of cases brought by taxpayers, which
is itself a function of the time required to complete the legal process (it can take many
years for a case to reach a conclusion), and the fact that if the taxpayer loses, penalties
and interest for the entire period since the initial assessment was calculated become
due. That is, while penalties and interest are suspended pending the outcome of the
court process, in the event of a taxpayer loss in the courts, penalties and interest are
immediately recalculated as if they had never been suspended.
The burden of demonstrating compliance with the documentation requirements
of Articles 39 and 39A of L. 3775/2009 and Article 26 of L. 3728/2008, including
requirements under the MoD regulations to show an arms-length pricing analysis
and any extenuating circumstances justifying a deviation from such arms-length
pricing (such as a market entry business strategy), rests with the Greek taxpayer.
However, once a taxpayer has demonstrated such prima facie compliance, the burden
of rebutting and proving either (1) lack of compliance, (2) failure to meet the arms-
length standard or (3) failure to suffciently demonstrate extenuating circumstances,
rests with the Greek tax authorities.
The statute of limitation for tax matters (including transfer pricing) is technically fve
years under Article 84 of L. 2238/1994. However, the actual position is somewhat
more complex.
For corporate tax purposes, the strategy of the Greek tax authorities has historically
been to audit each taxpayer every fourth or ffth year, so as to capture all open years
since the last audit was conducted. However, given the number of taxpayers in Greece
and the limited resources of the tax authorities, it has always been diffcult for the
tax authorities to complete an audit of every taxpayer within the required deadline.
Consequently, from time to time the Greek government introduces a specifc extension
to the statute of limitation to increase the period of the limitation for a particular year
or years. For example, by amendment L. 3790/2009, the statute of limitation for fscal
years expiring on 31 December 2009 was extended to 30 June 2010.
Going forward, transfer pricing will form part of this corporate tax audit process, and
will therefore be picked up on a cyclical basis as the corporate tax audit is conducted.
It is not yet clear whether transfer-pricing-specifc audits will ever be conducted by the
tax examiners.
In the future, transfer pricing audits will also arise under L. 3728/2008 through the
Ministry of Development (the audits themselves would be conducted by offcers of the
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Market Supervisory Authority, a division of the Ministry of Development). The statute
of limitation for these audits is equalised to the statute of limitation under the tax
legislation (i.e. technically fve years, although this may be extended as noted above).
Although no precedent yet exists, it is anticipated that during a regular corporate tax
audit the tax examiners will ask for the taxpayers documentation fle. Under Articles
39 and 39A of L. 3775/2009, for tax returns fled 1 January 2011 and thereafter, the
taxpayer has 60 days to provide that documentation.
On the other hand, pursuant to Article 9 of R. 2709/2008, an audit of a taxpayers
documentation fle by the Ministry of Development begins with a letter from the
Ministry requesting the taxpayer to submit such fle within 30 days. Once the Ministry
of Development audit has begun, the Market Supervisory Authority which conducts
the audit may also request other data for review, such as the taxpayers general ledger
or trial balance, fnancial statements, an explanation of how the documentation fle
was prepared, etc.
Audits conducted by offcers of the Market Supervisory Authority may result in
penalties for failure to comply with arms-length pricing or for failure to prepare
documentation, as stipulated in Article 26 of L. 3728/2008. However, these offcers
do not have the power to make an adjustment to taxable income if a transaction is
considered to have been conducted other than at arms length. In such cases, the
Market Supervisory Authority refers the documentation fles and other records to
the Ministry of Finance so the tax authorities can review and make an assessment if
considered appropriate.
Under either the Ministry of Developments or the Ministry of Finances transfer pricing
legislation, a taxpayer must fle a request to commence litigation within fve working
days from the date of notifcation of an assessment if it wishes to contest that decision.
The relevant ministry has 10 working days to respond to that request. If the request is
rejected, legal proceedings may be commenced in the Administrative Court; however,
the taxpayer must pay 20% of the fnes or penalties assessed during the audit to the
Administrative Court in advance. Although this 20% is refundable if the court rules in
the taxpayers favour, the Administrative Court will not accept the taxpayers request
for review if the 20% has not frst been deposited.
If the taxpayers request for litigation is rejected by the Market Supervisory Authority
or the tax examiners, the taxpayer can challenge this rejection by submitting a request
for review to the Administrative Court within 60 days of the date of rejection.
Failure to comply with documentation requirements
Failure to comply with either of the two transfer pricing documentation requirements
(i.e. the list of inter-company transactions at fscal year-end or transfer pricing
documentation) within the required time limits under both legislations results in a
penalty equal to 10% of the inter-company transactions that were not documented.
This penalty applies, regardless of whether a taxpayers transfer pricing is, in fact,
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being conducted at arms length or not. It is not yet clear whether a taxpayer could be
penalised twice by the Ministry of Development and the Ministry of Finance for the
same failure to provide transfer pricing documentation within the required time limits.
Failure to apply arms-length principle
Under Articles 39 and 39A of L. 2338/1994, if the tax examiners conclude that a
transaction is not being conducted at arms length, they may make an adjustment to
the taxpayers taxable income. In this case, a penalty equal to 10% of the additional tax
paid is also applicable.
In the event that the Market Supervisory Authority concludes a particular transaction
was not conducted on an arms-length basis under the transfer pricing legislation and
regulations of the Ministry of Development, a penalty of EUR5,000 may be imposed
and the fle shall be referred to the tax authorities (with the consequent potential for
an adjustment to taxable income and penalties, as noted above).
More importantly, however, in the latter case the criminal sanctions of the Market
Code also apply namely a fne (no limit prescribed) and/or imprisonment of up
to fve years. Again, it is not yet clear whether the Ministry of Development will be
this aggressive in pursuing transfer pricing issues, and it is hoped that a measure of
reasonableness will apply. However, taxpayers should certainly be aware that the
possibility of criminal sanctions for transfer pricing failures does exist.
The Ministry of Finance is now providing training in transfer pricing matters to its
existing pool of tax examiners, and transfer pricing issues are therefore likely to be
raised in corporate tax audits from 2010 on. However, as with any country introducing
transfer pricing legislation, a ramp-up period during which the tax examiners gain
experience in the area of transfer pricing is anticipated. Accordingly, the number or
scope of issues raised in the frst year or so of the new legislation may be limited.
The Ministry of Development is currently recruiting transfer pricing experts for its
Market Supervisory Authority in order to begin audits of taxpayers under Article 26 of
L. 3728/2008.
As the comparable uncontrolled price method has the highest status in the MoD
regulations, evidence of internal and external comparable data should be included
in the documentation fle if available. To demonstrate the comparability of such
transactions with the inter-company transaction, the taxpayer must provide suffcient
internal data, such as sales volume and units sold, for such an analysis to be made.
When reviewing comparable data provided by a taxpayer (including internal and
external comparables, as well as comparables taken from databases), a detailed
comparability analysis of the characteristics of the transaction being tested and the
parties to the transaction should be provided. The factors considered important in this
analysis are largely consistent with the comparability factors identifed in paragraphs
1.19 to 1.35 of the OECD Guidelines.
G
The MoD regulations permit the use of commercial databases to collect comparable
data. In such cases, the Greek taxpayer must provide an accurate description of the
database, the criteria and steps used to select the comparable companies, and a list
of all the companies which were eliminated from the search (and the reasons for
their elimination). It is understood that the Greek tax authorities have also licensed
commercial databases themselves for the purposes of conducting comparable searches,
although it is not known what steps the Ministry of Development has taken in this area.
As there is no audit history in Greece yet, it is not known which (if any) transactions
or industries may be targeted from the transfer pricing perspective. However,
considering the intentions behind and background to the introduction of Article 26
of L. 3728/2008 by the Ministry of Development, one potential risk area could be the
consumer goods industry.
Greece has an extensive treaty network, including treaties with almost all its major
trading partners. These treaties contain provisions to relieve double taxation through
the use of mutual agreement proceedings (MAP); however, to date, Greece has not
conducted any such negotiations.
Technically, there are no restrictions on the commencement of an application for MAP
following an audit assessment. Consequently, it is not necessary for the taxpayer to
have exhausted its rights through the domestic appeals process of the Administrative
Court in order to have the right to apply for MAP.
Greece has no APA regulations at this time, and has made no indication that the tax
authorities will introduce guidelines for APAs in the near future. However, as bilateral
APA negotiations are theoretically covered by the MAP provisions of Greeces tax
treaty network, it should be possible to apply for a bilateral APA between the Greek tax
authorities and the tax authorities of a treaty partner.
The Ministry of Finance is expected to issue regulations under Article 1 of L.
3775/2009 (in relation to Articles 39 and 39A of L. 2238/1994) in the near future.
Moreover, as Greek transfer pricing audit experience develops in the next few years,
practical application of the new legislations is also likely to become clearer.
With the lack of transfer pricing focus in Greece in the past, there has historically
been no liaison between the tax authorities and the customs authorities in this area.
However, there is no administrative requirement that government bodies maintain
taxpayer confdentiality between themselves, and as a result, it is possible that such
liaison may develop in the future.
Greece
3417. OECD issues
Greece is a member of the OECD and the provisions of Articles 39 and 39A of L.
2238/1994, Article 26 of L. 3728/2008 and the MoD regulations are all largely
consistent with the OECD Guidelines.
No joint investigations have taken place between the Greek tax authorities and any
other tax authorities to date. However, no law or regulation prevents Greece from
conducting such a joint investigation in the future.
The transfer pricing regulations apply to interest on inter-company loans. However, as
Greece currently has a safe harbour rule for thin capitalisation with a debt-to-equity
ratio of 3:1, signifcant activity between transfer pricing and thin capitalisation is not
expected at this time.
Hong Kong
35.
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Hong Kong
3501. Introduction
The increasing cross-border activities of Hong Kong businesses with those in Mainland
China and the expansion of the Hong Kong treaty network have put transfer pricing
in the spotlight in Hong Kong recently. In April 2009, the Inland Revenue Department
(IRD) issued Departmental Interpretation and Practice Notes No. 45 on Relief from
Double Taxation due to Transfer Pricing or Proft Reallocation Adjustments (DIPN
45). This was followed by the long-awaited DIPN 46 on Transfer Pricing Guidelines
Methodologies and Related Issues was published in December 2009. Both of these
practice notes seek to provide taxpayers with greater guidance and clarity in the area of
transfer pricing. In addition to DIPN 45 and DIPN 46, the decision made by the Court
of Final Appeal (CFA) in July 2009 in the Ngai Lik case (Ngai Lik Electronics Company
Limited vs Commissioner of Inland Revenue), which is to be discussed in the Legal
Cases section, contains signifcant transfer pricing implications. These developments
reshape the transfer pricing landscape in Hong Kong. It is expected that transfer pricing
will become an increasingly important tax issue in Hong Kong in the near future.
Section 20(2) of the Inland Revenue Ordinance (IRO) is the only statutory provision
that can be considered as enacted to deal with transfer pricing issues in Hong Kong.
This section applies where a resident person conducts transactions with a closely
connected non-resident person in such a way that if the profts arising in Hong
Kong are less than the ordinary profts that might be expected to arise, the business
performed by the non-resident person in pursuance of his connection with the resident
person shall be deemed to be carried on in Hong Kong, and such non-resident person
shall be assessable and chargeable with tax in respect of his profts from such business
in the name of the resident person.
The main thrust of IRO Section 20(2) is to ensure that any transactions a Hong
Kong resident has with a closely connected non-resident are conducted in a
reasonable manner, as if transacting with a third party in accordance with the
Section 20(2), however, has historically been perceived as having limited practical
application. Advance Ruling Case 14 and Case 27 are rare examples that demonstrate
how the IRD applies this section in practice. The IRD has often been more inclined
to use other provisions in the IRO, including the general anti-avoidance provisions,
to deal with transfer pricing issues, particularly if the potential amount involved was
International Transfer Pricing 2011 Hong Kong 435
Hong Kong
signifcant. For example, the IRD has historically sought to make transfer pricing
adjustments by:
Disallowing expenses incurred by the Hong Kong resident under IRO Sections 16
or17;
Bringing the non-resident taxpayers into tax under IRO Section 14 (and thereby
taxing both sides of the related party transactions); and
Challenging the entire arrangement under general anti-avoidance provisions
such as IRO Section 61A (allowing the IRD to disregard or to counteract the
mispricedtransactions).
Disclosure requirements
To combat abusive tax schemes used by corporations with tax evasion/avoidance as the
primary motivation, the key focus of the IRD is on the identifcation and investigation
of questionable transactions. The IRD achieves this through the scrutiny of the annual
profts tax return, a statutory form specifed by the Board of Inland Revenue under
Section 86 for a taxpayer to fulfl his/her profts tax reporting obligation. Taxpayers
are required to disclose in the annual profts tax return the following matters: (1)
transactions for/with non-resident persons, (2) payments to non-residents for use of
intellectual properties, (3) payments to non-residents for services rendered in Hong
Kong, and (4) transactions with closely connected non-resident persons.
3503. Other offcial guidance
The IRD releases Departmental Interpretation and Practice Notes to provide guidance
to taxpayers on a variety of issues as well as clarifcations of existing positions. These
publications are not legally binding; they do, however, provide the IRDs view on the
existing law and its administrative practices in its application of the law. The issuance
of DIPN 45 and DIPN 46 was the frst time that the IRD explicitly expressed its view in
dealing with transfer-pricing-related matters. Since these practice notes represent the
existing view of the IRD, they are retrospective in nature and should apply to taxpayers
historical, current and future transfer pricing arrangements. DIPN 45 and DIPN 46 are
summarised as follows:
DIPN 45
DIPN 45 provides guidelines on corresponding transfer pricing adjustments in a double
taxation arrangements (DTA) context. Hence, DIPN 45 applies adjustments only
to transactions between a Hong Kong entity and an entity in a jurisdiction that has
entered into a DTA with Hong Kong. DIPN 45 stipulates that if a taxpayer has a transfer
pricing adjustment in one of the treaty countries that has led to double taxation,
the IRD will consider allowing the taxpayer to make a corresponding adjustment in
Hong Kong, provided the IRD considers the adjustment made in the other country
is reasonable. To date, the countries that have concluded full-scope DTAs with
Hong Kong (i.e. not restricted to airline and shipping income) are Mainland China,
Luxembourg, Thailand, Belgium, Vietnam, Brunei, Indonesia and the Netherlands. The
DTAs with the latter three are not yet effective, pending ratifcations by Hong Kongs
government and the respective treaty counterpart. Hong Kongs government has also
agreed with Japan on a full-scope DTA that will soon be formally signed. A number
of jurisdictions, including Austria, the Czech Republic, Denmark, France, Hungary,
Ireland, Italy, Kuwait, Liechtenstein, the Macao SAR, Pakistan, Spain, Switzerland,
United Arab Emirates and the UK have also entered into negotiations of DTA with
HongKong.
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DIPN 46
DIPN 46 outlines the IRDs views of the legal framework for the IRD to deal
with transfer pricing issues, the methodologies that taxpayers may apply and
the documentation that taxpayers should consider retaining to support their
arrangements. DIPN 46 also provides some thoughts on transfer-pricing-related issues,
such as tax avoidance schemes, in particular:
DIPN 46 explains the relevant provisions (Sections 16(1), 17(1)(b), 17(1)(c)
and 61A) in the IRO and the relevant articles in DTAs that allow the IRD to make
transfer pricing adjustments. It is interesting to note that, contrary to the obiter
(i.e. non-precedential) views expressed in the CFA judgment in the Ngai Lik
case, to be discussed in the next section, the IRD believes that they can use the
deductibility provisions of the IRO (Sections 16 and 17) to challenge transfer
pricing arrangements, which creates a degree of uncertainty in this area;
DIPN 46 explains the defnition of an associated enterprise under the OECD
Model Tax Convention, which is relevant for transfer pricing in a DTA context.
It specifcally states that no threshold (e.g. percentage ownership criteria) has
been prescribed to defne an associated enterprise from a Hong Kong transfer
pricing perspective. As a result, taxpayers are advised to take a broad defnition of
associated enterprises when identifying and assessing related party transactions;
DIPN 46 confrms that transfer pricing in Hong Kong applies to domestic and
international-related party transactions. For transfer pricing adjustments made
by or in respect of non-DTA countries and in respect of domestic-related party
transactions, it is worth noting that no mechanism is currently in place to obtain
double taxation relief;
DIPN 46 explains the OECD Guidelines in the Hong Kong context, in particular
the way the OECD transfer pricing methodologies would be applied in Hong
Kong under the IRO. However, the IRD indicates a preference for the traditional
transfer pricing methods in DIPN 46, whereas the latest draft OECD position puts
all transfer pricing methods on an equal footing. This may imply that transfer
pricing documentation prepared based on the OECD Guidelines may not always be
accepted by the IRD;
DIPN 46 encourages the preparation of contemporaneous transfer pricing
documentation. Although the IRO does not mandate the preparation of transfer
pricing documentation, taxpayers are required to maintain suffcient documents to
substantiate their compliance with the arms-length principle under Section 51C of
the IRO. DIPN 46 also provides guidance on the type of information that is useful
tomaintain; and
DIPN 46 provides guidance on services in a related party context. Generally,
principles defned by the OECD are accepted by the IRD. However, DIPN 46
provides no guidance on safe harbour in respect of appropriate markups for
intragroup services and transfer pricing practice of cost-sharing arrangement.
3504 Legal cases
Ngai Lik Case
While the Ngai Lik case was primarily an anti-avoidance case, the CFAs decision in the
case has brought about transfer pricing implications for taxpayers engaged in offshore-
related party transactions. The case involves a reorganization scheme of the taxpayers
group. After the scheme, profts were shifted to related BVI entities that were newly
set up and had related party transactions with the taxpayer. The IRD considered that
Hong Kong
the scheme was entered into by the taxpayer with the sole or dominant purpose of
obtaining a tax beneft, contrary to the anti-avoidance provisions of Section 61A,
and assessed the profts of the BVI entities as those of the Hong Kong taxpayer under
Section 61A. The CFA, however, held that the Section 61A assessments raised by the
IRD in this case were not validly raised, because they were based on arbitrary amounts
rather than counteracting the tax beneft obtained by the taxpayer from its transfer
pricing arrangements. The CFA ordered that the assessments under Section 61A be
raised on the basis of a reasonable estimate of the assessable profts that the taxpayer
would have derived if it had hypothetically dealt with its related parties at an arms-
length price.
In addition, a clear but obiter part of the CFA judgment stated that the wording of the
expense deduction sections of the IRO, Sections 16(1), 17(1)(b) and 17(1)(c), would
not authorise the IRD to disallow the deduction of amounts expended for the purpose
of producing chargeable assessable profts simply on the basis that the amounts are
considered excessive or not at arms length. Rather, adjustments to the deduction
claims on the grounds that they are excessive could only be challenged by the anti-
avoidance sections, in particular Section 61A of the IRO. There appears to be a clear
argument based on these comments that, under the present provisions of the IRO, the
only real basis on which transfer pricing arrangements can be challenged by the IRD is
via the anti-avoidance provisions of the IRO, which is different from IRDs view in DIPN
46 that the use of Sections 16(1), 17(1)(b) and 17(1)(c) in the IRO is also applicable in
the context of transfer pricing issues. This creates a degree of uncertainty as to whether
IRO Sections 16(1), 17(1)(b) and 17(1)(c) are relevant to transfer pricing matters and
perhaps require a further CFA case to clarify.
In Hong Kong, the burden of proof lies with the taxpayers. Although the IRD does
not intend to impose disproportionate compliance costs on enterprises carrying on
business in Hong Kong, these enterprises are required to draw up their accounts
truly and fairly and may be called upon to justify their transfer prices and the
amount of profts or losses returned for tax purposes in the event of an enquiry, audit
orinvestigation.
Transfer pricing documentation is not mandatory under the IRO, and no specifc
details are provided in the IRO in relation to transfer-pricing-focused audits.
However, given that the statute of limitations in Hong Kong is seven years and the
view of the IRD as expressed in the DIPN 46 can be applied retrospectively, taxpayers
should keep good records to support the arms-length nature of their related party
transactions. Furthermore, to determine the accuracy of a tax return, the IRD may
require any taxpayer to provide suffcient records that would allow the IRD to obtain
full information in respect of the taxpayers income. Such records are required to
be maintained for a period of not less than seven years after the completion of the
transactions, acts or operations to which the taxpayer has undertaken.
The IRO does not provide a specifc penalty regime directed at a transfer pricing
offense, nor does DIPN 46 comment specifcally on penalties. Penalties may be
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imposed in accordance with the general penalty provisions. Taxpayers are potentially
subject to penalties under Section 82A in the event that transfer pricing is successfully
challenged by the IRD. In absence of a reasonable excuse and when the IRD
successfully challenges transfer pricing arrangements under anti-avoidance provisions,
penalties may apply. In Hong Kong, the IRD can theoretically apply penalties of up to
300% of underpaid tax.
The topic of transfer pricing is rather new in the IRDs agenda and, unlike in many
other countries, the IRD currently has no specifc unit devoted to deal with transfer
pricing investigations. However, we understand that the IRD is currently building
its expertise in the transfer pricing area by training its assessing staff as well as
participating in technical knowledge sharing and exchange seminars with tax
authorities in other jurisdictions.
Although the IRO does not mandate preparation of transfer pricing documentation,
DIPN 46 provides guidance on the types of information that is useful to maintain. Such
information includes an analysis of the functions and risks undertaken by the taxpayer,
and the methodology upon which it derived the transfer price through the use of
comparables in the benchmarking analysis.
Comparable information is generally available through various databases. No specifc
guidance is provided by the IRD on the sources of comparable data. We understand,
however, that the IRD has subscribed to the Bureau van Dijk (BvD) Electronic
Publishing SAs OSIRIS database.
3510. Limitation of double taxation and competent-
There is currently no mechanism to obtain double taxation relief for transfer pricing
adjustments made in a non-DTA context. In addition, the mechanism for double
taxation relief in a DTA context requires agreement by the IRD on the transfer pricing
adjustment made by the other side. This means that a corresponding adjustment made
in a DTA context is by no means automatic.
In case there is no agreement on the IRD side, taxpayers may seek to resolve the issue
with the competent authority of the other side through a mutual agreement procedure
(MAP). However, MAPs contain no obligation for both sides to reach an agreement on
resolving the double taxation that arises from transfer pricing adjustments.
DIPN 46 does not comment on the potential introduction of an APA regime in Hong
Kong to bring it in line with other developed countries. As such, currently, the only
avenue for obtaining upfront certainty on proposed transfer pricing arrangements is to
apply for a transfer-pricing-specifc ruling through Hong Kongs advance ruling process
under Section 88A of the IRO. Practically, however, there have been few cases where
the IRD has agreed to issue a ruling in connection with transfer-pricing-specifc issues.
Hong Kong
In a DTA context it is theoretically possible to apply for a bilateral APA, but to date this
has not happened.
As DIPN 46 is very new, it is yet to be seen how the IRD will effectively apply it to real
cases. However, we believe that if a taxpayers transactions with a closely connected
party, domestic or non-resident, are conducted with commercial justifcation and the
inter-company payment is set in line with the comments contained in DIPN 46, it is
likely that the transfer pricing policy would be acceptable to the IRD.
3513. OECD issues
Hong Kong is not a member of OECD. The IRD, however, expresses its view in DIPN
46 that it would generally seek to apply the principles in the OECD Guidelines, except
where they are incompatible with the express provisions of the IRO.
Hungary
36.
H
Hungary
3601. Introduction
Hungary became a member of the OECD in May 1996 and of the European Union on 1
May 2004.
Hungary introduced transfer pricing legislation in 1992, in Section 18 of the Corporate
and Dividend Tax Act (CDTA). Section 18 of the Hungarian CDTA prescribes the use of
the arms-length principle (referred to as the customary market price) when setting the
consideration associated with business contracts between affliated companies.
Hungary as an OECD member state has acknowledged that the arms-length principle
as defned in Article 9 of the OECD Model Tax Convention is the international transfer
pricing standard to be used.
The tools at the disposal of the tax authorities to monitor compliance include
notifcation requirements, documentation and tax audits. In addition to the
incremental tax that becomes payable, the costs of non-compliance with transfer
pricing rules include tax penalties of 50% of the adjustment as well as interest on late
payments of tax.
On 1 January 2003, a new subsection introducing transfer pricing documentation
requirements was added to Section 18 of the CDTA. This provision was followed by
more detailed regulations contained in Decree No. 18/2003 of the Ministry of Finance.
On 16 October 2009, Decree No. 22/2009. (X.16) of the Ministry of Finance was
published containing the changes of the documentation requirements pertaining to the
determination of the arms-length price. The amended decree came into effect as of 1
January 2010, and is frst applicable to the transfer pricing documentations regarding
the 2010 tax year.
These regulations require taxpayers to document each related party agreement with
respect to the method in which the arms-length price was determined, by the time
that the corporate income-tax return is due. Such documentation needs to be updated
for changes in the relevant circumstances that could cause unrelated third parties to
renegotiate the pricing terms and conditions.
International Transfer Pricing 2011 Hungary 441
Hungary
The penalty for non-compliance with the transfer pricing documentation requirements
is detailed in Section 172 (4) Act XCII on the rules of taxation and is a default penalty
of HUF2 million if the taxpayer fails to document its transfer pricing methods or retain
the relevant documents. The tax authorities have explained that non-compliance
includes lack of documentation, barely prepared documentation, or documentation
that does not meet the requirements determined in the law. The documentation must
cover each agreement, and the agreements cannot be consolidated unless the terms
of supply or performance are the same under the agreements or their subject matter is
closely related.
The basis of imposition of the default penalty is the subject of a continuing controversy
on the issue of whether the correct interpretation of the decree would impose the
default penalty in respect of each absence of documentation of each agreement
rather than per default identifed in a tax audit. The tax authorities have stated they
interpret the imposition of a default fne based on the number of agreements for which
documentation is not in place, counting each instance as a default.
Content requirements for the transfer pricing documentations regarding the 2010 tax
year are regulated by Decree No. 22/2009. As opposed to the provisions of the previous
decree, Decree No. 22/2009 allows the preparation of two different types of transfer
pricing documentation: a country-specifc, or a combined documentation. Taxpayers
are required to declare the option they choose in their corporate tax return.
The requirements regarding the country-specifc documentation mostly correspond to
those set out in Section 4 of Decree No. 18/2003 of the Ministry of Finance (i.e. details
of the related parties and inter-company transactions, industry analysis, company and
functional analysis, economical and fnancial analysis). According to the new decree,
taxpayers are allowed to prepare a combined transfer pricing documentation that shall
consist of two main parts:
The core documentation; and
The country-specifc documentation(s).
The core documentation should contain the following common standard information
with regard to each member company resident in any Member State of the
EuropeanUnion:
The general description of business structure;
The general description of the group in terms of its organisational, legal and
operational structure;
The general description of the related parties conducting controlled transactions
with EU group members;
The general description of the controlled transactions, as well as the functions
performed and risks assumed; and
The description of the transfer pricing policy or system within the group
The elements of the country-specifc documentation are generally similar in both
cases. The country-specifc documentation includes relevant data of the related parties
involved in the controlled transaction; general description of the taxpayers business
enterprise and business strategy; description of agreements; benchmark analysis; and
the description of comparable data.
Hungary 442 www.pwc.com/internationaltp
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Simplifed documentation
For transactions under agreements that do not exceed HUF50 million in value, net
of VAT, the new Decree No. 22/2009. of the Ministry of Finance also allows the use
of simplifed documentation. In contrast with Decree No. 18/2003, however, the
values of transactions shall be determined with respect to the period from the date of
execution of the contract until the last day of the fnancial year. This modifcation may
relate to the documentation requirements regarding the 2009 tax year if the date of
the preparation of the transfer pricing documentation is not prior to the date the new
decree enters into force, i.e. 1 January 2010. This type of documentation shall include:
the details of the related parties, the subject matter, date, terms and conditions of
the underlying agreement, benchmark study and the date when the documentation
wasprepared.
Exceptions
The requirement for documentation does not apply to individuals; small or
microenterprises (as defned in Section 3, Act XCV of 1999); or individuals and
transactions conducted on the stock exchange or at an offcially set price (however,
cases of insider trading, fraudulent attempts to infuence exchange rates or applying
prices in breach of legal regulations are not exempt).
3604. Legal cases
There has been little in the way of legal cases dealing with transfer pricing in Hungary.
Since the introduction of transfer pricing documentation requirements, the burden of
proof has passed on to the taxpayer. Taxpayers are required to support their related
party transactions with specifc documentation that has to be in place within fve
months of the end of the accounting period for which a corporate income-tax return
isfled.
As the documentation rules are clear as to the level of detail and approach
required, taxpayers are faced with carrying out a detailed analysis of their related
partytransactions.
In the event that adequate documentation is in place, it is up to the tax authorities
to demonstrate that the method selected, the search criteria and the uncontrolled
comparables identifed are not applicable. This assumes that the functions are correctly
determined and the fnancial analysis and implementation of related party agreements
are correctly disclosed.
The number of transfer pricing audits has increased signifcantly in the past year, and
this trend is expected to continue. During these audits, the tax authority reviews the
formal elements and also the supporting analysis of the inter-company transactions
from an arms-length point of view. Standard tax audits have raised queries regarding
the degree of compliance with the related party documentation regulations, with
increasing numbers of questions regarding the transfer pricing methodology selection.
Hungary
Facing budgetary pressures, the government has been under pressure to step
up enforcement activities. At the same time, in recent submissions on creating a
sustainable investment climate, the government has emphasised that it will also seek
to address taxpayers concerns of transparency in the enforcement of legislation.
regarding penalties, Hungarian tax authorities have been active in publicising that:
Penalties should not be considered to be a one-time payment as an alternative
tocompliance; and
Taxpayers will now be held to due dates, which previously have not been
strictlyenforced.
The penalties were introduced to encourage taxpayer compliance with the legislation
in the belief that the penalty would not have to be imposed. Non-compliance with the
legislation in practice has resulted in the recent public campaign of the tax authorities
to educate taxpayers about what is to come.
Examples of non-compliance include the imposition of penalties for not having
adequate transfer pricing documentation in place (i.e. the HUF2 million penalty)
and the requirement to have the documentation in place within fve months of the
accounting period end for which corporate income-tax declarations are required to
besubmitted.
Almost all Hungarian taxes are levied by self-assessment. In other words, the taxpayer
must fle the return and make any payment by the due date, without waiting for a
formal assessment or payment demand from the tax authorities.
In Hungary, a tax authority audit can be started at any time during the fve years
following the end of the year in which the return was originally due. The statutory
period of limitations for starting a tax audit is, therefore, six calendar years from the
year-end date. The tax auditors generally make feld visits to the taxpayers premises
lasting several weeks and covering a span of three to fve years. Their fndings are
discussed with the taxpayer and its representatives.
The tax authority will issue minutes on its fndings, and the taxpayer has 15 days to fle
their response to the minutes. The tax authority then issues its frst-level resolution.
Appeals against the frst-level resolution have to be fled within 30 days to a higher
authority within the tax administration. A second-level resolution may be issued by the
tax authority following the appeal against the frst-level resolution. The taxpayer can
then submit appeals against the second-level resolution to the relevant court.
Failure to comply with the Hungarian transfer pricing documentation regulations is
subject to a penalty of HUF2 million (approx. USD11,000).
Adequate and timely documentation should not be underestimated as an indicator of
the taxpayers good faith if transfer prices are queried. Good faith clearly will have a
bearing on the resolution of a transfer pricing dispute.
H
Transfer pricing adjustments (assuming they are in favour of the tax authority) could
not only increase the tax liability of the taxpayer but also result in a tax penalty of 50%
on any additional tax payable plus interest on late payment of tax at twice the base rate
of the National Bank of Hungary. As of 1 April 2010, the base rate of the National Bank
of Hungary was 5.5%.
In addition to the above, there is also the risk of double taxation when a
corresponding adjustment is not accepted in the other tax jurisdiction involved.
These risks exist for qualifying agreements in any of the years open to scrutiny by the
tax authority under the Hungarian statute of limitations, which is fve years.
The tax authority set up a central transfer pricing unit in 2006 to carry out transfer
pricing-specifc audits and assist in local general tax audits when a transfer pricing
issue is identifed. This unit also works closely with the department of large taxpayers,
which looks after the largest taxpayers in Hungary. As of 1 January 2007, the tax
authoritys directorate of high-importance taxpayers has sole jurisdiction in cases
defned by law, as well as in cases involving taxpayers regarded as high importance
under separate legislation. It is also responsible for conducting centralised inspections.
According to the Decree No. 37/2006 of the Ministry of Finance, high-importance
taxpayers include credit institutions and insurance companies organised as joint-stock
companies and (except for state entities, sole proprietors and private persons defned
by the Personal Income Tax Act), taxpayers with tax obligations (i.e. all tax obligations
of a company including those collected and payable by the company) of HUF2,200
million or more, provided that they are not subject to bankruptcy, liquidation, or
winding-up proceedings on the last day of the year preceding the tax year.
The largest 3,000 taxpayers in Hungary can expect tax audits at least every three years.
The tax authority has introduced a number of external databases, which it uses to
assist in its tax audits. The two major publicly available Hungarian databases are
KJK-Kerszv DVD Cghrek and IM Online, where public fnancial information can be
downloaded, on Hungarian companies. The tax authority also uses Bureau van Dijks
AMADEUS database and has developed its own internal database on the basis of the
fnancial information received during tax audits.
The tax authority has publicly stated that it considers entities that are either loss-
making or show an accounting proft of less than 2% of gross revenue as the subject of
particular attention in transfer pricing audits.
Hungary adopted legislation regarding advance pricing agreements on 1 January 2007.
The Decree No. 38/2006 of the Ministry of Finance details the procedure for making
Hungary
applications for advance pricing agreements. An application form is available at the
Hungarian Tax Authority website. (www.apeh.hu).
Procedure
The applications for advance pricing arrangements are lodged with the tax authoritys
central offce and are required to be co-signed by a tax adviser, a tax expert (a
registered professional tax specialist in Hungary), a chartered tax consultant, or a
lawyer. The application is subject to the following fees:
Fees
The fees are 1% of the arms-length price determined by the authority with the
following limits from 1 July 2009:
HUF500 000 but no more than HUF5 million for a unilateral APA where traditional
methods (CUP), resale price method (RPM), (CPM)) are applied;
HUF2 million but no more than HUF7 million for unilateral APA where other
(proft-based) methods (TNMM), proft split method (PSM) are applied;
HUF3 million for a bilateral APA but no more than HUF8 million; and
HUF5 million for a multilateral APA but no more than HUF15 million.
The application should be accompanied by a copy of the receipt certifying payment of
the application fee in full, duly signed by the issuing bank.
If an application for an advance pricing arrangement is dismissed, the tax authority
will refund 75% of the application fee to the taxpayer within 15 days of the resolution
on the dismissal of the application (usually 30 days after the issue of a resolution).
Notifcation to the local tax offce
All applications for an advance pricing arrangement are automatically notifed to the
local tax offce dealing with the day-to-day tax affairs of the taxpayer.
Appeals
Appeals against the frst instance resolution (ruling) must be addressed to the
chairman of the tax authority and fled with the tax authoritys central offce. If,
following an unsuccessful appeal, the resolution (ruling) is not cancelled, amended,
corrected, replaced or complemented as requested in the appeal, the decision on
the appeal must be prepared and presented to the chairman by a tax authority unit,
organisationally independent and separate from the unit that prepared the frst
resolution. This provides some comfort that there will at least be a peer review of
unsuccessful appeals.
Bilateral and multilateral procedures
In bilateral and multilateral procedures, the taxpayer will not be involved in the
exchange of information or multilateral procedure between the Hungarian Tax
Authority and the foreign tax authority or authorities. The Hungarian Tax Authority
does, however, have the right to request the applicant to supply, within eight days,
any additional information at the applicants disposal that is considered material
for the purposes of assessing the APA application, or for clarifying new facts, data or
circumstances, if any, that may emerge in the course of such procedures.
H
Verifcation audit
Once an application has been received and is determined to be complete, the tax
authorities should be expected to carry out a verifcation audit within 30 days
or acceptance of a complete application. This period can, as would be expected,
beextended.
Note: There is an annex to Decree No. 38/2006 of the Ministry of Finance that sets out
the details to be included in the advance pricing agreement application.
Advance pricing arrangement in practice
The tax authority requires information requested in the decree to be supplied in
advance of the submission of the application for advance pricing agreements, and it
is usual for a preliminary meeting to be held with the tax authorities to explain the
background of the application and clarify any initial queries that the tax authority
may have in respect of the information provided. The Hungarian Tax Authority is, in
practice, generally helpful in ensuring a smooth APA procedure for the taxpayer.
An interesting point to note is that there appears to be a clear preference to the
traditional methods of comparable uncontrolled price method, resale price and
cost-plus methods. The decree detailing the documentation rules clearly considers a
hierarchy of methods.
The Hungarian transfer pricing legislation continues to develop as part of the general
harmonisation with the EU legislation and directives and, therefore, taxpayers can
anticipate signifcant developments, both in terms of the quality of the tax audits and
legislative background. The past year has already seen an increase in the quality of tax
audits and imposition of default penalties where documentation is either incomplete or
not available. This trend is expected to continue.
3614. OECD issues
The Decree No 22/2009 of the Minister of Finance on Documentation states that it
is based on the OECD Transfer Pricing Guidelines for Multinational Enterprises and
Tax Administrations and related protocols, which include the OECD Transfer Pricing
Documentation Guidelines. Therefore the OECD transfer pricing developments should
be seen to play a major part in the development of transfer pricing legislation and
practice in Hungary.
Under Paragraph j) in Section 8 (1) of the Hungarian Corporate Tax Act, interest on
liabilities in an amount prorated to the portion of such liabilities that exceed three
times the equity capital results in an increase to the corporate tax base.
For purposes of thin capitalisation, liability means the average daily balance of
outstanding loans (with the exception of liabilities due from fnancial institutions) and
outstanding debt securities, while equity capital means the average daily balance of
subscribed capital, capital reserve, proft reserve and tied-up reserves.
Iceland
37.
International Transfer Pricing 2011 447 Iceland
3701. Introduction
Iceland has no direct transfer pricing legislation but it is a member of the OECD and
subscribes to the principles contained in the OECD Guidelines. However, there are no
direct references in Icelandic tax law or in other legislation to the OECD Guidelines.
In recent years, Icelandic companies engaged in international trade have become
increasingly aware of the needs and opportunities of a carefully structured transfer
pricing policy.
Icelandic tax authorities are showing an increased interest in implementing rules
and regulations on this issue, which will likely be based on the principles of the
OECDGuidelines.
Iceland has no collective statutory rules which are specifcally aimed at transfer
pricing. The statutory authority for addressing transfer pricing issues is found in the
application of general legal concepts, such as the anti-avoidance rule. Article 57 of the
Icelandic Income Tax Act No. 90/2003 (originally included in the tax code in 1971)
contains a general anti-avoidance rule stating that business transactions between all
parties should be based on the arms-length principle. With reference to the general
concept of this Article, tax authority can, in cases where transfer prices are not arms
length, adjust the taxpayers revenues and expenses so as to refect market value.
These adjustments can be performed only within the domestic statute of limitation
period (i.e. six years). Authorities have thus based its transfer pricing conclusions on
Article57.
The Income Tax Act includes several separate rules that can be identifed as transfer
pricing rules. However, those rules generally concern transactions between individuals
rather than between companies (e.g. a rule that obligates employees who receive their
wages in kind to account for them on their tax return based on market value).
The VAT Act also includes separate rules that can be identifed as transfer pricing rules,
as they address issues concerning how to price products when transactions between
related parties occur.
Transfer pricing issues will not be addressed unless there is a statutory rule that can be
built upon.
I
Iceland 448 www.pwc.com/internationaltp
Double tax conventions
In addition to domestic legislation, transfer pricing principles are stated in all double
tax conventions that Iceland has entered into with foreign countries. These principles
are based on Article 9 of the OECD Model Tax Convention.
Regulations
Iceland has no published regulations relating to transfer pricing.
OECD Guidelines
Iceland is a member country of the OECD and has embraced the OECD Guidelines for
transfer pricing purposes. In Iceland, it is expected that the OECD Guidelines and the
newly confrmed Code of Conduct for transfer pricing documentation in the EU will
likely have an impact in the future.
3704. Legal cases
Several legal cases concerning transfer pricing have reached the State Internal Revenue
Board. A few cases have also reached the District Courts and the Supreme Court of
Iceland. No transfer pricing cases are currently being processed through the courts.
In some legal cases of a different nature, it has been established that transfer pricing
issues can be addressed on the grounds of Article 57 of the Income Tax Act, even
though the rule is considered a general anti-avoidance clause. These cases also
established the arms-length principle for transactions between related parties.
The tax authorities carry the full burden of proof when trying to establish that a
transfer pricing adjustment is needed.
Tax audit procedures can be based on predetermined tax audit programmes or on a
random inspection of tax returns.
The tax authorities can request any information on the taxpayer and the taxpayer
must cooperate with the tax authorities on all tax audit procedures. The normal tax
audit is performed by local tax offces located around the country, but sometimes a
tax audit is performed by the Directorate of Internal Revenue and the Directorate of
Tax Investigations. Tax audits can be performed only within the domestic statute of
limitation period (i.e. six years).
The taxpayer has the right to an appeal to the local tax offce. This appeal must be
set forth within 30 days from the decision date. If the taxpayer does not meet that
deadline, then he or she can fle a complaint to the Director of Internal Revenue. Tax
authorities have two months to process the complaint. When a decision has been made,
the taxpayer can appeal to the State Internal Revenue Board within three months or
International Transfer Pricing 2011 Iceland 449
Iceland
take the case to the courts. The taxpayer can also wait for the decision of the State
Internal Revenue Board and then appeal it to the courts.
Penalties in the range of 15%25% on top of the tax base are applied where an
adjustment is performed based on a transfer pricing tax audit or a general tax audit.
No special transfer pricing unit operates within the Icelandic tax authorities.
The tax authorities have employees who are able to review any of the transfer pricing
transactions brought to its attention through tax audits or requests for binding rulings.
Icelandic tax authorities have participated in Nordic collaboration meetings on
transfer pricing issues and are formal participants in a Scandinavian work group that is
researching and developing rules on transfer pricing.
No comprehensive databases containing third-party comparable information are
available in Iceland.
The fnancial statements of all Icelandic companies are publicly available,
and the fnancial information contained therein can be used in searching for
comparableinformation.
There is no legal demand for documenting transfer pricing policies for Icelandic
companies when determining its transfer prices, but there is a legal demand for all
transfer pricing issues to be based on the arms-length principle.
3711. Risk transaction or industries
No particular transactions run a higher risk of being subject to investigation than
others, although cases regarding inter-company loans and fees seem to be at
theforefront.
The tax authorities can reopen a tax assessment upon request if there has been a
transfer pricing adjustment in a country with which Iceland has a treaty connection.
Those issues are addressed in the mutual agreement procedure provisions in double
taxation treaties aiming to avoid double taxation. Currently, tax authorities do not
follow any formal procedures, but in general proceedings have worked well with a
good fow of information between countries.
No APAs have been entered into in Iceland and no formal procedure for obtaining
such agreements exists. However, it is possible to obtain a binding ruling from the tax
Iceland 450 www.pwc.com/internationaltp
I
authorities or the Ministry of Finance according to Act 91/1998 in connection with a
particular transfer pricing issue that has not yet been executed.
No changes in law have been presented. Icelandic tax authorities are, however,
showing an increased interest in implementing rules and regulations on this issue,
which will likely be based on the OECD Guidelines.
No formal cooperation exists between the tax authorities and the customs
authorities on transfer pricing issues. However, these organisations may join forces if
deemednecessary.
3716. OECD issues
Iceland is a member country of the OECD and, as such, has embraced the OECD
Guidelines for transfer pricing.
When dealing with transfer pricing issues in the past, Icelandic authorities have not
based their decisions or referred to the OECD Guidelines.
The transfer pricing rule stated in all of Icelands double taxation conventions is based
on Article 9 of the OECD Model Tax Convention.
Icelandic authorities have not participated in any formal joint investigations in
connection with transfer pricing issues. However, it is not unlikely that they will do so
with other Nordic countries in the future.
Iceland has no statutory rules on thin capitalisation.
The general arms-length principle applies for charging management fees to
Icelandiccompanies.
India
38.
International Transfer Pricing 2011 451 India
3801. Introduction
A separate code on transfer pricing under Sections 92 to 92F of the Indian Income Tax
Act, 1961 (Act), covers intragroup cross-border transactions and is applicable from
1 April 2001. Since introduction of the code, transfer pricing has become the most
important international tax issue affecting multinational enterprises operating in India.
The regulations are broadly based on the OECD Guidelines and describe the various
transfer pricing methods, impose extensive annual transfer pricing documentation
requirements and contain harsh penal provisions for noncompliance.
3802. Statutory rules and regulations
The Indian Transfer Pricing Code prescribes that income arising from international
transactions between associated enterprises should be computed having regard to the
arms-length price. It has been clarifed that the allowance for any expense or interest
arising from an international transaction also shall be determined having regard to the
arms-length price. The terms international transactions, associated enterprises and
arms-length price have been defned in the Indian Income Tax Act.
Type of transactions covered
In general, the Indian tax authorities do not believe that domestic transactions will
erode Indias tax base because any shifted income is ultimately subject to tax in India.
Consequently, the legislation mainly applies to cross-border transactions.
Section 92B of the act defnes the term international transaction to mean a
transaction between two (or more) associated enterprises involving the sale, purchase
or lease of tangible or intangible property, provision of services, cost-sharing
arrangements, lending/borrowing of money, or any other transaction having a bearing
on the profts, income, losses or assets of such enterprises. The associated enterprises
could be either two non-residents or a resident and a non-resident. Furthermore, a
permanent establishment (PE) of a foreign enterprise also qualifes as an associated
enterprise. Accordingly, transactions between a foreign enterprise and its Indian PE are
within the ambit of the code.
Associated enterprises
The relationship of associated enterprises is defned by Section 92A of the Act to cover
direct/indirect participation in the management, control or capital of an enterprise
by another enterprise. It also covers situations in which the same person (directly or
indirectly) participates in the management, control or capital of both the enterprises.
I
India 452 www.pwc.com/internationaltp
In addition to this defnition, certain other specifc parameters have been laid down,
based on which two enterprises would be deemed as associated enterprises.
These parameters include:
Direct/indirect holding of 26% or more voting power in an enterprise by the other
enterprise or in both the enterprises by the same person;
Advancement of a loan, by an enterprise, that constitutes 51% or more of the total
book value of the assets of the borrowing enterprise;
Guarantee by an enterprise for 10% or more of total borrowings of the
otherenterprise;
Appointment by an enterprise of more than 50% of the board of directors or one
or more executive directors of an enterprise, or the appointment of specifed
directorships of both enterprises by the same person;
Complete dependence of an enterprise (in carrying on its business) on the
intellectual property licensed to it by the other enterprise;
Substantial purchase of raw material/sale of manufactured goods by an enterprise
from/to the other enterprise at prices and conditions infuenced by the latter; and
The existence of any prescribed relationship of mutual interest (none prescribed
todate).
Furthermore, in certain cases, a transaction between an enterprise and a third party
may be deemed to be a transaction between associated enterprises, if there exists
a prior agreement in relation to such transaction between the third party and an
associated enterprise or if the terms of such transaction are determined in substance
between the third party and an associated enterprise. Accordingly, this rule aims to
counter any move by taxpayers to avoid the transfer pricing regulations by interposing
third parties between group entities.
The arms-length principle and pricing methodologies
The term arms-length price is defned by Section 92F of the Income Tax Act to
mean a price that is applied or is proposed to be applied to transactions between
persons other than associated enterprises in uncontrolled conditions. The following
methods have been prescribed by Section 92C of the act for the determination of the
arms-lengthprice:
Comparable uncontrolled price method (CUP);
Cost plus method (CPM);
Transactional net margin method (TNMM); and
Such other methods as may be prescribed (no additional method has yet
beenprescribed).
No particular method has been accorded a greater or lesser priority. The most
appropriate method for a particular transaction would need to be determined having
regard to the nature of the transaction, class of transaction or associated persons and
functions performed by such persons as well as other relevant factors.
The legislation requires a taxpayer to determine an arms-length price for international
transactions. It further provides that where more than one arms-length price is
determined by applying the most appropriate transfer pricing method, the arithmetic
International Transfer Pricing 2011 India 453
India
mean (average) of such prices shall be the arms-length price of the international
transaction. Accordingly, the Indian legislation does not recognise the concept of arms-
length range but requires the determination of a single arms-length price.
However, some fexibility has been extended to taxpayers by allowing a +/-5% range
of the arithmetic mean of uncontrolled prices. There has been a long drawn litigation
with regard to the admissibility of the 5% range between the taxpayer and the Revenue
since the inception of the transfer pricing audits in India. The Revenue have been
of the view that the beneft of the range should be given only where the taxpayers
transaction price is within the +/-5% range of the mean arms-length price. Taxpayers,
on the other hand, have argued that the beneft should be allowed even when the
transaction price falls outside this range. The Indian Tribunals, which are the second
stage appellate authorities, have unanimously sided with the taxpayer on this matter.
In order to bring an end to this dispute, the Finance (No. 2) Act, 2009 w.e.f.1 October
2009 has been amended to provide that the arms-length price shall be the arithmetic
mean of prices determined by the most appropriate method. In cases for which the
variation between such arms-length price and the transfer price to the taxpayer does
not exceed 5% of the transfer price, the taxpayers price shall be deemed to be at arms
length. It also seeks to clarify the position by proposing that the beneft of the 5% range
would be available only if the arms-length price falls within +/-5% range of transfer
price. This, in turn, would have the effect of disallowing the beneft to taxpayers where
variation between the arms-length price and transfer price of the taxpayer exceeds
5%, leading to transfer pricing adjustments even though the transfer price is only
marginally outside the range.
In addition, it is provided that transfer pricing provisions will not be applicable when
the application of arms-length price results in a downward revision in the income
chargeable to tax in India.
Taxpayers are required to maintain, on an annual basis, a set of extensive information
and documents relating to international transactions undertaken with associated
enterprises. Rule 10D of the Income Tax Rules (1962) prescribes detailed information
and documentation that has to be maintained by the taxpayer. Such requirements can
broadly be divided into two parts.
The frst part of the rule lists mandatory documents/information that must be
maintained by a taxpayer. The extensive list under this part includes information on
ownership structure of the taxpayer, group profle, business overview of the taxpayer
and associated enterprises, prescribed details (nature, terms, quantity, value, etc.) of
international transactions, and relevant fnancial forecasts/estimates of the taxpayer,
etc. The rule also requires the taxpayer to document a comprehensive transfer pricing
study. The requirement in this respect includes documentation of functions performed,
risks assumed, assets employed, details (nature, terms and conditions) of relevant
uncontrolled transactions, comparability analysis, benchmarking studies, assumptions,
1
A scheme of Advance Rulings has been introduced under the Act in order to provide the facility to nonresidents and
certain categories of residents, of ascertaining their income tax liability, planning their income tax affairs well in advance
and avoiding long drawn and expensive litigation, An Authority for Advance Rulings has accordingly been constituted. The
nonresident / resident can obtain binding rulings from the Authority on question of law or fact arising out of any transaction /
proposed transactions which are relevant for the determination of his tax liability.
I
policies, details of adjustments, explanations as to the selection of the most appropriate
transfer pricing method, etc.
The second part of the rule requires that adequate documentation be maintained that
substantiates the information/analysis/studies documented under the frst part of the
rule (discussed above). This part of the rule also contains a recommended list of such
supporting documents, which includes government publications, reports, studies,
technical publications/market research studies undertaken by reputed institutions,
price publications, relevant agreements, contracts, correspondence, etc.
Taxpayers having aggregate international transactions below the prescribed
threshold of INR10 million are relieved from maintaining the prescribed
documentation. However, even in these cases, it is imperative that the documentation
maintained should be adequate to substantiate the arms-length prices of
internationaltransactions.
All prescribed documents and information have to be contemporaneously maintained
(to the extent possible) and must be in place by the due date of the tax return fling.
Companies are currently required to fle their tax returns on or before 30 September
following the close of the relevant tax year. The prescribed documents must be
maintained for a period of nine years from the end of the relevant tax year, and must
be updated annually on an ongoing basis.
The documentation requirements are also applicable to foreign companies deriving
income liable to Indian withholding tax.
It should be noted that, with effect from April 2009, the Central Board of Direct Taxes
(CBDT) has been empowered to formulate safe harbour rules. These rules will specify
the circumstances in which the tax authorities will accept the arms-length price as
declared by a taxpayer, without detailed analysis. The basic intention behind the
introduction of these rules is to reduce the impact of judgmental errors in determining
the transfer prices of international transactions. To date no safe harbour rules have
been issued by the CBDT. However, the adaptation of these rules might help relieve
the taxpayers of the burden of carrying out detailed comparability analysis and
benchmarking studies in support of their inter-company transactions.
Accountants report
It is mandatory for all taxpayers, without exception, to obtain an independent
accountants report in respect of all international transactions between associated
enterprises. The report has to be furnished by the due date of the tax return fling (i.e.
on or before 30 September). The form of the report has been prescribed. The report
requires the accountant to give an opinion on the proper maintenance of prescribed
documents and information by the taxpayer. Furthermore, the accountant is required
to certify the correctness of an extensive list of prescribed particulars.
The Authority for Advance Rulings (AAR)
1
has delivered a ruling in the case of
Vanenburg Group B.V., wherein it was held that the provisions relating to the
determination of the arms-length price are machinery provisions, which would not
apply in the absence of liability to pay tax, and accordingly, a taxpayer would not be
India
required to comply with the transfer pricing legislation in respect of income, which is
not chargeable to tax in India.
Based on this ruling, a possible view exists that where it is established that the income
is not subject to tax in India (under the provisions of the Act/DTAA), the taxpayer
would not be required to comply with the legislation relating to the maintenance of
transfer pricing documentation and furnishing of an accountants report.
It is relevant to note that although the ruling is binding only on the applicant who had
sought it, it does carry a certain degree of persuasive value.
In this context, it is important to note that entities that are enjoying a tax holiday
in India still need to comply with transfer pricing provisions and would need to
demonstrate that their international transactions have been carried out at arms
length. In addition, such entities would not be entitled to tax holiday on any upward
adjustment made to their transfer prices in course of assessments.
The burden of proving the arms-length nature of a transaction primarily lies with the
taxpayer. If the tax authorities, during assessment proceedings on the basis of material,
information or documents in their possession, are of the opinion that the arms-
length price was not applied to the transaction, or adequate and correct documents/
information/data were not maintained/produced by the taxpayer, the total taxable
income of the taxpayer may be recomputed after a hearing opportunity is granted to
the taxpayer.
3804. Tax audit procedure
Transfer prices are investigated by specialised transfer pricing offcers (TPO) in the
course of general tax audit procedures. A certain percentage of tax returns are selected
for detailed audit. A notice to this effect has to be statutorily dispatched to the taxpayer
within six months from the end of the fnancial year in which the return is furnished.
Such notice specifes the records, documents and details that are required to be
produced before the tax offcer.
Once an audit is initiated, the corporate tax assessing offcer (AO) may refer the
case to a TPO for the purpose of computing the arms-length price of international
transactions. Such reference may be made by the AO wherever s/he considers it
necessary. However, this can be done only with the prior approval of the commissioner
of income tax. In accordance with prevailing internal administrative guidelines of the
Revenue, all taxpayers having an aggregate value of international transactions with
associated enterprises in excess of INR50 million are referred to the TPO for detailed
investigation of their transfer prices. The threshold of INR50 million may be reviewed
on an ongoing basis.
The TPO would then send a notice to the taxpayer requiring the production of
necessary evidence to support the computation of the arms-length price of the
international transactions. The prescribed documentation/information maintained by
the taxpayer in respect of its transfer pricing arrangements would have to be produced
before the tax authorities during the course of audit proceedings within 30 days after
such request has been made. The period of 30 days can be extended to 60 days at most.
I
The TPO would undertake a detailed scrutiny of the case, taking into account all
relevant factors such as appropriateness of the transfer pricing method applied,
correctness of data, etc. The TPO is vested with powers of inspection, discovery,
enforcing attendance, examining a person under oath, compelling the production of
books of account/other relevant documents and information.
After taking into account all relevant material, the TPO would pass an order
determining the arms-length price of the taxpayers international transactions. A copy
of the order would be sent to the AO as well as the taxpayer. On receipt of the TPOs
order, the AO would compute the total income of the taxpayer by applying the arms-
length price determined by the TPO and pass an order within the time limit prescribed
for completion of scrutiny assessments.
Normally, scrutiny assessments are required to be completed within an upper time limit
of 33 months from the end of the relevant tax year. However, scrutiny assessments
involving transfer pricing audits would have to be completed within 45 months from
the end of the relevant tax year. This indicates that the Revenue intend to increase their
emphasis on transfer pricing audits. It is important to note that India completed its ffth
round of transfer pricing audits in October 2009.
3805. Revised assessments and appeals procedure
A taxpayer who is aggrieved by an order passed by the AO may appeal to the
commissioner of income tax, also called the appellate commissioner, within 30 days
of the date of receipt of the scrutiny assessment order. The offce of the appellate
commissioner is a type of quasijudicial authority, where both the Revenue and the
taxpayers make representations in support of their claims. The decision of the appellate
commissioner is refected in an appellate order.
An alternative dispute resolution mechanism has been instituted by the Finance Act
(2009) in order to facilitate expeditious resolution of disputes in all cases involving
transfer pricing and foreign company taxation. It has introduced the concept of draft
assessment orders, which would be issued by the AO pertaining to the order of the TPO
that is prejudicial to the taxpayer. Such draft orders would be issued for assessments
that are concluded on or after 1 October 2009. In cases involving foreign companies or
companies suffering transfer pricing adjustments, the AO is required to forward a draft
assessment order to the taxpayer, which would ordinarily include the order of the TPO.
A dispute resolution panel (DRP), comprising a collegium of three commissioners of
income tax, is constituted, to which the taxpayer would have recourse on receiving the
draft assessment order from the AO.
At this stage, the taxpayer has two choices: It could either accept the draft order as it
is, or seek to refer the matter to the DRP. The taxpayer has to communicate its decision
to the AO within 30 days of the receipt of the draft order. If the order is accepted by
the taxpayer as it is, the draft would be fnalised by the AO and served to the taxpayer.
If the matter is referred to the DRP, the panel would have nine months from the time
of referral to decide the matter, taking into consideration the draft order of the AO,
the order of the TPO and the taxpayers objections and evidence. The draft assessment
order would be fnalised after the DRP has rendered its decision to the AO. If the
taxpayer does not communicate its decision to refer the draft order to the DRP within
India
30 days, the AO would fnalise the assessment order without modifcation of the draft
assessment order.
However, an order of the AO that is based on the direction of the DRP would be
appealable directly to the income tax appellate tribunal. The orders passed by the AO
pursuant to the directions of the DRP are binding on the Revenue.
It is also clarifed that the taxpayer would have to take a call as to whether to opt
for the alternate dispute resolution mechanism route based on the draft assessment
order or fle an appeal in the normal course with the appellate commissioner against
the assessment order. Thus, the order of the AO can be agitated before the appellate
commissioner in the ordinary course (i.e. if it is not referred to the DRP).
Taxpayers that still feel aggrieved by the order of the appellate commissioner or, as
the case may be, the order of the AO passed in conformity with the directions of the
DRP have the right to appeal to the appellate tribunal, thereafter to the jurisdictional
High Court, and fnally to the Supreme Court. A similar right to appeal also rests with
the Revenue, except in cases where the DRP issues directions. In case of the latter (i.e.
where the DRP issues directions) these directions are binding on the Revenue and they
consequently lose their right to appeal.
The following stringent penalties have been prescribed for noncompliance with the
provisions of the transfer pricing code:
For failure to maintain the prescribed information/document: 2% of
transactionvalue;
For failure to furnish information/documents during audit: 2% of
transactionvalue;
For adjustment to taxpayers income: 100% to 300% of the total tax on the
adjustment amount; and
For failure to furnish an accountants report: INR100,000.
Further, taxable income enhanced as a result of transfer pricing adjustments does not
qualify for various tax concessions/holidays prescribed by the Income Tax Act.
3807. Legal cases
Since the enactment of the transfer pricing legislation took effect from 1 April 2001,
Indian tax authorities have completed fve rounds of transfer pricing audits. Since the
introduction of the legislation, there have been a few noteworthy judicial cases, which
have established important transfer pricing principles. These are summarised below:
Honeywell Automation India Ltd.
Facts and contentions:
The taxpayer is engaged in providing integrated automation and software solutions
for industrial and residential applications. In its transfer pricing documentation, the
taxpayer bifurcated the system integration division into two functionally separate
segments, one of which was incurring losses. The taxpayer argued that the loss in that
segment was due to certain economic and commercial reasons.
I
During the assessment proceedings, the TPO did not approve of the arms-length
nature of international transaction involving purchase of raw material for the system
integration division, which was benchmarked by the taxpayer applying TNMM as
the most appropriate method. However, the TPO held that since the subsegments
were part of the business of rendering system integration activities under the system
integration division, the operating proft of the entire division ought to be considered
for benchmarking analysis. Furthermore, not agreeing with the comparables selected
by the taxpayer, the TPO conducted a fresh comparables search. On an appeal by the
taxpayer to the appellate commissioner, the latter upheld the adjustment made by
theTPO.
Aggrieved by the order, the taxpayer appealed before the Appellate Tribunal and raised
limited arguments pertaining to the following:
Rejection of one loss-making comparable, which was considered by the TPO as a
comparable company in the previous years assessment; and
Exclusion of certain expenses while computing the operating margin.
Specifcally, in respect of provision for future losses made in the fnancial statements,
countering the appeal of the taxpayer, the Revenue argued that the fnancial statement
of the loss-making comparable was not available for the relevant fnancial year
and submitted that the appeal of the taxpayer on exclusion of costs should not be
entertained, as it was not made before the TPO and appellate commissioner.
Ruling
On perusal of the case, the Appellate Tribunal ruled that the comparable fnancial
data of earlier or subsequent years may be considered under Indias transfer pricing
regulations only in certain circumstances, wherein such data revealed facts or has
an infuence on the determination of transfer prices in relation to the transaction
beingcompared.
Accordingly, exclusion of a loss-making comparable to which the fnancial data was
not available for the fnancial year ended 31 March 2004, was upheld. In other words,
where the fnancial data of the company transgresses the relevant fnancial year, it
may not be regarded as a valid comparable. Furthermore, the Appellate Tribunal
upheld that in the application of TNMM as the most appropriate method, only those
incomes or losses having nexus to operating income or loss of the enterprise should be
considered. The matter was remanded to the TPO for determination on this account.
Comments/conclusions:
This ruling provided guidance on the use of comparable data and laid down that
comparable data for subsequent years should not be used in a comparability analysis.
Moreover, data for earlier years may not be considered for comparability analysis
unless such data reveals facts that could have infuence on determination of transfer
prices relating to transactions being compared. Furthermore, only items of income/
expenses having a nexus with the operating profts/losses should be considered for
comparability analysis.
Schefenacker Motherson Limited
Facts and contentions
Schefenacker Motherson Limited (SML) is a joint venture company engaged in the
manufacture of rear-view mirrors and cable assembly for rear-view mirrors for the
India
automobile manufacturing companies. The rear-view mirrors were supplied to the
automobile manufacturing companies in India, and the cable assemblies were exported
outside India to group entities.
SML applied TNMM to substantiate the arms-length pricing and used cash proft to
sales as the proft level indicator (PLI) in order to remove the effect of differences in
capacity utilisation, technology used, age of assets used in production and depreciation
policies between SML and comparable companies. TPO rejected the use of cash
proft to sales as the acceptable PLI and on appeal by the taxpayer to the appellate
commissioner. The appellate commissioner also upheld the order of TPO.
Ruling
The Appellate Tribunal overturned the appellate commissioners order and allowed the
adjustment to depreciation and the use of cash proft to sales as the PLI. The Appellate
Tribunal opined that the elements that constitute operating income should be decided
on a case-by-case basis depending on the facts, circumstances and nature of business
involved. The Appellate Tribunal observed that there were vast differences in the age
of machinery used and the investment in machinery between SML and comparable
companies. Accordingly, the Tribunal allowed the exclusion of depreciation while
computing operating margin.
The ruling highlights that the fundamental principle of comparability analysis is to
compare like with like. For this purpose, adjustments should be made for material
differences to make transactions/entities comparable to each other. Furthermore, the
ruling creates a precedent in support of the use of cash proft to sales or cash proft to
cost as a PLI in applying the TNMM in certain circumstances.
Skoda Auto India Private Limited
The taxpayer is engaged in the manufacture of passenger cars. The key international
transactions of the taxpayer involved the purchase of kits and payment of royalties,
the pricing of which was justifed using TNMM as the most appropriate method.
The taxpayer selected six car manufacturers as comparables and used the average of
multiple years data. In addition, CUP data (in the form of transaction price between
the parent company and other group companies) was used as a corroborative analysis
for the transaction of purchase of kits. The TPO rejected the application of the CUP
and further made an adjustment by disregarding certain comparables selected by the
taxpayer. On appeal by the taxpayer to the appellate commissioner, the latter upheld
the order of TPO.
At the Appellate Tribunal level, the taxpayer argued on the following issues:
Differences in business models of comparable companies (full-fedged
manufacturers) vis--vis the company (operating as an assembler); and
Low-capacity utilisation of the taxpayer as it was in the startup phase.
Ruling
The Appellate Tribunal upheld the rejection of CUP because the application of the
method by the taxpayer involved using controlled transactions as the basis, and in
principle, emphasised the need to undertake economic adjustments on account of
I
functional differences in order to ensure appropriate comparability. The Appellate
Tribunal laid down that:
Wherever necessary, economic adjustments (for capacity utilisation, unusual high
startup costs) should be made;
The taxpayer cannot be expected to get detailed information, which is not available
in the public domain;
In the absence of information in the public domain for making the adjustments,
approximations and assumptions can be relied upon; and
The beneft of the +/-5% range should be allowed to the taxpayer
However, considering that the arguments for low-capacity utilisation and adjustment
on account of functional differences were raised by the taxpayer only at the Appellate
Tribunal level, the Appellate Tribunal remitted the matter to the TPO for fresh
adjudication with specifc instructions to consider:
The impact of additionally borne non-cenvatable import duties;
The analysis of imports for the subsequent years to verify reduction in imports;
The relevance of product cycle and its impact on operating margins; and
Other options to neutralise the impact of higher costs.
The principle of adjustment for high startup costs enunciated in the judgment holds
signifcant value for companies that are in their initial stage of operations. The ruling
reemphasises the fact that a comparison should be made after economic adjustments
whenever necessary.
MSS India Pvt. Ltd.
The taxpayer, a 100% export-oriented unit, is engaged in the business of manufacture
and sale of high-quality kits of components and strap connectors. In the taxpayers
transfer pricing documentation, international transactions relating to import of raw
material and export of fnished goods were benchmarked using the CPM. The price
charged for import of raw material by the associated enterprise (AE) was determined
based on rates prevailing at London Metal Exchange, and a markup ranging between
2% and 6% was charged by the AEs towards services provided in relation to purchases
and freight and insurance. With regard to the export of fnished goods, the gross
margin earned on its exports to AEs was demonstrated to be comparable to gross
margins earned from exports to unrelated enterprises.
During the assessment proceedings, the TPO observed that the taxpayer had a history
of earning profts, and that the year under consideration was an exceptional year in
which it had incurred loss. Therefore, the TPO rejected the analysis conducted by
the taxpayer to demonstrate the arms-length nature of international transactions,
applied the TNMM using operating proft before tax to sales as the PLI. Accordingly,
the TPO made a transfer pricing adjustment by re-computing the operating revenue
of the taxpayer. The frst appellate level authority held that in view of the fact that
the taxpayer is a 100% EOU entitled to a tax holiday, there could not have been any
intention to avoid tax. Furthermore, the adjustment made by the TPO was deleted by
the appellate commissioner. Aggrieved by the order, the Revenue preferred an appeal
before the Appellate Tribunal.
India
Ruling
The Appellate Tribunal, with regard to the point relating to non-applicability of
transfer pricing provisions, dismissed the conclusion of the appellate commissioner to
the effect that transfer pricing provisions could not have been invoked on the facts of
the case because the taxpayer did not have any tax-avoidance motive. Furthermore,
it made reference to OECD transfer pricing principles, indicating preference for the
adoption of transactional proft methods to be applied only in cases in which it is not
possible to apply traditional transaction methods.
The Appellate Tribunal, in the context of the import of raw material from AEs, held that
the prices quoted on the exchanges after making appropriate adjustments to account
for differences was a suitable external comparable uncontrolled price. Regarding the
export of fnished goods to AEs, the Appellate Tribunal indicated that the Revenue
had not found any inconsistencies or factual error in the taxpayers determination
of ALP. In addition, the Appellate Tribunal held that as long as the prices at which
the international transactions are entered into are arms length, it is hardly relevant
whether the AE has ensured that the taxpayer has made a reasonable proft.
A few important principles that emerged from this ruling include:
The applicability of transfer pricing principles regardless of the tax benefts
accruing to the taxpayer;
The preference of traditional transfer pricing methods based on the fact pattern;
Emphasis on the transfer price as opposed to operating proftability; and
Once the initial burden of proof is discharged by the taxpayer, the onus shifts to
the Revenue to point out the reasons for not accepting the results presented by the
taxpayer.
UCB India Pvt Ltd
The taxpayer characterised itself as a licensed manufacturer and used the TNMM as
the most appropriate method. The taxpayer aggregated the results of its manufacturing
operations (comprising of formulations manufactured from imported as well as
locally purchased/manufactured API) and its distribution operations (small portion
of the turnover) and compared the combined proft margin with that of comparable
Indiancompanies.
The TPO rejected the TNMM analysis undertaken by the taxpayer and considered the
CUP method as the most appropriate method. The TPO compared the purchase price
of APIs imported by the taxpayer from an AE, with the price at which generic APIs were
purchased by the taxpayers competitors.
The taxpayer contended that because API1 is an originally researched raw material
of the foreign parent, the price of the taxpayers original research API may not be
compared with the price of a generic API. Therefore, the CUP method may not be
applied in its case. In addition, the CUP information used by the TPO was not available
in the public domain; therefore, it may not be used for the purpose of comparability
analysis. The TPO did not undertake a FAR analysis of the competitors selected by him
for CUP analysis.
I
The Revenue contended that TNMM is not the most appropriate method because:
It evaluates the effect of the international transaction only on profts, not the
international transaction itself;
The taxpayer had compared the profts at an entity level rather than the profts
arising from the international transactions; and
The taxpayer had not demonstrated that comparable companies were similar to the
taxpayer in terms of FAR analysis.
Ruling
The Appellate Tribunal held that the taxpayer had substantially complied with the
law in respect of maintenance of prescribed documentation. In relation to adoption of
the most appropriate method for determination of arms-length price, the Appellate
Tribunal disapproved the use of TNMM analysis on an entitywide basis by the taxpayer.
The Appellate Tribunal observed that TNMM refers to only net proft margin realised
by an enterprise from an international transaction or a class of such transactions,
but not operating margins of the enterprise as a whole. The Appellate Tribunal did
not accept the taxpayers arguments that it was not practically possible to look at
transaction level margins. It held that if a taxpayer wants to adopt a particular method
as the most appropriate method, then it is the taxpayers duty to maintain and furnish
the required data. However, the Appellate Tribunal also rejected the adoption of the
CUP method by the Revenue on the basis that it suffers from many defciencies and
infrmities, specifcally the lack of information and data on comparables.
On perusal of the case, the Appellate Tribunal ruled that as the transfer pricing
regulations were relatively new, the case required special consideration. The matter
was remanded to the AO for fresh adjudication with specifc directions that if external
comparables are not available due to lack of data in the public domain, the AO may
accept internal comparables including segmented data or internal TNMM. While
so remanding, the Appellate Tribunal allowed the taxpayer to adopt any method
prescribed under law that it considers to be the most appropriate method. It also
allowed the taxpayer to submit additional evidences, information and a fresh transfer
pricing study to support its case.
This Tribunal ruling emphasises the importance for companies to maintain detailed
segmented information for transactions with AEs and non-AEs and for substantiating
the basis of pricing the international transactions.
Quark Systems Pvt Ltd
The taxpayer is engaged in providing customer support services to AE. In the transfer
pricing documentation, TNMM was applied as the most appropriate method, and the
transfer price computed based on the returns earned by the comparable companies
identifed was concluded to be at arms length. During the scrutiny, the Revenue
rejected one company selected as comparable by the taxpayer on the grounds that the
company was in its startup phase and had made losses for consecutive years. The frst
level of appellate authority upheld the order of the Revenue and also observed that
the beneft range of 5% be granted to the taxpayer in determination of ALP. Aggrieved
by the order, both the taxpayer and the Revenue preferred an appeal before the
AppellateTribunal.
India
Before the Appellate Tribunal, the taxpayer argued that the comparable company
rejected by the Revenue had successfully passed through the quantitative revenue flter
applied in the taxpayers transfer pricing documentation, and it was also emphasised
that this comparable company did not have any startup expense during the period and
was fully functional based on number of employees on the payroll. The taxpayer also
contested that once functional comparability is established, the comparable should
not be rejected on grounds such as startup phase, negative net worth, etc. In addition,
before the Appellate Tribunal, the taxpayer argued for the rejection of one high-
margin comparable company on the basis that the company had signifcant controlled
transactions and also brought to the notice of the Appellate Tribunal the mathematical
error in computation of ALP.
The Revenue argued functional incomparability, negative net worth, and startup
phase against the company contested to be included by the taxpayer. In relation to the
company that the taxpayer requested to be rejected, the Revenue argued that once the
taxpayer has included a company within its list of comparables, it is not proper for the
taxpayer to reject this.
Ruling
In its ruling, remanding the order back to the Revenue, the Appellate Tribunal
upheld the need for a proper FAR analysis of the tested party and the comparables
in determination of ALP and objected to the selection of comparables merely on the
basis of business classifcation provided in the database. The Appellate Tribunal also
highlighted the need to follow principles of substantial justice, where the taxpayer
should be given an opportunity to rectify a bona fde mistake when it is based on facts
on record.
The ruling emphasised that selection of comparables rests on a proper FAR analysis
and principle of substantial justice to be considered in applying the burden of proof. In
addition, the Appellate Tribunal held that the taxpayer may reject its own comparable
selected in the TP study on merits, in light of the additional/substantive facts available
at the time of a transfer pricing audit.
CA Computer Associates Pvt Ltd
The taxpayer is engaged in the business of distribution of software products of AE in
India and development of software. During the year, the taxpayer had made payments
of royalty/licence fee to the AE for the software product distributed and applied the
CUP method to support the arms-length nature of the international transaction.
Furthermore, the taxpayer also had signifcant write-off of bad debts in its books
ofaccount.
During the scrutiny, the Revenue determined ALP of payment of royalty to be nil, to the
extent of write-off of bad debts during the year, contesting that any independent entity,
acting as a sole distributor for the off-the-shelf product of a licensor, would have sought
for a waiver of royalty payable, considering the large amount of non-receivables, which
were ultimately written off as bad debts. The frst level of appellate authority decided
the case in favour of the Revenue.
Before the Appellate Tribunal, the taxpayer argued that write-off of bad debts may not
be a factor to determine the ALP of payment of royalty and the Revenue had exceeded
I
jurisdiction by following the method that is not authorised under Indian transfer
pricing regulations.
Ruling
The Appellate Tribunal, deciding the matter, upheld the views of the taxpayer and
quashed the adjustment to the royalty made by the Revenue.
The ruling emphasises that the Revenue is bound to follow only the methods
prescribed in Indian transfer pricing regulations and may not go beyond the four walls
erected by the Income Tax Act.
McDonalds (India) Pvt. Ltd
The taxpayer had entered into a master licence agreement and service agreement with
the overseas parent company for carrying out a restaurant business in India. As per
the master licence agreement, the taxpayer was to pay a royalty of 5% on sales during
the year. As per the agreement, the 5% royalty was to be paid even if the restaurant
business was carried out through the franchises in India. Furthermore, the master
licence agreement stipulated that the taxpayer should spend a minimum of 5% of the
sales during the year towards advertising and promotion of the restaurant business.
Under the service agreement, the taxpayer performed certain services on behalf of the
parent in return for an agreed markup on cost.
For the purpose of carrying out its operations, the taxpayer had entered into a
franchise agreement in India. As per the franchise agreement, the franchisee was
required to pay the royalty of 5% of sales to the taxpayer and had to spend a minimum
of 5% of sales towards advertisement. Furthermore, the taxpayer had entered into a
marketing support agreement with franchises, wherein the taxpayer had agreed to
bear part of the advertisement expenses of the franchisee company with the intention
to expand the business and increase the return on investment.
Additionally, the taxpayer was appointed as a service representative to carry out, on
behalf of the foreign parent, services described in the services agreement, and these
services did not include advertising on behalf of the foreign parent.
The Revenue contended that the arrangement between the taxpayer and the overseas
parent was to retain lower profts in India by way of the taxpayer bearing additional
advertising expenses of the franchises.
Ruling
The Appellate Tribunal observed that under none of the agreements, did the US parent
have to bear the cost of advertising, and the income to the US parent remained the
same, irrespective of whether the advertising expenditure was borne by the taxpayer
or the franchises. Accordingly, the Appellate Tribunal upheld that the transfer
pricing provisions were not applicable, as the arrangement with regard to advertising
expenditure is between the taxpayer and its Indian franchises. The addition made by
the Revenue by invoking transfer pricing provisions of the Income Tax Act with regard
to advertising expenditure was therefore deleted.
India
Transfer pricing provisions were not applied to the advertisement expenditure borne
by the taxpayer a wholly owned subsidiary of a foreign company in India under the
franchise agreement with Indian franchises because the beneft to the parent company
remained the same irrespective of whether the advertisement expenditure was borne
by the taxpayer or by the franchises.
Dana Corporation Advance Authority Ruling
The applicant is a US company and had undergone reorganisation bankruptcy
proceedings initiated under the bankruptcy code of the US. Accordingly, the
applicant fled a copy of the reorganisation plan, and the court order approved the
reorganisation. Under the scheme of reorganisation, the applicant had transferred
shares of its Indian subsidiary companies to its US subsidiary without consideration.
Furthermore, the applicant transferred all of its holdings in India and other
subsidiaries around the world to an ultimate holding company, and fnally the
applicant got merged into another subsidiary of the ultimate holding company. It was
stated in the written submission fled that the liabilities taken over by the ultimate
holding company from the applicant was more than the assets.
On the basis of the above facts, the applicant desired to have a ruling on whether the
transfer of shares of the Indian companies by the applicant to its US subsidiaries is
taxable in India.
The applicant contended that the transfer of shares was without consideration, and
as such, no income may be attributed to the transfer of shares. Consequently, transfer
pricing provisions may not be made applicable in the absence of a chargeable income.
The Revenue argued that the taking over of liabilities by the ultimate holding
company was a consideration for transfer of shares. Furthermore, it was argued that
the transfer of shares of an Indian company is an international transaction under the
transfer pricing provisions and as such, consideration for transfer of shares should be
determined on an arms-length basis.
Ruling
In deciding the case, the AAR ruled that if no consideration had passed from or on
behalf of the transferee companies to the transferor company and the charge of
capital gains under section 45 of the act fails to operate for want of consideration or
determinable consideration, then the transfer pricing provisions may not be applied.
Furthermore, the AAR upheld that transfer pricing provisions are not an independent
charging provision in respect of international transactions. The application of arms-
length principle on an income depends on identifcation of such income by the
charging provisions of the act. Accordingly, the AAR held that the transfer of shares by
the applicant under the re-organisation without consideration would not be chargeable
to tax.
The ruling emphasises that the transfer pricing provisions ought to apply when income
arises from an international transaction. The transfer pricing provisions of the act are
not intended to bring to charge income that is not otherwise chargeable. Although an
AAR ruling is binding on the applicant and the Revenue, it does have persuasive value,
I
and the Revenue and appellate authorities do take note of the principles laid down by
AAR in deciding similar cases.
Vertex Customer Services India Pvt Ltd
The taxpayer is engaged in providing call centre services and had adopted the
TNMM. The benchmarking analysis of comparables refected a positive operating
proft to operating cost. However, the taxpayer showed a loss from the international
transaction after making adjustments for (1) cost relating to frst-year operation, (2)
cost relating to excess capacity and (3) provision for doubtful debts towards sums
due from the parent company. The adjustments were made on the grounds that these
were extraordinary costs and required to be excluded in computing the arms-length
price under the income tax rules. The rules provide that the net proft margin arising
in comparable uncontrolled transactions may be adjusted for differences between the
international transaction and the comparable transaction, which could materially
affect the amount of net proft margin in the open market. Although the TPO accepted
the frst two adjustments, the third adjustment was rejected on the grounds that the
provision of doubtful debts, being an ordinary item of expenditure, did not qualify for
adjustment. The AO sought to levy a penalty in respect of the adjustment to the transfer
price arising as a result of the taxpayer not accepting the adjustment.
On merits, the taxpayer accepted the addition though it challenged the levy of penalty.
The appellate commissioner allowed the appeal in favour of the taxpayer. Aggrieved by
the order, the Revenue preferred an appeal before the Appellate Tribunal.
Ruling
Dismissing the appeal, the Appellate Tribunal held that the taxpayer had accepted
the addition and did not challenge it; therefore, it does not automatically give rise to
levy of penalty. Moreover, the taxpayer had made full disclosure of the facts of the
case. The question whether the provision for doubtful debt was an extraordinary item
warranting exclusion from operational cost is a debatable point on which there can
be two opinions. Referring to various case laws, the Appellate Tribunal upheld that
penalty may not be imposed where there is merely a difference of opinion and where
the party concerned has not acted deliberately in defance of law or in conscious
disregard of its obligation.
The Appellate Tribunal also referred to the accounting standard issued by the Institute
of Chartered Accountants of India, dealing with extraordinary items, while justifying
that the issue could have two opinions. Accordingly, the Appellate Tribunal held that
the computation of proft margins for comparability analysis could not be said to have
not been done in good faith or without due diligence.
This is one of the frst Tribunal judgements on the applicability of penalty provisions for
transfer pricing adjustments made by the AO and is expected to provide considerable
relief to companies having transfer disputes with the Revenue. This ruling is signifcant
because it highlights that penalties should not be levied in case of any transfer pricing
adjustment for which the taxpayer has made reasonable efforts to establish that the
transfer price meets the arms-length standard.
India
Customer Services India Pvt. Ltd
The taxpayer is a wholly owned subsidiary of its US parent, and is engaged in the
business of providing call centre/IT-enabled services to customers of its US parent.
For analysing the arms-length nature of its international transaction, the taxpayer
had used fnancial data of comparable companies relating to two previous years. At
the stage of assessment proceedings, at the request of TPO, the taxpayer furnished
fnancial data in respect of selected comparables for the relevant fnancial year in
which the international transactions had been entered into (or the current year). The
TPO ignored the fnancial data presented by the taxpayer pertaining to the current
year and determined the arms-length price applying only the data relating to the past
twoyears.
The taxpayer preferred an appeal against the TPOs order before the appellate
commissioner. The appellate commissioner held that the TPO was not justifed in
using prior-year data for determination of the arms-length price for the taxpayers
international transactions. Aggrieved by the order of the appellate commissioner, the
Revenue preferred an appeal before the Appellate Tribunal.
Ruling
The Appellate Tribunal ruled that data to be used in analysing the comparability of
an uncontrolled transaction with an international transaction should relate to the
fnancial year in which the international transaction had been entered into. The
ruling indicates that prior-year data is to be used only in exceptional circumstances,
where the use of such data could have an infuence on determination of arms-length
price. However, the ruling is silent about the taxpayers contention with regard to
impossibility of performance (i.e. that current-year data for comparable companies
may not be available at the time of preparation of transfer pricing documentation).
The Tribunal allowed the taxpayer the beneft of the +/-5% range even where the
taxpayers transactional price did not agree with the arms-length price after applying
the +/-5% beneft.
The ruling emphasises the use of current-year data for determination of the arms-
length price and allowed +/-5% range in line with the earlier Tribunal rulings.
Philips Software Centre Private Limited
The Indian company is a tax holiday unit engaged in provision of software
development services to its overseas affliates. The taxpayer had considered the CPM
as the most appropriate method for determining ALP for its international transaction.
In addition, a corroborative analysis was conducted using TNMM. The Revenue
disregarded the TP analysis/documentation and adjustments made. A new search was
conducted by the Revenue, and the ALP was determined after the profts of comparable
high-margin companies were normalised. The appellate commissioner upheld the ALP
so determined while allowing marginal tax relief to the company.
Ruling
The Appellate Tribunal inter alia held as follows:
Application of TP rules to taxpayers eligible for the tax holiday requires
demonstration of tax avoidance;
I
Flaws in the taxpayers analysis are a prerequisite for rejecting the TP analysis
carried out by the taxpayer;
Companies with even a single rupee of transactions with AEs should not be
considered as comparables;
Adjustments need to be made to margins of the comparables in order to eliminate
any differences on account of functions, assets and risks;
Requirement for specifc adjustments in relation to (1) difference in risk profle
(2) difference in working capital position (3) difference in accounting policies
(depreciation); and
The TPO may not conduct a fresh search using data beyond the specifed date (i.e.
the date of fling of the income tax return by the taxpayer).
In addition to the above, the Tribunal also provided guidance on applicability and
quantifcation of the working capital/risk adjustment and allowed the taxpayer the
beneft of the +/-5% range in determining the arms-length price.
This is a landmark order that has clarifed a number of issues affecting the taxpayer
in the feld of transfer pricing. In general, the ruling emphasises that the transfer
pricing analysis prepared by the taxpayer stands, unless the Revenue reject it as being
completely fawed. In the absence of such a rejection, the Revenue may not deviate
from the analysis except on specifc issues in which the taxpayer is shown to be wrong.
Subsequent to this ruling, the Indian High Court admitted an appeal by the Revenue
against the order of the Appellate Tribunal on matters of law and stayed the impugned
judgment without enforcing recovery proceedings. Accordingly, the order rendered by
the Appellate Tribunal in the transfer pricing matter stands suspended.
Perot Systems TSI (India) Ltd
The taxpayer, an Indian company, is engaged in the business of providing business
consulting, software solution and services. In course of its operations, the taxpayer had
extended interest-free loans to two of its AEs in Bermuda and Hungary, which used the
loans for making investment in step-down subsidiaries. The taxpayer contended that
the loans were made based on an approval from the Reserve Bank of India (RBI).
During the assessment proceedings, the TPO applied the CUP Method, used the annual
LIBOR rate on a US dollar loan and added to this the arithmetic mean of the average
basis points charged by fve companies in order to compute the interest rate. Using this
approach, the TPO arrived at an arms-length interest of LIBOR +1.64% and made an
upward adjustment for interest for the taxpayers loan transaction with the AEs. The
AO gave effect to the adjustment made by the TPO in his order. On an appeal by the
taxpayer to the appellate commissioner, the latter upheld the adjustment made by the
Revenue and denied the beneft of the allowance of 5% as claimed by the taxpayer.
Aggrieved by the order, the taxpayer preferred an appeal before the Appellate Tribunal.
Ruling
The Appellate Tribunal ruled that the transaction involving granting of a loan to the
AEs was an international transaction under the Indian transfer pricing regulations. As
a result, the rate of interest on the loan should be integral to the determination of the
arms-length price. The Appellate Tribunal also agreed with the view of the Revenue
that the transaction of the taxpayer in the form of an interest-free loan would result in
India
shifting of profts outside India. The Tribunal made the observation that an approval
from the RBI was not suffcient for justifcation of arms-length nature of the price
involved in a loan transaction. Based on these facts, the Appellate Tribunal upheld
that notional interest can be imputed under Indian transfer pricing code and in this
particular case, the taxpayer would not be eligible for the allowance of 5%, as the
arms-length price was computed using a specifc LIBOR rate and not a set of prices.
This is the frst Indian transfer pricing ruling that dealt with the arms-length nature
of an outbound loan transaction. The Indian transfer pricing regulations applicable
for all cross-border transactions and an MNC cannot escape its tax liability by arguing
that its interest-free loan was actually a capital contribution to its AEs. An interest-free
loan between two related parties is a clear case of transfer of proft from India to its AE
located in a tax haven where there is no corporate tax.
IL Jin Electronics (I)(P) Ltd.
Facts and Contentions
The taxpayer is engaged in the manufacture of printed circuit boards for one of
its group companies in India. During the year under audit, the taxpayer imported
45.51% of its raw materials from its AE located in Korea, while the balance 54.49%
was procured locally. The AE in Korea purchased these raw materials from unrelated
vendors and charged a markup for its procurement services. The taxpayer adopted
the TNMM method and used the operating margin results of a set of comparable
companies to demonstrate the arms-length nature of the import transaction. During
the audit, the TPO rejected certain high-loss-making comparable companies identifed
by the taxpayer and made an upward adjustment to the taxpayers import prices by
applying a higher arms-length operating margin to the total turnover of the taxpayer.
Aggrieved by the order, the taxpayer preferred an appeal before the appellate
commissioner, who ruled the case in favour of the Revenue. Consequently, the taxpayer
brought an appeal before the Appellate Tribunal.
The taxpayer contested before the Tribunal that in arriving at the arms-length price
for the import transaction, it is important to consider the actual purchase price paid
by its AE to the unrelated vendors as well as the markup charged by its AE for its
procurement services. In addition, the taxpayer argued that working capital differences
between the taxpayer and the comparable companies are considered in arriving at the
arms-length operating margin under the TNMM method. Finally, the main contention
of the taxpayer was that because only 45.51% of the total raw materials were imported
from its AE, any upward adjustment to the import price should be based only on
45.51% of the taxpayers turnover, and not the total turnover.
Ruling
The Appellate Tribunal observed that an alternative methodology for TP analysis
taking foreign AE as a tested party by applying the resale price method or CPM would
have been the ideal approach to determine the arms-length price in the present case.
However, in the absence of any supporting analysis/information presented in relation
to the details of prices of the raw material purchased by the AEs from the third-party
vendors by the taxpayer, the Appellate Tribunal held that the adoption of alternative
methodology was not possible and hence, only TNMM could be used as the most
appropriate method.
I
The Appellate Tribunal agreed with the taxpayer that transfer pricing adjustment
should be made based only on 45.51% of the turnover, and not the total turnover.
This ruling is important in the context of application of the TNMM method, when
the method has been applied on an entity-level basis due to the fact that segmented
fnancial data are not available with the taxpayer for transactions with its AEs. In such
a case, any transfer pricing adjustment is to be made only on a proportionate basis
and not on the basis of the total turnover of the taxpayer. The Appellate Tribunal also
commented on use of foreign associated enterprises as the tested party to determine
the arms-length price.
o) Morgan Stanley and Co.
The Supreme Court of India, in the case of the investment bank Morgan Stanley & Co.,
USA (MS Co.) had the opportunity to examine whether MS Co. had a PE in India under
the India-USA Tax Treaty, as a consequence of the back-offce operations outsourced
by it to its captive business process outsourcing (BPO) unit in India (MSAS), and if yes,
whether the payment of arms-length remuneration by MS Co. to MSAS extinguished
MS Co.s liability to be taxed in India.
In this case, MS Co., which is engaged in fnancial advisory, corporate lending, and
securities underwriting services, outsourced some of its activities to MSAS. MSAS was
to support the main offce functions of MS Co., which included equity/fxed income
research, account reconciliation and providing IT-enabled services. MS Co. sent
certain staff members to India for stewardship activities to ensure that its standards of
quality are met. MS Co. also sent staff members on deputation to MSAS (as and when
requested by MSAS), where such employees continued to be employed by MS Co. and
their salaries and fees paid directly by MS Co.
The Supreme Court ruled that MS Co. did not have a fxed-place PE or an agency PE in
India under the tax treaty, as a consequence of the back-offce operations outsourced
to MSAS. Further, the visit by employees of MS Co. to MSAS for stewardship activities
was also not found to create a PE in India under the tax treaty. However, with reference
to the personnel of MS Co. on long-term deputation to MSAS, the Supreme Court held
that as such personnel continued to be employees of MS Co., having a lien on their jobs
with MS Co., the employees could result in MS Co. having a service PE in India.
As regards profts attributable to the PE, it was observed by the Supreme Court that as
MSAS was remunerated at operating cost plus arms-length markup determined using
TNMM, and as the transfer pricing analysis of MSAS adequately refected the functions
performed and the risks assumed by it, no further profts would be attributable to
the PE. Here, it would be necessary to ensure that all operating costs are adequately
captured in the cost base, on which the markup is to be applied, before a taxpayer can
be said to be at arms length.
However, there have been two judicial cases in the recent past that diverge from the
above principle. In the case of SET Satellite Singapore, it was held by the Appellate
Tribunal that payment of arms-length remuneration to a dependent agent PE does
not necessarily extinguish the tax liability of the non-resident in India. Furthermore,
in the case of Rolls Royce Plc, the Appellate Tribunal has disregarded the argument
of the taxpayer that payment of arms-length remuneration to a PE extinguishes the
tax liability of the non-resident in India and has proceeded to attribute the profts of
India
Rolls Royce Plc, which can be said to accrue or arise directly or indirectly through the
operations of its PE in India.
Mentor Graphics (Noida) Private Limited
The Mentor Graphics case illustrates the importance of carrying out a detailed transfer
pricing analysis of the specifc characteristics of the international transaction with
the associated enterprise, including an analysis of the functions, assets and risks, and
affrms that a mere broad comparison is not enough.
The taxpayer, in this case, had carried out a detailed transfer pricing analysis and had
chosen a set of comparables. However, this set was rejected by the TPO, and a new set
of comparables was chosen by the TPO. The TPOs set was also upheld by the appellate
commissioner. The Appellate Tribunal, while reviewing the analysis and comparables
set of both the taxpayer and the TPO, has laid down certain important principles,
which will have far-reaching implications on almost all transfer pricing cases in India.
The broad principles have been outlined below:
The Appellate Tribunal has recognised that transfer pricing is not an exact science
in which mathematical certainty is possible; some approximations cannot be ruled
out. It needs to be prima facie shown that the transaction was properly examined
and comparable prices were objectively fxed, in a bona fde, honest manner, as
required by law;
Reiterating the principles laid down in the case of Aztec Software and Technology
Services Limited, the Appellate Tribunal has observed that risks are an important
consideration in any transfer pricing analysis, which are related to the economic
principle that the greater the risk, the higher the return. In case of material
differences in risks between the controlled enterprise and comparables, the
identifed comparables are not correct if appropriate adjustments for differences
are not possible. Signifcant risks like market risk, contract risk, credit and
collection risk, risk of infringement of IP, etc. are critical factors to consider.
Adjustments may also be necessary for differences in working capital, risks and
growth, R&D expenses, etc.;
The Appellate Tribunal held that, as Mentor Graphics was a captive software
development service provider to Ikos Systems USA, most of the business risk,
such as contract risk, market risk, credit risk, warranty risk, price risk, etc., was
borne by Ikos. Further, the intellectual property right to all the intangibles that
were provided to Mentor Graphics for carrying out software development services
was owned by Ikos. Therefore, the Appellate Tribunal held that the TPO failed
to appropriately consider functions, assets, intangibles etc. while selecting the
comparables, and accordingly, the order of the TPO was not sustainable; and
The Appellate Tribunal noted that the TPO had considered as comparables,
companies having dealings with related parties. Furthermore, it was not made clear
why certain comparables chosen by the taxpayer were rejected by the TPO. The
Appellate Tribunal observed that the TPO could undertake a fresh search only if the
comparables chosen by the taxpayer were insuffcient or defcient. The Appellate
Tribunal thus held that there was lack of application of mind and arbitrariness in
the TPOs order.
On the other hand, the Appellate Tribunal observed that Mentor Graphics had
carried out a proper screening and a detailed analysis while choosing comparables.
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Based on the in-depth examination, the Appellate Tribunal constructed a smaller
set of comparables from the taxpayers set. Here, the Appellate Tribunal specifcally
mentioned that high-proft and high-loss makers were not being selected, as the
taxpayer worked in a no-risk environment. The Appellate Tribunal deleted the
adjustment made by the TPO and upheld the transfer price of the taxpayer.
The Appellate Tribunal thus held that once a taxpayer undertakes appropriate due
diligence in preparing a transfer pricing analysis to justify the arms-length nature of
its international transactions, the analysis may not be arbitrarily rejected during audits
based on inferences and presumptions. The case law also gives recognition that the no
risk, captive, contract software development support service provider characterisation
of the taxpayer is an appropriate evaluation from a transfer pricing perspective.
In the backdrop of signifcant transfer pricing audit adjustments in India in the recent
past, the ruling provides some assurance that taxpayers undertaking due diligence and
detailed/robust analysis are better positioned to face intense transfer pricing audits
inIndia.
Development Consultants Private Limited
The Appellate Tribunal pronounced its ruling in the case of Development Consultants,
an Indian construction and engineering services company, approving the tested
party concept and the use of foreign benchmarking studies adopted by Development
Consultants. While the taxpayer succeeded in getting its transfer pricing adjustment
cancelled/reduced, the observations made by the Appellate Tribunal provide positive
guidance for all taxpayers using such methods in their transfer pricing defence.
The signifcant conclusions of the Appellate Tribunal are summarised below:
Considering the procedural requirements to submit contemporaneous
documentation, the Appellate Tribunal took a pragmatic view to clarify that there
was no lack of opportunity for the tax authorities to verify in depth and detail, the
documents, evidences and other explanations fled by the taxpayer;
In an important step towards the judicial development of the Indian transfer
pricing legislation, the Appellate Tribunal affrmed that in order to select the most
appropriate method for determining the arms-length price, it is frst necessary to
select the tested party, which will be the least complex of the controlled taxpayers
engaged in the transaction and will not own valuable intangible property or unique
assets that distinguish it from potential uncontrolled comparables. The Appellate
Tribunal noted the concept of tested party, referring to Section 1.482-5 of the US
transfer pricing regulations; and
The Appellate Tribunal also took on record the foreign benchmarking exercise
conducted by the taxpayer and observed that the benchmarking exercise had been
examined by the TPO and commissioner of appeals, but they had not been able
to refute or controvert the analysis of the taxpayer. While accepting the foreign
benchmarking exercise, the Appellate Tribunal recognised that no transfer pricing
adjustment should be made if the tested party earns margins within the arms-
length level, as determined through the foreign benchmarking exercise, after
allowance of the 5% fexibility from the arithmetic mean, as per provisions of the
Indian transfer pricing laws.
The ruling focuses on the importance of the tested party concept, which otherwise has
not been dealt with by the Indian transfer pricing legislation, but is commonly used
India
in almost all Indian transfer pricing documentation. It also upholds the use of foreign
benchmarking studies, which is always necessary in case of taxpayers having foreign
associated enterprises as the tested party. The TPOs often have been hesitant to use
or review foreign benchmarking studies, but this ruling strengthens the taxpayers
position for using such benchmarking studies.
The importance of performing a detailed functional analysis and understanding of
the taxpayers business is also refected in the ruling, as the TPO or the commissioner
of appeals had failed to recognise or appreciate the true functional character of the
various parties to the international transactions.
Cargill India Private Limited
The Appellate Tribunal examined the provisions of the transfer pricing regulations
relating to maintenance of information and documents and their furnishing before the
transfer pricing authorities for determining the arms-length price. The case relates to
Cargill India Pvt. Ltd., where the TPO levied penalty under Section 271G of the Act on
account of non-submission of documents within the prescribed time as required under
section 92D of the Act read with Rule 10D.
The Appellate Tribunal, while reversing the levy of penalty on account of non-
submission of documents, arrived at certain fundamental conclusions, which will have
far-reaching implications on almost all transfer pricing cases in India.
The Appellate Tribunal clarifed that the documents and information to be kept
and maintained as per Rule 10D is extensive, and the information and documents
prescribed under all the clauses of Rule 10D would be required only in the rarest
of cases. Therefore, the taxpayer and the tax authorities, depending upon the facts
and circumstances of the case, are required to consider relevant information and
documents needed for determining the arms-length price.
The Appellate Tribunal further observed that, having regard to the purpose of the
regulations, a notice issued by the TPO requiring the taxpayer to furnish any prescribed
information/documents, cannot be vague or nonspecifc. Such a notice must require
the taxpayer to furnish specifc information, which according to the TPO, is necessary
for determination of the arms-length price of the international transactions of the
taxpayer and should be issued after examination of documents on record and proper
application of mind. The Appellate Tribunal noted that such a notice issued under
section 92D(3) is a serious notice, as noncompliance could lead to imposition of
penalty, and accordingly specifying the information and documents in the notice
was important. Furthermore, the specifc clause of the rule or the details of the
international transaction relating to which default was committed by the taxpayer also
should be stated in the show-cause notice in order to treat it as valid, and to enable the
taxpayer to fle a proper reply in defence.
This ruling by the Appellate Tribunal is a step in the right direction, as it focuses on the
meaningful construction of the procedural provisions of the Indian transfer pricing
regulations in order to achieve the purpose of the regulations.
There is a special transfer pricing team within the Indian tax authorities that deals
with transfer pricing issues. The team comprises trained TPOs who deal with transfer
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pricing issues arising during the course of an audit. Indian tax authorities are actively
training their staff to increase competency in handling transfer pricing issues.
3809. Use and availability of comparables information
Taxpayers are required to maintain information on comparables as part of their
transfer pricing documentation to demonstrate that the pricing policy complies with
the arms-length principle. Comparable information is a crucial element for defending
transfer pricing in India. Indian revenue offcials have indicated that, to the extent
possible, Indian comparables should be used. Use of foreign comparables is generally
not acceptable, unless the tested party is located overseas. In some cases, the TPOs
have exercised their power [under Section 133(6) of the Act] to obtain private
information from other taxpayers and used the same comparables for the taxpayer
undergoing audit.
Availability of comparable information
The quality of comparable information available in Indian databases is reasonable. A
few agencies that work in tandem with government departments provide electronic
databases giving detailed fnancial and descriptive information for companies listed
on the stock exchange. Some databases also give summary information on unlisted
companies. It is also possible to obtain information about Indian public companies
from the Registrar of Companies (RoC) upon payment of statutory fees.
The Indian Ministry of Finance had constituted a Joint Working Group, comprising
offcers from Income Tax and Customs to suggest measures for cooperation between
the Income Tax and Customs departments. Based on the recommendations of
the Working Group, the Ministry of Finance has laid down that periodic meetings
should be held between Income Tax and Customs personnel to discuss joint issues
requiringattention.
The Ministry of Finance also has decided that exchange of information in specifc
cases would be done, and for this purpose, offcers from the two departments
would be nominated at each of the four metros. Furthermore, offcers from the two
departments would make databases available to each other, relating to related parties/
associated enterprises on a need-to-know basis. The Ministry of Finance also has
decided to develop and organise training programmes to train the offcials of both the
departments to familiarise them about the treatment of transfer pricing matters in the
other department.
The above action by the Ministry of Finance can be seen as the frst clear statement
of intent of the government of India towards addressing transfer pricing matters in
a harmonious manner between the Customs and the Income Tax departments (as
transfer pricing offcers have, in the past, expressed a view that the price accepted by
other authorities is not conclusive evidence for determining the arms-length price for
transfer pricing purposes). This also suggests that going forward, Customs and Income
Tax authorities would be coordinating and exchanging information with each other
on transfer pricing matters. Such an increase in liaison between the two departments
makes it imperative for companies operating in India to plan and document their
transfer prices comprehensively based on valuation principles contained in Customs
India
as well as Income Tax laws and also deal with both authorities in a harmonious and
seamless manner.
No transactions or industries are excluded from the possibility of a transfer pricing
investigation. Software development, business process outsourcing, banking,
telecommunication, pharmaceutical and automobile (and ancillary) are some of the
industries that have been subject to intense transfer pricing audits in recent times.
Outsourcing companies rendering core/high-value services to associated enterprises
need to carefully analyse and set their transfer prices. Furthermore, specifc situations
such as sustained losses, business strategies, transactions with entities in tax havens,
royalties and management charges paid should be suffciently documented.
The arms-length principle applies to loans and interest charges. However, at present,
there are no rules that specifcally deal with thin capitalisation and no set permissible
debt to equity ratios in the act or the transfer pricing code. However, the Indian
government has already put forward a proposal for a new direct tax code that will
replace the existing income tax code with effect from 1 April 2011. A draft of the new
direct tax code has already been circulated for public comment and includes thin
capitalisation provisions.
The proposed regulations do not prescribe any capital gearing ratio unlike typical
thin capitalisation regulations and instead provides the recharacterisation of
debt as equity and the reverse upon identifcation of an impermissible avoidance
arrangement, in other words where arrangement among parties is (1) not at arms
length (2) lacks commercial substance or (3) adopts means that are ordinarily not
adopted for bona fde purposes. The absence of specifed capital gearing ratio allows
subjectivity and discretion at the hands of the Revenue while evaluating whether
a given capital structure is indeed at arms length with commercial substance.
Furthermore, there is no indication on how the debt-equity composition is proposed to
be reviewed for the purposes of arms length and any parameters used to judge their
commercialsubstance.
The proposed thin capitalisation provisions are now becoming an area of concern and
evaluation for multinational enterprises operating in India to review their respective
capital structures and identify appropriate and acceptable benchmarks.
In view of Indias exchange control rules, charging management service fees to Indian
residents beyond the prescribed threshold requires regulatory approval. It may be
possible to obtain regulatory approval for such charges, based on transfer pricing
documentation proving the arms-length nature of the charge. Management service
fees charged to Indian taxpayers are tax-deductible if charged on an arms-length
basis, subject to limitations under the domestic tax law. Management charges to Indian
taxpayers are generally scrutinised in detail during transfer pricing audits. To mitigate
the risk of disallowance, the charge should be evidenced by extensive supporting
documentation proving that the services were rendered and were necessary to the
business of the recipient of the services (the beneft test).
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Where an Indian taxpayer is providing such services, the taxpayer should be
compensated on an arms-length basis.
The competent authority provisions/mutual agreement procedure (MAP) is an
alternate dispute resolution mechanism that companies are increasingly beginning
to use, especially in cases for which the tax amount in dispute is signifcant. MAP
settlements typically have been sought on issues relating to transfer pricing, PE matters
and proft attribution.
Most Indian tax treaties contain an associated enterprises article, which contains
relieving provisions that require one country to reduce the amount of tax charged to
offset the enhanced tax liability imposed by the other country to refect the arms-
length standard. This article refers to competent authority provisions (contained in the
relevant mutual agreement procedure article of the treaty) for consultation between
authorities of both countries to prevent double taxation of taxpayers. MAP/competent
authority provisions are an integral part of Indias extensive treaty network.
The MAP route can be pursued by taxpayers simultaneously with the domestic
dispute resolution process. In the event the MAP route is invoked, the competent tax
authorities of the countries involved negotiate until they reach an agreement on the
transfer prices acceptable to both the authorities. In order to facilitate the MAP, the
Indian government has introduced rules and also has entered into memoranda of
understanding (MoU) with the competent authorities of the UK and US. An advantage
of applying for MAP under the MoUs mentioned is that the Revenue will suspend the
collection of tax, where the taxpayer has an adjustment in relation to transactions with
the associated enterprises. Under the MoUs, the collection of tax is deferred while MAP
is in process. However, the taxpayers need to provide the appropriate bank guarantees
in support of the potential tax payable prior to resorting to the MAP.
The increasing use of MAP by taxpayers and the resulting effective resolution of issues
between the competent authorities and the taxpayer is an encouraging step in the
Indian scenario.
3815. OECD issues
India is not a member of the OECD. However, India has been invited to participate as
an observer in the OECDs Committee on Fiscal Affairs, which contributes to setting
international tax standards, particularly in areas such as tax treaties and transfer
pricing. Indias transfer pricing legislation broadly adopts the OECD principles. Tax
offces have also indicated their intent of broadly following the OECD Guidelines
during audits, to the extent the OECD Guidelines are not inconsistent with the Indian
Transfer Pricing Code.
There is no evidence of joint investigations having taken place in India. However,
almost all Indian tax treaties contain provisions for the exchange of information and
administrative assistance, under which the Indian tax authorities may exchange
information with other countries for transfer pricing purposes. Furthermore, with
India
increased transfer pricing awareness, joint investigations may be undertaken by the
Indian tax authorities in the future.
Revenue offcials have indicated the possibility of introducing rules on cost
contribution arrangements (CCA), thin capitalisation and international transactions
with associated enterprises based in tax havens.
There are currently no provisions enabling taxpayers to agree to pricing policies in
advance with the tax authorities. However, the new direct tax code, which will replace
the existing income tax code with effect from 1 April 2011, includes provisions for
taxpayers to apply for an advance pricing agreement.
3819. Payment of royalty
The Union Cabinet of India has approved a proposal to permit all payments towards
royalty, lump sum fees for transfer of technology, payments for use of trademarks/
brand names under the automatic route without any restrictions and subject to foreign
exchange management (current account transaction) rules, 2000. The objective of this
change in policy is to freely promote the transfer of high-end technology into India.
This amendment in the exchange control regulations could have implications on
the inter-company royalty arrangements that multinational enterprises have with
their Indian affliates. Due to exchange control limitations, multinational enterprises
may have in the past restricted the royalty charge to their Indian affliates in line
with the limits prescribed under the automatic approval route. With the removal
of such a restriction, multinational enterprises may consider revisiting their
royalty arrangements with their Indian affliates in order to align them with the
arms-lengthstandard.
With this change in policy, a robust transfer pricing documentation for supporting the
arms-length nature of royalty payments would be of utmost importance to defend the
deductibility of such payments before the Revenue.
Indonesia
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Indonesia
3901. Introduction
Indonesia has adopted the arms-length standard for transactions between related
parties. As the tax system is based on self-assessment, the burden of proof lies with the
taxpayer, not with the tax authorities.
3902 Statutory rules
For income tax purposes, the legislation dealing with transfer pricing is found in Article
18 of the 1983 Income Tax Law, as revised by the 1991, 1994 and 2000 Income Tax Law
and further by Income Tax Law No. 36/2008.
Article 18 states that the tax authorities may adjust a taxpayers taxable income for
related party transactions that are not carried out on an arms-length basis. Related
parties are deemed to exist in the following circumstances:
Where a taxpayer directly or indirectly participates in 25% or more of the capital of
another taxpayer, or where a company participates in 25% or more of the capital
of two taxpayers, in which case the latter two taxpayers are also considered to
berelated;
Where a taxpayer directly or indirectly controls another taxpayer or where two or
more taxpayers are under common control; and
Where there is a family relationship by blood or marriage.
In September 2008, Parliament passed the new income tax (Law No. 36/2008) that
has been implemented from 1 January 2009. Article 18 (3) of the new income tax law
provides that the fve arms-length pricing methodologies from the OECD Guidelines
should be used to set or review transfer prices.
For value added tax (VAT), a virtually identical provision is included in Article 2 of the
1983 VAT Law as revised by the 1991, 1994 and 2000 VAT Law and further revised by
Income Tax Law No. 36/2008.
A circular issued by the Directorate General of Taxes (DGT) titled Directives for the
Handling of Transfer Pricing Cases (Circular No. SE-04/P, 7/1993) contains guidance
for tax auditors on what types of proft manipulation practices should alert them to
the possibility of transfer pricing issues that would require investigation. Although this
represents the offcial policy of the tax offce, it would theoretically be overridden by
the law if the two were in confict.
International Transfer Pricing 2011 Indonesia 479
Indonesia
A new step was taken by the Indonesian government in early 2008. Government
Regulation No. 80/2007, which was issued on 28 December 2007 and effective from 1
January 2008, explicitly states that taxpayers engaging in transactions under common
control must maintain documentation which proves adherence to the arms-length
principle. At this stage, however, the type of documentation required and how to test
the arms-length nature of particular transactions is still unclear.
We expect the Minister of Finance (MOF) to elaborate further on this issue in a new
MOF regulation. What is clear thus far is that the Indonesian Tax Offce (ITO) has
stated in the 2007 tax administration law that documents requested in a tax audit must
be delivered within one month of the request. This could mean that transfer pricing
documentation submitted after 30 days can be ignored.
Indonesia operates on a self-assessment system with companies setting their own
transfer prices. The burden of proof lies with the taxpayer to prove that the original
price has been set at arms length. In a tax audit context, if a taxpayer does not have
documentation to support its position, there is a high risk that the ITO will make
substantial adjustments, such as the full denial of deductions for management services
fees or royalties paid to related parties.
Audits are a signifcant feature of tax administration in Indonesia because of the self-
assessment system. For years up to 2007, the tax offce has 10 years (but no later than
2013) within which to audit and issue assessments (and additional assessments if new
facts, previously undisclosed, are found). For years from 2008 onwards, the time span
for the issuing of underpaid tax assessment letters is reduced to fve years.
So far, the tax authorities have not undertaken any audits specifcally relating
to transfer pricing. Nevertheless, tax audits conducted in relation to overall tax
compliance will invariably focus on inter-company transactions, especially transactions
involving non-residents. Where there appears to be price discrepancies between
intragroup transactions and third-party transactions, corrections of transfer prices will
be included in the audit fndings.
Specifc transfer pricing audits are rarely conducted; however, transfer pricing
reviews generally take place as part of a broader tax audit. The ITO substantially
increased the level of transfer-pricing-focused audits during 2009. The ITO has issued
audit questionnaires to many taxpayers requesting specifc transfer-pricing-related
information. These questionnaires can be a precursor to a formal audit. The ITO has
also commenced transfer pricing risk profling to identify priority candidates for
transfer-pricing-focused audits.
The ITO has been strictly enforcing the 30-day rule in tax audits. In practice, if a
taxpayer has not prepared transfer pricing documentation prior to receiving a request
in an audit, the taxpayer will likely fnd it diffcult to provide a satisfactory response
within the 30-day timeframe.
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Tax audits are conducted through desk reviews as well as visits to company premises
by the tax authorities. These may involve meetings or correspondence, and settlement
of the audit may in many cases take place through formal negotiation rather than
litigation. The conduct of the taxpayer may infuence the outcome.
The tax authorities also have the power to perform investigations. Investigations are
generally used only where fraud or evasion is suspected. Experience has shown that the
main trigger of an investigation by the tax authorities has been information obtained
by them through their information network or provided to them by informants such as
disgruntled former employees.
Indonesia has an extensive system of tax audits. Taxpayers claiming refunds are
automatically subject to tax audits. A tax return that indicates a loss generally also
triggers a tax audit. In addition, the ITO has recently commenced a risk-profling
exercise designed to identify high-risk candidates for transfer pricing audits. Risk
factors include losses (or poor proft performance compared to industry norms) and
high volumes of related party transactions.
The provision of information and other duties of a taxpayer
The tax authorities have wide-ranging statutory powers to call for information
relevant to an audit, such as accounting records, agreements, supporting documents
and taxreturns.
3906. Tax objections and the appeals procedure
Tax auditors adjust related party transactions where they believe the price differs
from an arms-length price. Taxpayers have the right to object to assessments raised
by the tax offce. The objection must be lodged in writing within three months of the
issuance of the assessment and should be addressed to the DGT at the particular offce
from which the assessment was issued. The DGT has 12 months to issue a decision in
relation to the objection. Under the 2000 Tax Administration Law, the DGTs decision
supported the position of the tax service offce, and the tax in dispute had to be
paid within one month of the date of the assessment, irrespective of the taxpayers
disagreement or submission of a tax objection.
The 2007 Tax Administration Law changed this process. Under the 2007 Tax
Administration Law, which was effective from 1 January 2008 (and applies to tax
years beginning on or after this date), taxpayers are required to pay only as much
as they agreed to with the tax auditors during the tax audits closing conference. If
the taxpayer did not agree with any of their corrections, taxpayers do not need to
payanything.
However, taxpayers need to exercise care when deciding how much to pay, because an
unfavourable DGT decision on the objection gives rise to an administrative penalty of
50% of the underpaid tax. The penalty increases to 100% if an appeal is lodged and the
decision is not in the taxpayers favour.
Indonesia
Taxpayers may appeal to the Tax Court against DGT decisions on their objections.
To have the Tax Court hear the appeal, the taxpayer must pay 50% of the total tax
assessment. An uncertainty prevails regarding the minimum amount to be paid for
fling an appeal. According to the 2007 Tax Administration Law, the same rule should
apply: taxpayers pay only as much as agreed in the closing conference. However,
the Tax Court Law, which governs tax appeals, demands a minimum payment of
50% of the tax due. Which rule will survive is presently unclear. However, given the
uncertainty, taxpayers have little choice but to pay the 50% amount to ensure that their
case is not thrown out on a technicality.
Currently, the Tax Court is the best arena for taxpayers to receive fair hearings. If the
appeal to the Tax Court is still unsuccessful, taxpayers can appeal to the Supreme
Court, provided that certain criteria are met.
It is worth noting that Indonesia has a civil law system in which the courts do not
operate on the basis of precedence and their decisions are not published. Furthermore,
tax cases cannot be appealed beyond the Tax Court or Supreme Court or in any civil
court other than the State Administrative Court. This court deals with complaints by
persons adversely affected by government decisions and has rarely, if ever, been used in
tax cases.
3907. Tax penalties
Penalties of 2% per month are imposed for late payment of tax, up to a maximum of
48% of the unpaid tax. In criminal cases, fnes of 200%400% of the unpaid tax are
possible, as is imprisonment.
A team within the central tax offce specialises in transfer pricing issues. Generally,
tax auditors who handle the day-to-day aspects of a tax audit are not transfer pricing
specialists, although they usually have some training in transfer pricing. Transfer-
pricing-related inquiries are undertaken by the relevant tax audit department, without
assistance from external advisers.
Comparable information may be used to demonstrate that a particular price is an
arms-length price. However, with the exception of certain sectors such as banking
and insurance, there is very little publicly available fnancial data. The tax authorities
do not tend to use proft comparisons to justify transfer pricing adjustments, although
abnormally low profts or losses may be triggers that lead to selection for audit.
Given the lack of publicly available data for the local market, it is common practice for
regional benchmarking studies to be included in Indonesian transfer pricing studies.
There are no excluded transactions. For certain industries where it may be diffcult to
establish levels of actual proft arising in Indonesia, tax authorities have the power to
impose taxes based on deemed proft. Marine or international aviation companies, oil
and gas drilling companies, and foreign representative offces are included under this
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principle/regulation (Article 15 of the 1983 Income Tax Law, as revised by the 1994
Income Tax Law and further by Income Tax Law No. 17/2000).
Although most of the transfer pricing issues challenged in tax audits in Indonesia have
focused on cross-border transfer pricing, the law also covers transfer pricing that takes
place within the country. Examples of where the tax offce may use these provisions
are in respect of luxury sales tax imposed on domestically produced luxury goods,
transactions subject to value added tax, or proft shifting to utilise losses.
Companies must disclose transactions with related companies for tax purposes. The
disclosures are quite detailed and illustrate how the tax authority follows the practice
of a number of other countries in the Asia-Pacifc region, particularly Japan, Korea,
China, the Philippines, Singapore, Malaysia and Australia, which have some form of
disclosure requirements in their annual income tax returns. The disclosure form was
revised for the 2009 tax year to include additional details, including whether transfer
pricing documentation has been prepared.
The statement requires taxpayers to disclose the following details about their
transactions with related parties:
With whom the transaction is made and the nature of the taxpayers relationship
with the counterparty;
The type of transaction;
The value of the transaction; and
Which method was applied in determining the relevant transfer price (one of the
fve arms-length transfer pricing methods recognised in the OECD Guidelines
must be disclosed for each transaction), and the rationale for why that method was
selected.
For 2009 and later tax years, taxpayers must also make detailed disclosures about
whether they have prepared transfer pricing documentation such as:
Company profle and ownership structure;
Types of transactions and any similar transactions with independent parties;
Analysis of OECD comparability factors; and
Selection and application of the most appropriate transfer pricing method.
It is currently unclear whether the tax authorities will use the disclosures for selecting
candidates for transfer pricing audits, as has been the practice in other countries where
disclosures are required.
The competent authority process may be considered once the domestic appeal process
has been exhausted. However, the competent authority process has rarely been used in
Indonesia, because companies in the past have usually received satisfactory settlements
on appeals made to the Tax Court and also because transfer pricing assessments were
fairly uncommon until a few years ago.
As of early 2010, the ITO had received a number of competent authority requests
arising from transfer pricing assessments raised in the previous year. Given the increase
Indonesia
in transfer pricing audit activity and assessments raised by the ITO, it is likely that the
number of competent authority cases will continue to increase in the future. The DGT
plans to introduce a dedicated unit for handling mutual agreement procedure (MAP)
cases in the near future.
As from 1 January 2001, the Indonesian Income Tax Law includes a provision that
authorises the Indonesian DGT to enter into an APA, which is valid for agreed periods
and is renegotiable. An APA can involve a foreign tax authority. This provision
specifcally allowing APAs is a welcome development, although, at the time of writing,
no APAs have yet been concluded. As is the case in many other countries, unilateral or
bilateral APAs can be an advantageous way of resolving transfer pricing uncertainties
before they become acrimonious disputes. The DGT intends to establish a specialist
APA team after it has accumulated more experience in MAP cases.
It is anticipated that further rules and regulations (e.g. approaches to transfer pricing
methodologies) will be issued in the near future. In particular, it is expected that
specifc regulations will be introduced to outline the DGTs views on the transfer
pricing issues associated with services, royalty and interest transactions. It is also
anticipated that the tax authorities will continue to conduct extensive transfer pricing
audits in the next few years.
Although the income tax authorities and customs authorities both fall under the MOF,
there does not appear to be a routine exchange of information between them.
No information is available on the DGTs willingness to participate with tax authorities
from foreign countries in joint investigations of taxpayers. However, the DGT,
according to the Exchange of Information article in double taxation agreements, is
not precluded from carrying out investigations.
Ireland
40.
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Ireland
4001. Introduction
As part of the 2010 Finance Act, enacted in April 2010, Ireland has fnally introduced
broad-based transfer pricing legislation. The legislation endorses the OECD Transfer
Pricing Guidelines for Multinational Enterprises and Tax Administrations and adopts
the arms-length principle. The introduction of general transfer pricing legislation
in Ireland was widely anticipated and brings the Irish tax regime into line with
international norms in this area. The new regime applies to domestic as well as
international related party arrangements and comes into effect for accounting periods
commencing on or after 1 January 2011, in relation to certain arrangements entered
into on or after 1 July 2010.
Prior to the publication of the new legislation, the transfer pricing provisions contained
within the Irish tax legislation were previously only of limited application, and few
resources were devoted to the issue by the Irish tax authorities. Despite the absence
of local regulations and scrutiny prior to the 2010 Finance Act, transfer pricing was
already a signifcant issue both for multinationals operating in Ireland and for Irish
companies investing abroad because of the transfer pricing regulations in place in
many overseas jurisdictions where the affliates trading with Irish companies were
located. For this reason, it is considered that the introduction of equivalent transfer
pricing rules into the Irish system is not expected to result in signifcant changes to the
underlying pricing for these transactions.
Part 35A of transfer pricing legislation
Part 35A, Section 835A to Section 835H, of the 1997 Taxes Consolidation Act (Part
35A), contains Irelands newer domestic law dealing with transfer pricing. Part 35A
confers a power on the Irish tax authorities to recompute the taxable proft or loss of a
taxpayer where income has been understated or expenditure has been overstated as a
result of certain non-arms-length arrangements. The adjustment will be made to the
Irish taxable profts to refect the arrangement had it been entered into by independent
parties dealing at arms length.
The new transfer pricing rules apply to arrangements entered into between associated
persons (companies) on or after 1 July 2010, involving the supply or acquisition of
goods, services, money or intangible assets and relating to trading activities within the
charge to Irish tax at the trading rate of 12.5%. However, an exemption from the new
rules is available for small- and medium-sized enterprises.
International Transfer Pricing 2011 Ireland 485
Ireland
Two unique characteristics
The new regime includes many features expected of a jurisdiction introducing transfer
pricing rules for the frst time, but interestingly the legislation contains the following
two unique characteristics:
The new regime is confned to related party dealings that are taxable at Irelands
corporate tax rate of 12.5% (i.e. trading transactions); and
A grandfather clause whereby arrangements entered into between related parties
prior to 1 July 2010, are excluded from the new transfer pricing rules.
Exclusion of non-trading activities
The new transfer pricing regime is confned to related party dealings that are taxable
at Irelands corporate tax rate of 12.5% (i.e. trading transactions). Activities that are
deemed to be non-trading or passive in nature and which are taxable at the higher
rate of 25% will be excluded from the scope of the new regime.
Passive income for the purposes of the new regime may include interest, royalties,
dividends and rents from property where the income arising is not derived from an
active trade. In practice, each transaction must be examined in the context of the
company and its business to determine if it will constitute trading or passive income.
The question of whether a trade exists will initially be decided by the taxpayer because
the Irish tax system is based on the principle of self-assessment. The term trade is
defned in Irish tax legislation as including every trade, manufacture, adventure or
concern in the nature of trade. However, the legislation does not outline specifc
rules for distinguishing between trading and non-trading activities. Guidance as to
what constitutes trading is available from case law and from a set of rules known as
the Badges of Trade, which have been laid down by the courts in various cases over
the years and which were set out in the 1954 report of the UK Royal Commission on
Taxation. This report and the approach of the courts have been adopted into practice in
Ireland to examine the specifc facts of an individual case and look for the presence, or
absence, of common features or characteristics of trade.
In addition to the available case law, it is possible for a taxpayer to make a submission
to the Irish tax authorities to seek an advance ruling on whether trading activities are
being carried out.
The distinction between whether a companys activities are deemed to be trading
or passive in nature is therefore crucial for determining whether the related party
transactions will fall within the scope of the new regime. The determination will
depend on the specifc facts and circumstances of each case.
Grandfather clause
The other unique characteristic in the legislation is that the transfer pricing rules will
apply only to arrangements entered into on or after 1 July 2010. The term arrangement
is defned within the draft legislation as arrangements or agreements, whether or not
legally enforceable or intended to be legally enforceable. The Irish tax authorities have
not yet provided any guidance on how they will interpret what a new arrangement
willbe.
Ireland 486 www.pwc.com/internationaltp
I
Other key features of the new transfer pricing regime
Associated persons
Part 35A will apply only to arrangements between associated persons. Two persons
party to an arrangement will be considered associated if one person participates in the
management, control or capital of the other person or if a third person participates
in the management, control or capital of each of the two persons party to the
arrangement. A person is deemed to be participating in the management, control or
capital of another person if that other person is a company and is controlled by the
frstperson.
Nature of related party dealings
Part 35A applies only to related party arrangements involving the supply and
acquisition of goods, services, money or intangible assets. It is noted that all these
terms are commonly used in the OECD Transfer Pricing Guidelines, with the exception
of the term money. The OECD guidelines instead use the terminology fnancial
relations.
1
The Irish tax authority has not issued any guidance on how it will interpret
the term money; therefore, this represents an area where further clarifcation from the
Irish tax authorities can be expected in the future.
Effective date
Part 35A will come into effect for accounting periods commencing on or after 1
January 2011, in relation to any arrangement entered into on or after 1 July 2010. For
example, a company with a 31 December year-end will be subject to the new transfer
pricing rules for the year ended 31 December 2011, and any subsequent year but only
in relation to arrangements entered into on or after 1 July 2010.
Understatement of Irish profts
The new regime is one way, facilitating an upwards adjustment to taxable profts
where the profts of an Irish taxpayer are understated as a result of non-arms-length
transfer pricing practices. The regime confers a power on the Irish tax authorities to
recompute the taxable proft or loss of a taxpayer where income has been understated
or where expenditure has been overstated. The adjustment will be made to refect
arrangements that would be entered into by independent parties.
Exemption for small- and medium-sized enterprises
Part 35A contains an exemption from the transfer pricing rules for small and medium
enterprises (SMEs). The defnition of a SME is assessed at a group level and is based on
the defnition in the EU Commission Recommendation of 6 May 2003. In this regard, a
group will be regarded as a SME if it has:
Fewer than 250 employees; and
Either a turnover of less than EUR 50 million or assets of less than EUR 43 million.
This exemption is likely to have the effect of excluding a large number of domestic Irish
companies from the new transfer pricing regime.
1
OECD Guidelines, Chapter I, I-3
Ireland
Summary
Following is a summary of the conditions that need to be met for the Irish transfer
pricing rules to apply to an arrangement:
The taxpayer does not qualify as a small- or medium-sized enterprise;
The arrangement involves the supply or acquisition of goods, services, money or
intangible assets;
At the time of the supply, the supplier and the acquirer are associated;
The profts, gains or losses arising from the relevant activities are within the charge
to Irish tax under Case I or Case II of Schedule D (that is, trading transactions
within the charge to tax at the 12.5% trading rate);
The consideration payable or receivable under the arrangement is not at arms
length and results in an understatement of Irish profts; and
The terms of the arrangement were agreed on or after 1 July 2010.
Branches
Based on the defnition of person as defned in domestic Irish tax legislation, any
arrangements entered into between a branch and its head offce will not fall within the
scope of the transfer pricing rules on the basis that a branch and head offce cannot
constitute two separate persons. However, a transaction between an Irish branch and
a foreign affliated company will fall within the scope of the rules on the basis that this
will constitute a relationship between two separate persons.
4003. Other rules and regulations
Documentation
Part 35A states that companies will need to provide documentation as may reasonably
be required and that documentation will need to be prepared on a timely basis. The
Irish tax authorities issued further guidance (Tax Briefng Issue 07 of 2010) on the
documentation that is required to be prepared by taxpayers to be compliant with the
transfer pricing rules.
The guidance note supports the legislative basis and indicates that a company is
required to have transfer pricing documentation available for inspection if requested by
the Irish tax authorities.
Reference is made to the fact that the purpose of the documentation should be to
demonstrate compliance with the transfer pricing rules. The Irish tax authorities have
stated that the form and manner that the documentation takes will be dictated by the
facts and circumstances of the transactions and recognise that the cost involved in
preparing the documentation should be commensurate with the risk involved. As an
example, the guidance note states that the Irish tax authorities would expect complex
transactions to have more detailed documentation in place in comparison with
simpletransactions.
Notably, the guidance note states that it is best practice that the documentation
is prepared at the time the terms of the transaction are agreed. Additionally, the
guidance note states that for a company to be in a position to make a correct and
complete Tax Return, appropriate transfer pricing documentation should exist at
the time the tax return is fled. It is worth noting that the taxpayer can maintain
documentation in a form of its own choosing. Additionally, where documentation
exists in another territory which supports the Irish arrangement, this will also
I
be suffcient from an Irish transfer pricing perspective, on the basis that the
documentation is in English. The Irish tax authorities have also confrmed that they
will accept documentation that has been prepared in accordance with either the OECD
Transfer Pricing Guidelines or the code of conduct adopted by the EU Council under
the title EU Transfer Pricing Documentation.
The Irish tax authorities have set out a comprehensive list of information that
must be included in the documentation that is prepared. The documentation must
clearlyidentify:
Associated persons for the purposes of the legislation;
The nature and terms of transactions within the scope of the legislation;
The method or methods by which the pricing of transactions was arrived at,
including any benchmarking study of comparable data and any functional analysis
performed;
How that method has resulted in arms-length pricing or where it has not, what
adjustments were made and how the adjustment has been calculated;
Any budgets, forecasts or other papers containing information relied on in arriving
at arms-length terms, etc., or in calculating any adjustment; and
The terms of relevant transactions with both third parties and associates.
The Irish tax authorities have confrmed that transfer pricing documentation must be
available for relevant arrangements that take place in accounting periods beginning
on or after 1 January 2011. The Irish tax authorities have also confrmed that
documentation requirements will not apply to so-called grandfathered arrangements,
the terms of which were agreed before 1 July 2010. The guidance note states that an
arrangement will qualify for this transitional treatment if:
The terms of the pre-1 July 2010, agreement clearly envisage the transaction; and
The application of these terms delivers the price of the transaction.
Other regulations
Prior to the introduction of the new transfer pricing regime, domestic transfer pricing
provisions in Irish tax legislation, with one exception, were specifc to particular types
of transactions or to particular categories of taxpayer. A brief summary of these limited
provisions is set out as follows.
Section 1036
One other general transfer pricing provision is contained in Section 1036, Taxes
Consolidation Act 1997. This section applies where, for example, an Irish company
carries on business with an overseas affliate and, through the control exercised
over the Irish company, the Irish company produces either no profts or less than the
ordinary profts that might be expected to arise. In these circumstances, the overseas
affliate will be chargeable for Irish income tax in the name of the Irish company as if it
were an agent of the Irish company.
Although a broad-based section, Section 1036 is not supported by any guidance from
the Irish tax authorities on the application of the legislation, and defnitions are not
provided for key terms such as close connection and substantial control included in
the section. Further, the section focuses on whether the profts realised by an Irish
company are commensurate with the ordinary profts expected, rather than whether
Ireland
the prices for the international related party transactions entered into by the Irish
company are at arms length.
Owing to these uncertainties, it is not believed that this section is applied in practice.
Companies engaged in businesses qualifying for incentive tax rates
Among the more limited transfer pricing provisions which had been enacted were
those applying to Irish companies qualifying for Irelands incentive tax rate of 10%.
The 10% incentive tax rate dates to the early 1980s and was known as manufacturing
relief. The relief is due to expire on 31 December 2010, and the introduction of
a specifc transfer pricing regime in Ireland has been timed to coincide with the
expiration of manufacturing relief.
VAT and transfer pricing
On 2 April 2007, the Irish government enacted anti-avoidance legislation in relation to
transactions between connected persons. This legislation gives the Irish tax authorities
the power to impute an open-market value to the amount on which VAT is chargeable
on a supply of goods or services. The legislation is a transposition of Article 80 of EU
Council Directive No. 2006/112/EC, an EC directive that member states were not
necessarily obliged to enact locally.
Other domestic transfer pricing provisions
Other anti-avoidance provisions have been enacted for:
The transfer of land between connected persons;
The charge to capital gains tax on the sale of assets to connected persons;
The transfer of trading stock to a connected person at the time a trade is
discontinued; and
The exemption from tax in Irish tax legislation for income arising from certain
qualifying patents.
In the last point, the provisions apply where the payer and benefcial recipient are
connected, stating that the exemption will apply only to as much of the payment as
would have been made by an independent person acting at arms length.
4004. Legal cases
Although Irelands new transfer pricing legislation is effective only for accounting
periods commencing on or after 1January 2011, the decision of the Irish High Court
in the case of Belville Holdings Limited v Cronin in 1985 suggests that the Irish courts
have been willing in the past to impose arms-length pricing in transactions between
related parties.
The transaction considered in this case was the provision of management and other
head-offce services by Belville Holdings Limited, an Irish company, to its Irish resident
subsidiary companies. As well as holding shares in subsidiaries, Belville Holdings
Limited carried on a trade of managing its subsidiaries and providing fnance to them.
For all periods up to the year ended 30 October 1978, the total expenses incurred by
Belville Holdings Limited were apportioned among the subsidiaries and recharged
to them. This company policy changed with effect from the period commencing 1
November 1978, whereby only the operating expenses directly incurred for the beneft
of the subsidiaries were recharged; other expenses not specifcally allowable to the
I
subsidiaries were borne by Belville Holdings Limited. This had the effect of trading
losses being incurred by Belville Holdings Limited following the change of policy.
The case focused on two accounting periods, the period ended 30 June 1979, and
the year ended 30 June 1980, in which Belville Holdings Limited and all but two
of its subsidiaries realised trading losses. Belville Holdings Limited did not receive
management fees from its subsidiaries in these periods. However, the two proftable
subsidiaries paid over their entire profts in each period to Belville Holdings Limited
as dividends. Under tax legislation in force at the time, Belville Holdings Limited, by
virtue of the trading loss it incurred in each period, claimed a repayment of the tax
credits attaching to the dividends received from its two subsidiaries.
The Inspector of Taxes rejected the repayment claim of Belville Holdings Limited. The
Irish tax authorities took the view that the losses of Belville Holdings Limited were not
genuine trading losses, on the basis that Belville Holdings Limited had arranged its
policy for recharging its management expenses to facilitate the claim for repayment of
the tax credits. This position was upheld in the Appeal Court, which relied on the UK
case of Petrotim Securities Limited v Ayres (1963) in stating that notional management
fees equivalent to the market value of the services provided by Belville Holdings
Limited should be included as assessable income of Belville Holdings Limited.
On appeal by Belville Holdings Limited to the High Court, the judge upheld the
position of the Appeal Commissioners that notional management fees should be
included in the tax computation of Belville Holdings Limited. However, the High Court
also found that there was no evidence to uphold the Appeal Commissioners arbitrary
estimation of the market value of the services provided, which was set at 10% of the
income of each of the two subsidiaries. For this reason, the High Court upheld the
appeal of Belville Holdings Limited, but crucially did not refer the matter back to the
Appeal Commissioners to reconsider a more appropriate valuation of the notional
management fees.
The issue later arose as to whether the High Court division in Belville Holdings Limited
had defnitively found in favour of the taxpayer or whether the High Court intended to
refer the matter back to the Appeal Commissioners. A Supreme Court hearing found
that the High Court decision could be interpreted only as being in favour of Belville
Holdings Limited.
In conclusion, although the Irish courts never ruled on an appropriate market value for
the notional management fees, the case of Belville Holdings Limited v Cronin indicates
that the Irish courts may support the Irish tax authorities in applying arms-length
pricing for transactions between connected persons. No other such cases have come
before the Irish courts since 1985, and it is doubtful whether the Belville Holdings case
could be solely relied upon in consideration of transactions between an Irish company
and an international related party prior to the effective date of the new transfer
pricingrules.
Under Irelands self-assessment system, the burden of proof in the event of an audit by
the Irish tax authorities will fall on the taxpayer.
Ireland
Legislation permits the Irish tax authorities to carry out an inspection of tax returns
fled under self-assessment. The purpose of such an inspection is to satisfy the Irish tax
authorities that a return is complete and accurate.
The Irish tax authorities are not obliged to disclose why they have picked a particular
company or tax return for inspection. However, the selection of a return for inspection
does not mean that the Irish tax authorities have evidence that tax has been underpaid.
In many cases, the return is selected for audit for straightforward reasons, such as the
level of turnover or profts generated by the company or the industry sector in which
the company operates.
In the past, it would have been unusual for the Irish tax authorities to audit an Irish
taxpayer for the sole reason of reviewing the arms-length nature of its international
related party dealings. Rather, transfer pricing issues have been considered as part of
a general corporation tax audit. However, with the introduction of Part 35A, it can be
expected that the Irish tax authorities will begin to enforce the new rules with specifc
transfer pricing audits for larger multinational groups.
The frst opportunity that the Irish tax authorities will have to audit any related party
arrangements and apply the new transfer pricing rules will come in 2012, when
companies fle their corporate tax returns for their 2011 fnancial year.
The annual corporation tax return form does not require an Irish company to disclose
details to the Irish tax authorities on the type and value of the international related
party dealings entered into by the taxpayer.
The provision of information and the duty of the taxpayer to cooperate
Auditors of the Irish tax authorities are fully entitled to inspect any original record of
transactions conducted in the period under audit which is relevant to the companys
tax position, or any document that links an original record to the companys
fnalised fnancial statements. Recent legislation has signifcantly widened auditors
inspection powers. An auditor is now entitled to inspect any document that relates
to the companys business, not just records the company is obliged to maintain for
taxpurposes.
Part 35A states that only authorised offcers, designated in writing by the Irish tax
authorities, may make enquiries in relation to transfer pricing. The Irish tax authorities
have yet to clarify who will be an authorised offcer, but it is expected to be inspectors
within the Large Cases Division of the Irish tax authorities.
The Irish tax authorities will conduct a tax audit under the terms of the Charter of
Taxpayers Rights. Under the charter, the Irish tax authorities are obliged to approach
the audit on the assumption that the company is fully tax compliant and its returns are
correct. Prior to commencing the audit, the auditor can be expected to have carried out
a detailed review of the companys tax fles under all tax heads. The auditor will also
I
have conducted a review of any information contained within the Irish tax authorities
regarding the companys industry sector.
Also relevant to the audit procedure in Ireland is the Irish tax authorities Code of
Practice for Tax Audits, which sets out the procedures to be followed by the Irish
tax authorities in their conduct of an audit and in reaching a settlement with the
taxpayer. In notifying the company of their intention to undertake an audit of the
companys tax affairs, the Irish tax authorities give the company until a specifed
date to decide whether it needs additional time to prepare a written disclosure of any
negligent underpayments of tax. In the context of an audit by the Irish tax authorities,
a disclosure states the amounts of any tax liabilities previously undisclosed for the
taxheads or periods within the scope of the audit enquiry, together with the companys
calculation of the associated interest and penalties arising from the undisclosed
liabilities. The disclosure must be accompanied by payment of the total liability arising
in respect of tax, interest and penalties. Details on the calculation of interest and
penalties are set out under Additional tax and penalties.
Audits generally commence with an opening meeting between the company and the
offcial(s) of the Irish tax authorities carrying out the audit. In the situation where the
taxpayer decides to make a written or verbal disclosure in relation to the returns under
review, this will be presented to the auditor at the opening meeting. The auditor may
ask for more information concerning the disclosure.
The initial audit work is likely to be devoted to checking the accuracy of any disclosure
made by the taxpayer following notifcation of the tax audit. The auditor will
then commence the inspection of the books and records supporting the tax return
beingaudited.
We expect the Irish tax authorities will adopt the same approach for dealing with
transfer pricing audits.
Following an audit, the Irish tax authorities may make an assessment where they are
dissatisfed with a return or returns made by the company. Generally, a time limit of
four years applies to the making of assessments where a full return has been made.
Where a taxpayer is dissatisfed with an assessment raised by the Irish tax authorities,
the taxpayer has the right to appeal against the assessment. This appeal must be in
writing and be made within 30 days of the issue of the assessment. The appeal can
be resolved by an agreement reached with the Irish tax authorities or by means of a
hearing in front of the Appeal Commissioners.
Depending on the decision of the Appeal Commissioners, the taxpayer may have
further avenues to appeal for a re-hearing to the Circuit Court, or to the High Court or
Supreme Court on a point of law.
Part 35A does not contain any specifc penalty provisions with respect to a transfer
pricing adjustment. In the absence of specifc penalty provisions being included, the
Irish tax authorities have indicated that the general corporate tax penalty provisions
Ireland
and the Code of Practice will apply to assessments raised due to transfer pricing
adjustments under the new transfer pricing rules.
Under the general corporate tax penalty provisions, interest arises on underpaid tax at
a daily rate of 0.0273%, which is 9.96% per annum.
Also in their Code of Practice, the Irish tax authorities have set out a penalty grid,
which shows the penalties charged for each of three categories of negligence on the
part of the taxpayer. The least serious category of negligence is insuffcient care (with
a 20% penalty), and the most serious is deliberate default (with a 100% penalty).
This grid is reproduced here:
Category of
tax default
Net
tax-geared
penalty Net penalty after mitigation where there is:
Cooperation
only
Cooperation
including prompted
qualifying disclosure
Cooperation
including unprompted
qualifying disclosure
Deliberate default 100% 75% 50% 10%
Gross carelessness 40% 30% 20% 5%
Insufcient care 20% 15% 10% 3%
The grid also shows that the penalty level can be reduced where:
1. The taxpayer cooperates during the audit with the Irish tax authorities. (Essentially
this means that the taxpayer complies with all reasonable requests made by the
Irish tax authorities for records and assistance.); and
2. The taxpayer makes a prompted qualifying disclosure (as a consequence of the
notifcation letter received from the Irish tax authorities) or unprompted qualifying
disclosure (no notifcation received from the Irish tax authorities that the taxpayer
has been selected for audit).
It remains to be seen how the Irish tax authorities will apply the Code of Practice. But
the authorities have clarifed in Tax Briefng Issue 07 of 2010 that the quality of the
supporting documentation will be a key factor in determining whether the adjustment
should be regarded as correcting an innocent error or as being a technical adjustment.
The Irish tax authorities do not have a dedicated transfer pricing unit. When transfer
pricing issues have arisen, resources have been drawn from international tax specialists
or the Large Cases Division of the Irish tax authorities. Going forward, only authorised
offcers designated in writing by the Irish tax authorities may make enquiries in
relation to transfer pricing. The Irish tax authorities have yet to clarify who will be
authorised offcers, but they are expected to be inspectors within the Large Cases
Division of the Irish tax authorities.
Should an Irish company not have internal comparable data to support the arms-
length nature of its international related party transactions, it may be able to
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obtain data on the gross and net margins of comparable companies operating in
Ireland by acquiring the annual returns of relevant companies from the Companies
RegistrationOffce.
All companies registered in Ireland are obliged to fle an annual return with the
Companies Registration Offce, unless an exemption from fling applies. Depending
on the size of the company, fnancial statements may be required to be fled with the
annual return.
4012. Risk transactions and industries
There are not considered to be particular related party transactions or industry sectors
that could be regarded as facing a higher-than-normal risk of a transfer pricing enquiry
from the Irish tax authorities.
To some extent, Irish taxpayers could be considered (indirectly) to be at a higher risk
of a transfer pricing review should overseas tax authorities, which have developed
extensive transfer pricing regulations, focus their attention on transactions or
industries that include overseas affliates of an Irish taxpayer.
Irish companies normally contemplate competent authority proceedings in respect
of transfer pricing adjustments imposed by overseas tax authorities on international
related parties that trade with the Irish companies, rather than transfer pricing
adjustments imposed by the Irish tax authorities.
Currently all of Irelands tax treaties contain a mutual agreement procedure. The
Irish tax authorities are willing to support requests for competent authority relief
on application by Irish taxpayers, subject to the facts and circumstances of the cases
coming within the provisions of the relevant double tax treaty.
It should also be noted that as a member of the European Union, Ireland is bound
by the Code of Conduct to eliminate double taxation in the area of transfer pricing,
approved by the EU Council of Finance and Economic Ministers on 7December
2004. The Code of Conduct aims to ensure more effective and uniform application
by EU member states of the 1990 Arbitration Convention (90/436/EEC), which was
designed to deal with double taxation issues faced by taxpayers arising from transfer
pricingadjustments.
Ireland does not have a formal APA procedure for Irish companies to agree prices with
the Irish tax authorities for international related party transactions. However, the Irish
tax authorities have been willing to negotiate and conclude bilateral advance pricing
agreements with treaty partners, and they are generally willing to consider entering
such negotiations once a case has been successfully accepted into the APA programme
of the other jurisdiction. It remains to be seen whether Ireland will formalise its APA
procedures in light of the recent introduction of the new transfer pricing rules.
Ireland
It should also be noted that the Irish tax authorities have, upon request, provided
inward investors with advance rulings on key tax issues relevant to the decision to
establish operations in Ireland. Until recently, these advance rulings were generally
provided on a companys qualifcation for Irelands manufacturing relief. Of late, the
key tax issue upon which taxpayers are requesting advance rulings from the Irish tax
authorities is whether income from a particular activity would be regarded as trading
income (taxed at 12.5%) or passive income (taxed at 25%).
In May 2003, the Irish tax authorities released a document titled Guidance on
opinions on classifcation of activities as trading. This document was prepared in
response to the growing number of advance opinions being requested of the Irish
tax authorities on the appropriate classifcation of particular activities for taxation
purposes. While its main purpose is to clarify the procedure for requesting an advance
opinion, the document from the Irish tax authorities also provides signifcant practical
guidance on the tax authorities attitude about what constitutes a trading activity.
The practical guidance is found in a number of examples set out in the document.
These examples are used by the Irish tax authorities to illustrate their thinking on three
key issues discussed in the document:
The notion that trading presupposes activity;
The distinction between trading and investment; and
The importance of the role of the applicant company in a group structure.
It should be noted that the Irish tax authorities have chosen not to set threshold criteria
(such as number of employees, value of tangible fxed assets, etc.) which, once met or
exceeded, would automatically deem an activity to be considered a trade.
It is understood that there is no liaison between the income tax authorities and the
customs authorities, even though they are both under the same Board of Management
and are controlled by the Minister for Finance.
Nevertheless, there is a signifcant overlap between the methods applied by the
Customs Service to value a transaction between related parties and the methods
contained in the OECD Guidelines to assess compliance with the arms-length
principle. Companies also must take care to ensure that any transfer pricing policies
implemented are also appropriate from a customs perspective and vice versa.
4016. OECD issues
Ireland is a member of the OECD, and the Irish tax authorities have publicly recognised
that the OECD Guidelines are the internationally accepted standard for the allocation
of profts among entities of a multinational. The new transfer pricing rules endorse
the OECD Guidelines, and Part 35A should be construed in a manner that best ensures
consistency with the OECD Guidelines.
I
Under the terms of Irelands tax treaties and the EU Mutual Assistance Directive, the
Irish tax authorities can and do exchange information with treaty partners and fellow
EU member states. Generally, Irelands tax treaties also allow for communication
between Ireland and the treaty partners for the purposes of implementing the
provisions of the double tax treaty.
There are no specifc thin capitalisation rules in Ireland, but some provisions
in the Irish tax legislation can deny a full deduction for interest payments in
certaincircumstances.
Interest payments to overseas affliates may, depending on the location of the
recipients, be reclassifed as distributions in certain situations, and therefore would not
be tax-deductible.
Other provisions apply to deny an interest deduction in circumstances where
borrowings from a related party are used to acquire share capital from (or lend to) a
company which immediately before the loan was connected with the borrower.
The reader is urged to consult with an Irish tax adviser concerning the application of
the deemed distribution and restriction on deductibility of interest rules.
The new transfer pricing rules will apply to the provision of management services
where those services represent an arrangement for the purposes of Part 35A as
described previously. Where an Irish company is paying for management services, the
general rules on deductible expenses will apply. Generally this means that a payment
will be deductible for tax purposes where a company receives a beneft from the
management services provided, once the payment is connected with the companys
trade and was at an arms-length price.
When a company is providing services, it should be remunerated for those services on
an arms-length basis and be seen to be generating income from the services provided
to ensure a tax deduction is obtained for the costs it incurs in providing the services.
This would usually be achieved by adding a proft element or markup to the cost of
providing the services.
Israel
41.
International Transfer Pricing 2011 497 Israel
4101. Introduction
On 24 July 2002, the Israeli Parliament completed comprehensive tax reform
legislation, which came into effect 1 January 2003. The reform includes transfer
pricing provisions which require all cross-border inter-company transactions to
be carried out at arms-length terms. The enacted Sections 85A, 243 and 244(A)
incorporate the arms-length principle, which applies to any international transaction
in which there is a special relationship between the parties of the transaction, and a
price was settled for property, a right, a service or credit. Sections 85A, 243 and 244(A)
came into affect upon issuance of fnal transfer pricing regulations by the Israeli
Parliament on 29 November 2006.
Overview
The Israeli transfer pricing regulations (the Israeli TP rules) promulgated under
Sections 85A, 243 and 244(A) of the Israeli Tax Ordinance (ITO) generally follow the
OECD Guidelines as well as Section 482 of the US Internal Revenue Code. The Israeli
TP rules require that all cross-border transactions carried out between related parties
be consistent with the arms-length principle and are expected to be taxed accordingly.
According to Section 85A of the ITO, the Israeli TP rules apply substantially to all types
of cross-border transactions
1
in which a special relationship
2
exists between the parties
to the transaction. These transactions, including various types of services (such as
research and development, manufacturing, marketing, sales and distribution), the use
or transfer of tangible and intangible goods and fnancing transactions, are required to
be carried out according to the arms-length principle. The Israeli TP rules also address
topics such as determining market terms, reporting research of market terms and
transitional provision.
On 29 October 2007, the Israeli Tax Authorities issued a transfer pricing form titled
Declaration of International Transactions. The new form must be flled out for every
cross-border transaction between related parties and attached to the annual income
tax return. This form applies to the 2007 tax year and onwards. The transfer pricing
form contains the following details:
1
Upon approval by the tax-assessing ofcer granted to a taxpayer, certain one-time transactions may be excluded from the
scope of the regulations.
2
According to the Section 85A of the ITA, special relationship includes the association between an individual and his/her
relative, the control of one party to the transaction over the other or the control of one individual over the other parties to the
transaction, whether directly or indirectly, singly or jointly with other individuals.
I
Israel 498 www.pwc.com/internationaltp
Transaction number;
An indication whether this is a one-time transaction;
Description (type of asset or service and feld of activity);
Details of the related party involved in the transaction;
Place of residency of the related party; and
Total amount of the transaction.
The taxpayer is required to attach to the annual tax return the signed transfer pricing
form, stating that I hereby declare that the transaction with foreign related parties is in
accordance with the arms-length principle, as defned in Sections 85A of the Israeli Tax
Ordinance and the relating regulations (free translation from Hebrew).
Application of the arms-length principle under the Israeli TP rules
Application of the arms-length principle is generally based on a comparison of the
conditions in a cross-border controlled transaction with the conditions surrounding
similar transactions entered between independent companies (comparable
companies). To determine if a cross-border controlled transaction has been carried
out in accordance with the arms-length principle, the following steps need to be taken:
Identify the cross-border controlled transactions within the group;
Identify the tested party for each respective transaction;
Perform a functional analysis with special emphasis on comparability factors
such as business activity, the characteristic of property or service, the contractual
conditions of the cross-border transaction and the economic circumstances in
which the taxpayer operates;
Select the appropriate transfer pricing method(s);
Select the comparable companies and establish an armslength range determined
by the comparable companies; and
Examine whether the tested partys results fall within the arms-length range.
In general, the Israeli TP rules specify six hierarchical transfer pricing methods which
would need to be applied in the following order:
Comparable uncontrolled price (CUP) method A method that compares the prices
for property or services transferred or provided in a controlled transaction to the
price charged for property or services transferred in a comparable uncontrolled
transaction under comparable circumstances;
Resale price method (RPM), cost plus (CP) method or comparable profts method
(CPM) Methods that compare the proftability that a taxpayer realises from a
controlled transaction to proft margins in comparable uncontrolled transactions;
Proft split method (PSM) A method that compares the controlled transaction
with an uncontrolled transaction according to the division of profts or losses
between related parties, that refects the contribution of each party to the
transaction, including the exposure to risks and rights to the assets relating to the
transaction; and
Other methods In cases where none of the above-mentioned methods can
be used to derive the most reliable measure of an arms-length result, the
taxpayer may apply any other method as the most appropriate method under the
specifccircumstances.
International Transfer Pricing 2011 Israel 499
Israel
The arms-length range
A cross-border controlled transaction is considered to be arms length if, following
the comparison to similar transactions, the result obtained does not deviate from
the results of either the full range of values derived from comparable uncontrolled
transactions when the CUP method is applied or the interquartile range (the values
found between the 25th and 75th percentiles in the range of values) when applying
other methods. Under a TP audit, if the results of the cross-border controlled
transaction fall outside the relevant range (either the full range or the interquartile
range, depending on the method used), the transfer price will be set at the median of
the comparable results.
Transitional provision
The Israeli TP rules shall apply to international transactions carried out on and after
the day of their publication. However, a transfer pricing study carried out before these
regulations were published and that within two years of their publication, shall be
deemed a transfer pricing study carried out according to these regulations if it was
carried out according to the accepted guidelines published by the OECD or by its
member states.
Advanced pricing agreements (APA)
A taxpayer that is a party to a cross-border controlled transaction may request an APA
from the Israeli tax authorities for a particular transaction or for a series of transactions
that have been set at arms-length levels. The request for such an agreement should
include supporting documentation with respect to the transaction, including
documents that demonstrate how the transfer price was established, inter-company
agreements, and opinions or any other supporting documentation that supports the
arms-length compensation that has been established for the specifc transaction.
The tax-assessing offcer will inform the taxpayer of his decision within 120 days
(this period can be extended to 180 days). If the tax-assessing offcer does not
respond during this period, the transfer price will be deemed to have been set at
arms-lengthlevels.
Currently, the Israeli tax authorities issue only unilateral APAs. At the conclusion of
the APA procedure there is a binding agreement between the taxpayer and the Israeli
taxauthorities.
Reporting procedures
The Israeli TP rules require all taxpayers engaging in cross-border controlled
transactions to include in their annual tax return the Declaration of International
Transactions form.
Furthermore, the tax-assessing offcer may issue the taxpayer a formal letter of request,
requiring the taxpayer to submit, within 60 days of the letters request, all relevant
documentation and other information related to the inter-company transactions. This
information includes:
Description of the principal cross-border controlled transactions and the parties
involved in these transactions;
Description of the business environment and the economic circumstances in which
the parties operate;
Israel 500 www.pwc.com/internationaltp
I
Functional analysis of the parties involved in the transactions (including functions,
risks and resources employed);
Selection of the pricing method and the reasons behind such selection; and
Economic analysis (determination of arms-length prices).
In addition, the taxpayer should submit supporting documentation such as contracts;
any disclosure made regarding the controlled transactions to any foreign tax authority,
including any request for an advanced pricing agreement; and any differences between
the prices reported to the foreign tax authority and the prices reported in the Israeli tax
returns. Furthermore, the taxpayer is required to disclose all transfer pricing studies
conducted or an assessment prepared for purposes of fling to the Israeli or other
foreign tax jurisdictions, as well as any opinion from an accountant or lawyer, if such
were given.
According to the Israeli TP rules, the initial burden of proof lies with the taxpayer.
The taxpayer is required to submit the appropriate documentation and relevant
information of the inter-company transactions to the tax-assessing offcer within 60
days of the latters request. Once the taxpayer has presented all relevant information as
required, the burden of proof shifts to the assessing offcer.
4104. Penalty regime
No specifc TP penalties exist under the Israeli TP rules. However, general penal and
monetary sanctions set in Israeli tax legislation may apply.
Italy
42.
International Transfer Pricing 2011 501 Italy
4201. Introduction
Transfer pricing has gained attention in recent years in Italy. The main reason is an
ongoing relocation of manufacturing out of Italy to territories with low production
costs, developed infrastructure, tax incentives and a skilled labour force, as a long-term
strategic response to the increasingly challenging business environment. In addition,
highly centralised business model structures resulting from supply chain restructuring
(i.e. change of business model for distribution or manufacturing companies) also have
become more common within MNEs with a concentration of high-value intangibles
and entrepreneurial functions and risks in tax-advantaged jurisdictions.
Notwithstanding this increasing focus on transfer pricing, the statutory rules in Italy
and tax authority circulars relating to transfer pricing are dated.
Statutory rules on transfer pricing are set out in Article 9 and Article 110 of the Italian
Income Tax Code.
Article 110, paragraph 7 states that components of the income of an enterprise derived
from operations with non-resident corporations that directly or indirectly control the
enterprise are controlled by the enterprise or are controlled by the same corporation
controlling the enterprise, have to be valued on the basis of the normal value of the
goods transferred, services rendered and services and goods received, if an increase in
taxable income derives there from. Possible reductions in taxable income as a result of
the normal value rule are allowed only on the basis of mutual agreement procedures or
the EU Arbitration Convention.
Article 9, paragraph 3 states that normal value means the average price or
consideration paid for goods and services of the same or similar type, carried on at
free market conditions and at the same level of commerce, at the time and place in
which the goods and services were purchased or performed. For the determination
of the normal value, reference should be made to the extent possible to the price
list of the provider of goods or services. In the absence of the providers price list,
reference should be made to the price lists issued by the Chamber of Commerce and to
professional tariffs, taking into account usual discounts.
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Italy 502 www.pwc.com/internationaltp
The translation of the above statutory rules into operating guidelines was effected
through the Ministry of Finance instructions in Circular Letter No. 32/9/2267, dated
22 September 1980. The circular letter provides principles and methods to be used in
determining normal value. In particular, it:
Defnes the scope for the application of transfer pricing rules;
Details the base methods to be used to determine normal value:
CUP (required method where applicable);
Cost plus method.
Details the alternative methods acceptable as check methods and when the base
methods are not applicable:
Global proft split;
Proft comparison;
Return on invested capital; and
Gross margin comparison.
Provides specifc guidelines for transactions relating to the sale of tangible assets,
intangibles, interests and intragroup services.
The 1980 circular letter was released following the 1979 OECD Transfer Pricing
Report. The 1995 OECD Guidelines are a general point of reference and the basis for
any mutual agreement or APA procedures. However, they have not been incorporated
as such yet into the Italian legal framework, and in some cases local practice may vary
from both the 1979 and the 1995 OECD positions.
New rules to refect the 1995 OECD Guidelines have been expected for some time but
were deferred, partly as a result of the economic environment in 2009. A completed
draft legislative decree is now understood to be ready for ministerial approval, with
tax authority expectations in spring 2010 that this approval will take place during the
current calendar year.
4204. Legal cases
In recent years there have been various court decisions relating to transfer pricing.
The most important cases are listed below; they provide general principles on various
points (i.e. concept of free competition, arms-length defnition, burden of proof and
necessary documentation in order to deduct the inter-company charges). Decisions
from the Court of Cassazione represent the fnal Italian court of appeal or the Supreme
Court. Provincial and regional tax court decisions represent frst and second instance.
Judgment No. 13233 of the Civil Cassation, fscal division (October 2001)
Judgment No. 13233 deals with the concept of free competition.
The Italian company subject to assessment (ITCO) purchased goods from its foreign
parent. The Italian tax authorities (ITA) adjusted the purchase price on the grounds it
was not at arms length. ITCO appealed to the court and claimed that transfer pricing
provisions were not applicable in its case due to the absence of free competition in this
sector in Italy; only one other Italian company produced the same product, and this
was under licence from its foreign parent. The court determined that in order to speak
of free competition it is enough that a similar product is sold in Italy without any
International Transfer Pricing 2011 Italy 503
Italy
legal restriction on pricing. There is no need to have ideal free competition. For this
reason, the court rejected the appeal.
Judgment No. 130 of the Tax Court of Tuscany (January 2002)
Judgment No. 130 concerned the defnition of arms-length value.
The tax court stated that normal value can be determined by reference to average
data from the sector in particular, data provided by the trade association to which the
Italian resident company belongs, also confrmed by fnancial statement data from
Italian companies in the same sector.
Judgment No. 253 of the Tax Court of Ravenna (November 2002)
Judgment No. 253 concerned a non-interest-bearing loan made to a controlled non-
resident company.
The ITCO granted a non-interest-bearing loan to a controlled company resident
in Luxembourg. The ITA assessed interest income at the normal value based on
the Italian Bankers Association (ABI) prime rate. The ITCO was not able to justify
the reasons for having granted a signifcant non-interest-bearing loan to its foreign
affliate, when the ITCO bore interest costs on its own external debt. The tax court
recognised that the inter-company loan should create income for the Italian company
and correct the amount of interest calculated by the ITA.
Judgment No. 1070 of the Tax Court of Vicenza (February 2003)
Judgment No. 1070 concerned inter-company sales made without markup.
The ITCO sold raw materials to a German-related company at a price equal to purchase
price without any markup. Based on data in the companys fnancial statements, ITA
derived an average markup on costs realised by the ITCO in its other operations (38%)
and applied this markup to the sale of raw materials.
The tax court determined that the assessment should be cancelled for the
followingreasons:
The operation under review was of negligible value compared with the volume of
purchases and sales made by the ITCO as a whole;
The operation was not comparable with the companys usual inter-company
transactions (The ITCOs business activity consisted of sales of fnished
products);and
The operation was undertaken for the purpose of allowing the German company to
produce a particular product for sale to an important Italian client. The aim was a
signifcant increase of the ITCOs overall business.
Judgment No. 13398 of the Civil Cassation, fscal division
(September 2003)
Judgment No. 13398 concerned the burden of the proof.
The ITCO (in a tax loss position) applied to sales made to its French parent company a
6% rebate once a certain sales threshold was reached. The ITA considered the rebate
had not been justifed by reference to costs and risks borne by the French company
and consequently determined an adjustment on the ITCO, arguing that the company
should have demonstrated that the rebate was justifed by reference to distribution
costs and risks borne by the parent company, and consequent savings for the ITCO.
A matching of savings and rebates was considered necessary to show that the prices
applied were in line with those applied to the third parties.
I
The court decided that in the absence of the required benefts demonstration, the ITA
adjustment was correct.
Judgment No. 158 of the Tax Court of Milan (June 2005)
Judgment No. 158 concerned the documentation necessary to support the deductibility of
inter-company services charges.
The ITCO received charges from its foreign parent company under a multilateral
service agreement. These charges were considered non-deductible by the ITA due to
alleged lack of documentation.
The Milan Tax Court decided in favour of the ITCO judging that it had presented
suffcient documentation to show the certainty of the costs sustained and that the costs
were related to the ITCOs business, including:
Written agreement describing the services provided;
Comfort letter issued by a major audit frm attesting that the cost allocation had
been correctly performed and that the attribution of costs to the various group
entities had been made on the basis of the benefts they received;
Invoices containing a detailed description of the services performed;
Demonstration that the costs borne, with reference to the services received,
were correctly recorded in the accounting records and included in the fnancial
statements of the Italian company; and
Documentation describing, for each type of service, the nature of the activity
performed and the advantage received by the Italian company.
Judgment No. 22023 of the Civil Cassation, fscal division (October 2006)
Judgment No. 22023 sets out the important principle that the inappropriateness of a
companys transfer pricing must be proved by the ITA, upon whom lies the burden of
demonstrating that the company does not comply with the arms-length principle.
The ITCO, which purchased cars from foreign-related companies, bore repair and
maintenance costs on new cars, without adequate remuneration. The ITA argued
that this caused a reduction in the Italian tax base and an increase of proft for related
companies resident in low-tax jurisdictions but did not provide any real evidence
ofthis.
The court decided in favour of the ITCO because the ITA did not demonstrate that the
groups transfer pricing was unfair. The court referred to the OECD Guidelines, which
expressly state that if the local jurisdiction provides that the tax authorities should set
out the reasons for any adjustment, the taxpayer is not obliged to prove the correctness
of its transfer prices unless the tax authorities have frst demonstrated (at least prima
facie) that the arms-length principle has not been observed.
Judgment No. 1/30/2007 of the Tax Court of Piedmont (January 2007)
Judgment No. 1/30/2007 provides guidance on whether costs relate to the business and
on fair market value of services received.
In order to fulfl its contractual obligations with a newly acquired Italian company,
the ITCO in a startup phase, availed itself of consulting services from a UK-related
company (UKCO). The consulting agreement between the ITCO and the UKCO
provided for charges from the UK based on ITCO turnover (5% during the frst year
of activity; lower percentages in the following years). The agreement provided that
the fee to the UKCO should not in any event exceed the underlying costs, with a
15%markup.
Italy
The ITCO deducted the charges from the UKCO for income tax purposes. The ITA
challenged the deduction due to the generic description of the invoices issued by the
UKCO and for failure to demonstrate the reasonableness of the charge taking into
account quality and quantity of services received.
The ITCOs appeal was accepted at frst instance. The ITA appealed the frst instance
judgment but the Court of Second Instance of Piedmont confrmed the ITCOs position.
The reasons given for the decision were that:
Although the description in the invoices was generic, reference to the agreement
with the UKCO allowed it to be inferred that there was a complex activity of a
constant and continuous nature that rendered it impossible to provide an analytical
description of the services actually provided in each invoice;
The activity was necessary for the ITCO, which was in a startup phase without the
resources and skills required by its client;
The lump-sum remuneration (percentage of turnover) for the service provider was
not considered as tax avoidance but was in line with the provisions of Ministerial
Circular 32/80 concerning transfer pricing;
The taxpayer is required to prove the costs related to the business and were
appropriately determined; and
The fact that the agreement provided that the remuneration for the UKCO should
not exceed the latters costs plus a 15% markup demonstrated in the eyes of the tax
court that the consideration agreed was determined by reference to the costs borne
by the service provider.
Judgment No. 52 of the Tax Court of Pisa (February 2007)
Judgment No. 52 concerned the applicability of the CUP methodology.
The ITA issued a notice of assessment on the ITCO, a company operating in the garden
pumps market, to cover revenue resulting from the sale of products to a French-related
party at a price lower than normal value. The ITA compared the sale prices applied to
third parties with those applied to the French-related company, observed that the inter-
company prices were lower by about 10%, and assessed the difference.
However, the court agreed with the arguments of the taxpayer, which demonstrated
that the transactions taken by the ITA were not comparable as regards the stage
of commercialisation, the volumes involved and the number of shipments. These
differences would have been suffcient to justify a 10% difference in the sale price. The
court stated that the ITA should at least have carried out an analysis of the tax rates in
force in the two countries and of the comparable transactions.
Judgment No. 9497 of the Civil Cassation, fscal division (April 2008)
Judgment No. 9497 concerned the power of the ITA to verify the appropriateness of
compensation agreed between Italian resident companies.
The ITCO had an existing contract with its directly controlled Italian refnery for the
receipt of certain refnery oil services. The refnery compensation was guaranteed to
cover all the plants fxed costs and variable costs and provide a fair proft margin.
Both the ITA and the provincial tax court disallowed the proft margin paid by the ITCO
to the refnery. However, the regional tax court decided that the service received by
the ITCO was defnitely related to its own operations, and any requirements in transfer
pricing and anti-avoidance provisions that would allow the ITA to disregard the
agreement between the parties were not met.
I
The Supreme Court revoked this judgment, determining that the ITA may verify the
amount of costs and proft in fnancial statements or tax returns and make relative
adjustments where there are no accounting irregularities or errors in legal documents.
The ITA may deny deductibility, in whole or in part, where a cost is considered to
be without foundation or is disproportionate. Therefore, the ITA is not bound to the
values or the compensation arrived at in company decisions or contracts.
Judgment No. 20 of the Regional Tax Court of Bologna (April 2008)
Judgment No. 20 concerned the deductibility of management costs derived from a written
contract between the parties prior to the cost recharge and the use of a percentage of
turnover mechanism.
The ITCO was charged certain management costs by its parent based on a lump-sum
linked to estimated turnover. The ITA disallowed the deductibility of these costs as
there had been no analysis of their nature and, therefore, it might be assumed some
were not relevant to the ITCOs business.
The ITCO argued that although it was part of a group, it was not wholly controlled,
as there was a 35% minority interest. The services were agreed and performed on the
basis of a written agreement signed before the fscal year in question. The contract
stated remuneration for these services (equal to 2.86% of turnover), which should be
considered arms length.
The regional tax court agreed with the taxpayer arguments taking into account the fact
that the ITAs case was based on mere assumption. The ITA did not prove the absence
of services or that the services had no bearing on the ITCOs business.
Judgment No. 87 of the Regional Tax Court of Milan (March 2009)
Judgment No. 87 concerned the application of the arms-length principle to inter-company
sales in a multinational group.
The ITA issued a notice of assessment on the ITCO (a contract manufacturer) for
fscal year 2003, on the basis that the ITCO had sold fnished goods to a Swiss-related
company at a price lower than the arms-length price in order to transfer income to
Switzerland. The ITAs challenge was based on the fact that the Swiss company sold the
same products to an Italian reseller in the group at a higher price.
The ITCO claimed the higher price charged by the Swiss company to the Italian reseller
was justifed for the following reasons:
The Swiss company owned the trademarks and patents, performed research and
development, and bore the foreign exchange, credit and inventory risks;
The ITCO performed manufacturing for the Swiss company and did not bear any
inventory risk as a contract manufacturer; and
The Italian reseller performed fnishing activities based on local market preferences
and managed the sales network.
The court cancelled the assessment, as it did not consider the ITA had discharged
the burden of proof to show the prices to be non-arms length. Moreover, the court
considered that the sales prices from the ITCO to the Swiss company were in line with
those applied by the Swiss company.
Italy
Judgment No. 5926 of the Civil Cassation, fscal division (March 2009)
Judgment No. 5926 concerned the deductibility of inter-company costs charged by a non-
resident entity to its permanent establishment in Italy.
The case dealt with the determination of certain overhead costs (administrative
expenses, fight operations and maintenance of the feet) related to the international
airline business, paid by a company resident outside Italy also for its permanent
establishment in Italy.
The ITA issued a notice of assessment on ITCO for 1998, disallowing costs that it
considered undocumented. The provincial tax court confrmed the ITAs position.
The ITCO appealed to the Supreme Court, claiming that it was not possible to make a
detailed individual analysis of costs as they were incurred by the overseas company and
charged pro rata to the branches based on the latters sales. The fnancial statements
and the auditors report were appropriate to support the non-resident company costs
charged to Italy, unless the tax offce could show error committed by the auditor.
The Supreme Court agreed to the taxpayers case and confrmed that the auditors
report was adequate to support the costs registered into the yearly fnancial statement.
The general principle is that the burden of proof lies with the Italian tax authorities;
however, the taxpayer is expected to demonstrate the fairness of its inter-company
transactions in the event of an assessment by the tax authorities. This general principle
also has been confrmed by the above Civil Cassations decision, dated October 2006
and by the Judgment No. 52 of the Tax Court of Pisa, dated February 2007.
Particular rules apply to cross-border transactions involving counterparties (including
third parties) resident in tax havens. The Italian taxpayer, in order to deduct the
relevant costs, must provide evidence:
That the foreign party is a genuine commercial undertaking; and
That the transactions were effected in connection with a real economic interest and
that the relevant transaction actually took place.
The costs must be disclosed in the companys tax return; otherwise penalties will apply.
The ITA focuses its attention on major taxpayers and hence on multinationals. From
2002, taxpayers with turnover above approximately EUR26 million are expected to
be systematically audited at least once every two years. From 2002, also the taxpayers
with turnover above EUR5.2 million will be systematically audited at least once every
four years. These audits may be complete and extensive or just focus on specifc items
such as transfer pricing. Even if these parameters are not consistently met, audits are
becoming signifcantly more regular.
New provisions concerning large corporations have been introduced by Law Decree
n. 185/2008 (the so called anti-crisis decree) converted into Law n. 2, dated 28
January 2009. Companies with revenue above EUR300 million will be subject to
substantial control on their income tax and VAT returns in each fscal year following
I
that in which the fling has been made. This revenue threshold gradually will be
reduced to EUR100 million by the end of fscal year 2011.
The ITA is increasing the level of exchange of information with foreign tax authorities.
the tax authorities
There are no specifc documentation requirements concerning transfer pricing, but
this is expected to change when the Italian transfer pricing law is updated. The tax
police is aware that most multinational groups prepare documentation and will ask
for it. Where no documentation exists they have greater freedom to organise the audit
as they wish. Where economic rationale is a key part of a taxpayers transfer pricing
argument, it is advisable to have prepared documentation.
General rules on tax documentation apply; accordingly, all income and expense items
should be capable of adequate substantiation.
The ITA may require taxpayers to produce contracts or other documents (also in the
form of answers to questionnaires) during an audit. In this case, taxpayers are obliged
to comply with the requests. If a taxpayer fails to submit documentation within 15 days
after the tax authorities request (term may be extended at tax authorities discretion),
an assessment may be made based on the tax authoritys assumptions.
Tax audits in Italy are normally carried out on the taxpayers premises. The audit
visit may be preceded by a formal request for information by the tax authorities, but
normally tax audits are not announced in advance. Apart from exceptional cases, the
duration of an onsite tax audit may not exceed 60 days. At the end of the audit, the
authorities release a report with fndings and proposed adjustments.
The company may fle a defence brief or rebuttal against the tax audit report with
the relevant tax offce within 60 days. Until the 60 days have elapsed, the tax offce
may not issue any tax assessment. The tax authorities will not necessarily issue an
assessment immediately after the 60 days expire, and the formal assessment may not
appear for some time.
Tax issues, including transfer pricing, may be settled with the tax authorities without
litigation. The relevant procedure was introduced by Decree 218/1997 and is termed
accertamento con adesione. If an agreement is reached, an offcial report is drawn up,
showing the amount of taxes, interest and penalties due.
Once litigation commences, the company and the tax authorities may still settle the
dispute out of court. Indeed, they are required to consider this option. The procedure
introduced by Article 48 of the Decree 546/1992, is called the judicial settlement
procedure. In the event a settlement is reached, penalties are reduced to one-third.
If the dispute is decided in court, penalties are applied in full. There are three stages
before a fnal judgment is reached with no further prospect of appeal: First Instance
(provincial); Second Instance (regional); and Supreme Court or Corte di Cassazione.
Italy
Unless a suspension is obtained while the dispute is pending, the tax authorities are
allowed to collect 50% of the tax assessed before the frst instance decision is given,
two-thirds of the tax (and penalties) due following the frst-degree judgment, and the
total taxes (and penalties) due following the second-degree judgment.
Italian tax law requires taxpayers to fle tax returns, maintain tax books and records,
withhold tax at source, etc. If the taxpayer does not fulfl these obligations, then
administrative or in certain cases, criminal penalties may be imposed. The general
penalty regime applies to transfer pricing.
Administrative penalties range from 100% to 240% of the amount of tax unpaid.
Special rules apply where similar violations are repeated over various fscal years.
Administrative penalties arise due to the fact of an adjustment. There is no need for the
tax authorities to adduce negative taxpayer behaviour for penalties to arise.
Penalties may be reduced:
To one-tenth of the minimum (i.e. 10% of tax on adjustment) for spontaneous
disclosure (without any tax audit in place);
To one-quarter of the minimum (i.e. 25% of tax on adjustment) for a negotiated
settlement on a tax assessment (Accertamento con Adesione) which is reduced
to one-eighth if the taxpayer agrees to all adjustments proposed at the end of the
audit within 60 days and before an assessment is formally made); and
To one-third in the event of the judicial settlement procedure (see the
precedingparagraph).
The tax offce has four years from the end of the year in which the tax return was fled
to issue assessments for additional tax. This period is increased to fve years if no return
was fled (Art. 43 DPR 600/1973), and to 8 years if a crime report is issued.
Based on Legislative Decree n. 74 dated 10 March 2000, transfer pricing adjustments
may trigger criminal penalties as related to issues of valuation. Although it is
arguable that the concept of valuation in the legislative decree should not cover
transfer pricing business practices, the Italian tax authorities do tend to notify the
outcome of a transfer pricing assessment to the local public prosecutor when the
adjustment amount exceeds the relatively low threshold for notifcation.
There are units dedicated to transfer pricing, and the number of audits has increased in
recent years. There are more qualifed personnel performing audits, and staff members
in local offces also have received transfer pricing training. There is an improved level
of preparation and appreciation of resources that can be used in conducting transfer
pricing audits.
The Italian administrations have created specifc task forces to monitor larger
companies on all their tax issues, with particular emphasis on transfer pricing and
permanent establishments where appropriate.
I
Use
In order to support their transfer pricing policy, a taxpayers documentation often
includes a benchmark analysis, showing that the results earned by the company fall
within the arms-length range of results realised by comparable companies.
Availability
Italian companies are required by law to fle their fnancial statements with the
local Chamber of Commerce. In this respect, it is possible to obtain detailed data on
the results of other companies, including extensive notes in many cases. These can
be regularly accessed online both by taxpayers and the tax authorities. There are
databases allowing research of comparable companies at a European and Italian level.
The Italian tax authorities have access to these.
In January 2008 the Italian tax authorities (Agenzia delle Entrate) issued Circular
Letter n. 6/E, dated 25 January 2008. The circular highlights international transfer
pricing for consideration as well as inter-company transactions between resident Italian
companies when an internal transfer pricing issue could occur due to the presence of a
favourable tax regime.
The Italian Tax Police (Guardia di Finanza) issued Circular Letter, n.1/2008,
containing guidelines to be followed by its offcers when performing tax audits.
Chapter 6, titled International Tax and tax audits methodologies, provides specifc
operative guidelines for tax offcers when assessing companies on transfer pricing and
permanent establishment issues.
The circular provides specifc criteria for offcers to identify Italian companies whose
inter-company transactions warrant particular attention. The following are specifcally
mentioned and are typical of the type of transaction where emphasis is placed
inpractice:
Transactions with foreign-related companies in jurisdictions where they beneft
from favourable tax regimes;
Transactions concerning intangible assets (such as royalties) and services
(management fees);
Transactions where the Italian company acts as a mere intermediary
(commissionaire, agent) and receives a commission-based remuneration; and
The sale of high-value intangible properties by the Italian company to
foreignentities.
Italy has begun to use the EU Arbitration Convention and has given an impetus to
mutual agreement procedures for intra-EU issues. Based on our experience, use of the
competent authority process to obtain correlative adjustments has not been common in
Italy in other circumstances.
Italy
On 23 July 2004, an offcial procedure was published for a so-called International
Ruling, which was introduced by Article 8 of Law Decree No. 269 of 30 September
2003. This advance ruling is unilateral, although it is possible to achieve a bilateral
effect by using two unilateral agreements.
The procedure involves companies engaged in international activity, and may cover
transfer pricing, dividends, royalties and interests. The following may apply:
Italian resident enterprises that have transactions that fall under the Italian
transfer pricing rules and/or entities that are owned by non-resident shareholders
or themselves own non-resident entities and/or enterprises that receive or pay
dividends interest or royalties to or from non-Italian persons; and
Any non-resident company carrying on activity in Italy through a permanent
establishment.
The application for a ruling must be submitted to one of the competent offces (i.e.
Milan or Rome Offce, on the basis of company or permanent establishment tax
residence). The information to be included in the ruling application, under penalty of
no acceptance, is as follows:
General information concerning the company, such as the name, its registered
offce, its tax and VAT identifcation number, and so on;
Documentation that proves the eligibility requirements;
The scope of the application and the purpose of the ruling request; and
The signatures of the legal representatives.
Within 30 days from receipt of the application or from the completion of any inquiry
activity, the relevant rulings offce may notify the taxpayer to appear to verify the
accuracy of the information provided and to defne terms and conditions for the
subsequent negotiations. The full procedure should be completed within 180 days from
the fling of the request, but the parties may agree to extend the deadline. In practice,
the APA negotiation procedure is fairly lengthy.
Once an agreement has been reached, it remains in force for three years (the year
in which the agreement is signed and the two following years). There is no roll-
backprovision.
Within 90 days before the expiry of the agreement, the taxpayer may ask for a renewal.
The Revenue Offce must approve or decline a renewal at least 15 days before the
agreement expires.
As mentioned above (paragraph 4203) new legislation is expected to be issued
during the course of 2010. It should bring changes to the legal rules and the status
of the OECD Guidelines as well as documentation and penalties. In relation to
documentation, there is an expectation that the ITA may refer to the EU Code of
Conduct on transfer pricing documentation (EU TPD) (2006/C 176/01), and also
specifcally clarify what they expect to see.
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The ITA also have indicated on more than one occasion that they hope to establish a
framework for bilateral APAs under the relevant tax treaties.
Administrative rules enable the exchange of information between direct tax and
customs authorities, and recent experience suggests that such an exchange does occur
(in particular as regards importation of goods from tax haven jurisdictions).
4216. OECD issues
Italy is a member of the OECD and uses the OECD Guidelines in bilateral dealings
with other tax authorities. In the absence of detailed and up-to-date local regulations,
reference is often made to the 1995 OECD Guidelines by taxpayers, but the 1980
Ministerial Circular still tends to be a tax auditors frst point of reference until the
lawchanges.
The Italian courts have recognised the 1995 guidelines as persuasive. It is also
important to note that in relation to other OECD material (e.g. the OECD Model Treaty
Commentary) in three identical decisions relating to a permanent establishment case,
all in 2006, the Supreme Court limited the role of the OECD commentary. This was
held not to have legislative value but to represent, at the most, a recommendation that
may not override local law.
On 1 May 2006, Italy became the 12th party to the joint OECD Council of Europe/
OECD Convention on Mutual Assistance in Tax Matters. As a party to the convention,
Italy enhances its ability to combat tax evasion and avoidance through exchange
of information on a wide range of taxes. The other parties to the convention are
Azerbaijan, Belgium, Denmark, Finland, France, Iceland, the Netherlands, Norway,
Poland, Sweden and the US. A key feature of the convention is the ability to take part in
simultaneous multilateral examinations. Some joint investigations already have been
carried out.
4218. Deductibility of interest payable
The 2008 Finance Act (24 December 2007 Law no. 244) replaced the previous interest
deduction limitations (i.e. thin capitalisation and pro rata rules).
The new rule states that interest payable and similar charges are wholly deductible, in
each fscal year, to the extent of interest receivable and similar income. In addition, any
excess of interest payable over interest receivable is deductible up to 30% of EBITDA.
The non-deductible amount may be carried forward without any time limit.
The new interest deduction limitation does not apply to certain taxpayers, including
individual entrepreneurs, partnerships, banks, fnancial entities, insurance companies,
and their holdings. It does apply, however, to holdings of industrial and commercial
groups. The rule applies to interest due both to related parties and to third parties.
Japan
43.
International Transfer Pricing 2011 513 Japan
4301. Introduction
Japan has had transfer pricing legislation in force since 1986, and it was one of the
frst countries to undertake advance pricing agreements (APAs) specifcally to cover
transfer pricing. Japan remains progressive and energetic in its approach to developing
transfer pricing practice. The Japanese tax authorities have a tremendous amount
of experience, and are committing more and more resources to the policing of the
transfer pricing regime. To date, many signifcant tax assessments based on transfer
pricing adjustments have received publicity. As a result, taxpayers should pay careful
attention to Japans transfer pricing environment.
4302. Statutory rules and other regulations
Japan enacted formal transfer pricing legislation in April 1986 with the Special
Taxation Measures Law (STML), Article 66-4, and since 2005, Article 68-88 for
consolidated companies (collectively, STML Articles 66-4 and 68-88). In support
of STML Articles 66-4 and 68-88, related cabinet and ministerial orders were issued
through the Special Taxation Measures Law Enforcement Order, Article 39-12 (since
2005 Article 39-112 for consolidated companies; collectively Enforcement Order
Article 39-12 and 39-112) and the Special Taxation Measures Law Ministerial Order,
Article 22-10 (Enforcement Order Article 22-10). The National Tax Agencys (NTA)
interpretation and guidance for the application of the transfer pricing rules are set out
in the related Special Taxation Measures Law Basic Circulars, dated 8 September 2000
(the 8 September 2000 Circular), 1 June 2001 (the 1 June 2001 Circular), and 25 June
2001 (the 25 June 2001 Circular), respectively.
Japan is a member of the OECD and actively participated in drafting the 1995 OECD
Guidelines for multinational enterprises (MNEs). As such, the NTA supports the
theory and practices set out in the OECD Guidelines, as confrmed by the 1 June 2001
Circular. In practice, the OECD Guidelines are interpreted and implemented within
the framework of Japans own transfer pricing legislation, as well as Japans unique
political and economic context. This localisation of OECD principles has created some
signifcant differences in the implementation of the Guidelines in Japan compared with
other jurisdictions.
Nevertheless, Japans transfer pricing legislation, consistent with the OECD Guidelines,
is based on the arms-length principle. Put briefy, STML Articles 66-4 and 68-88
provide that a corporation (or other juridical person) that has conducted the sale
or purchase of inventory, rendered services, or engaged in other transactions with a
foreign-related party, must do so at an arms-length price. In transactions where the
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Japan 514 www.pwc.com/internationaltp
Japanese tax authorities determine that arms-length principles have not been adhered
to for the purposes of corporation tax, the price can be adjusted to approximate a third-
party transaction. In this situation, under the legislation, the Japanese tax authorities
have broad powers to recalculate the transfer price.
Framework of the transfer pricing legislation
In general terms, the legislation applies to international transactions between a
juridical person and an affliated foreign juridical person. As discussed in more
detail later, two juridical persons are affliated when a juridical person is engaged in a
transaction with a foreign juridical person with which it has a special relationship.
Applicability
Foreign transactions
In general, the Japanese authorities do not believe that there is a threat of lost tax
revenues in domestic transactions because any shifted income is ultimately taxed in
Japan. Consequently, Japans legislation applies only to foreign affliated transactions.
The rules apply between related corporations, regardless of whether the non-Japanese
company is the parent or the subsidiary. However, the rules do not apply to Japan-
sourced income of a non-Japanese affliate, where that income is taxable in Japan, due
to such affliate having a permanent establishment in Japan.
Juridical persons
The legislation applies to cross-border transactions between a juridical person and a
foreign juridical person. Juridical persons include corporations, corporations in the
public interest such as incorporated associations or foundations, and cooperative
associations such as agricultural cooperative associations or small-enterprise
cooperative associations. The legislation therefore does not apply to partnerships,
unincorporated joint ventures, unincorporated associations or individuals. A foreign
juridical person is a juridical entity that is established under the laws of a foreign
country and does not have its main offce in Japan.
The legislation does not specifcally refer to partnership transactions. While it is
thought that the legislation does not treat corporate partners as related by reason of
their partnership interests, it is believed that certain partnership transactions may be
covered if the relationship test is met and the transaction is between Japanese and
foreign taxpayers.
Defnition of affliated
Juridical persons are deemed to be affliated when a juridical person is engaged in a
transaction with a foreign juridical person with which it has a special relationship. A
special relationship is said to exist:
If they have a 50% or greater common ownership (see 50% test section); and
If another special relationship exists (see Other Special Relationship section).
The 50% test
The 50% test will be met if the taxpayer, who is a juridical person, directly or indirectly
owns 50% or more of:
The total number of issued shares (voting and non-voting) in the other juridical
person; and
The total amount invested in the other juridical person.
International Transfer Pricing 2011 Japan 515
Japan
Thus, the test will be satisfed in the typical case of a Japanese subsidiary of a
foreign parent as well as in the case of a foreign subsidiary of a Japanese parent.
Two corporations are deemed to be affliated in instances where, in a brother-sister
group, 50% or more of the issued shares (voting and non-voting) in each of the
two corporations are owned by the same party. Under the indirect ownership rules,
a corporation is deemed to own the stock held by another corporation if the frst
corporation owns 50% or more of the issued shares of the second corporation. This
ownership can be through one corporation or through several corporations. There
are no provisions in the Japanese tax law with respect to partnerships. Each partner,
however, is generally deemed to personally hold the assets of the partnership.
Accordingly, in the case of stock in a corporation, the number of shares deemed
held by each partner is proportionate to the partners ownership in the partnership.
Family attribution rules would also apply in determining whether indirect ownership
would meet the 50% test. Thus, in the case of a spouse, any holdings of the spouse are
included and, in certain cases, holdings of the spouses family.
Other special relationship
A special relationship will also exist in situations where the 50% stock ownership test is
not met. A special relationship includes situations where:
50% or more of the offcers of the company are or were employees or offcers of the
other company (to date no time limit has been specifed);
The representative director of the company is or was an employee or offcer of the
other company;
A considerable proportion of a companys operating transactions are with the
second company (operating transactions are those transactions that are generally
related to the corporations main source of revenue); and
A considerable proportion of a companys outstanding loans, which are necessary
to the companys operations, have been borrowed from or guaranteed by the
second company.
Transactions through unaffliated parties
The Japanese legislation will also apply to transactions entered into with unaffliated
persons in cases where the transactions with the foreign affliates are conducted
through an unaffliated person (presumably acting as a conduit). This rule is designed
to address transactions that take place with an unrelated trading company. Trading
companies in Japan play a vital role in facilitating the import and export of goods.
They act as an intermediary between the seller and the purchaser of the goods
in question. Some commentators believe this provision was necessary because in
Japan a substantial portion of the import/export business is conducted through
tradingcompanies.
Types of transactions covered
The legislation covers transactions involving the sale or purchase of tangible personal
property and other transactions. The legislation was deliberately left quite broad to
give the NTA a greater degree of fexibility. The types of transactions falling within the
other transactions category include:
Rents from tangible assets;
Royalties for the use of and consideration for the sale or purchase of
intangibleassets;
Interest on loans or advances; and
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Fees for inter-company services.
The legislation sets out detailed rules for transactions involving tangible personal
property, and requires the use of equivalent methods for other transactions. It should
be noted that the Japanese reporting form (Schedule 17(4) for taxpayers with fscal
years ending on or after 1 April 2009, formerly Schedule 17(3)), which is part of a
corporations annual tax return, includes requests for information regarding these
other transactions (see Section 4305).
Methods of arms-length price determination
The legislation provides that the affliated juridical persons must conduct their
transactions at an arms-length price. While the legislation does not specifcally
recognise either a range of arms-length prices or net proftability as a standard for
establishing specifc arms-length prices, both concepts are introduced by the 1 June
2001 Circular for the purposes of irregularity checks during audits. In addition, the
28 April 2005 amendment to the 1 June 2001 Circular provides that in determining
the arms-length price of the tested transaction, where more than one comparable
transaction has a high level of comparability, the average of those transactions may be
used as the arms-length price/proftability.
The sale or purchase of inventory
The legislation provides specifc methods for determining an appropriate arms-length
price. It provides that the arms-length price should be determined, in the case of the
sale or purchase of inventory, under:
The comparable uncontrolled price (CUP) method;
The resale price method; and
The cost plus method.
If these methods cannot be used, either a reasonable method that is similar to the
above methods, or other methods prescribed by Enforcement Order 39-12 should
beapplied.
The Japanese legislation does not provide a priority for the application of the CUP,
resale price, or cost-plus methods. In drafting STML Articles 66-4 and 68-88, the
legislators are believed to have felt that the absence of a priority of methods would give
companies greater fexibility in fnding the appropriate inter-company price to properly
refect an arms-length price within the particular industry or market. This tends to
suggest that a priority has not been assigned to any of the various methods.
The other methods
Enforcement Order Articles 39-12 and 39-112 in effect introduce the proft split
method and, for fscal years beginning on or after 1 April 2004, the transactional net
margin method (TNMM), as other methods. The proft split method requires profts
to be allocated between enterprises based on a key, with the following factors, either
singly or in combination, being used as an allocation key for calculating the proft split:
1. Costs if costs from the proft and loss account are the allocation key, then profts
could be allocated on the basis of the relative proportion of an enterprises:
a. Manufacturing plus operating costs; or
b. Staff costs plus costs for related facilities.
Japan
2. Assets if assets from the balance sheet are the allocation key, then profts could be
allocated on the basis of the relative proportion of an enterprises:
a. Operating assets; or
b. Capital employed.
It should be noted that Enforcement Order Articles 39-12 and 39-112 do not exclusively
require the use of this approach. Other factors illustrating the degree to which each
party contributed to the realisation of income can also be considered, although in
practice this might be less readily accepted by the NTA. The 8 September 2000 Circular
also allows the use of the comparable proft split method and the residual proft split
method. The comparable proft split method distributes the proft to the parties by
reference to the proft split ratio of a comparable transaction between unrelated parties
where such information is available. The residual proft split method may be applied
when either party to the controlled transaction owns signifcant intangible assets. In
this method, routine profts are frst distributed to the respective parties by reference to
the information of the uncontrolled transaction without having signifcant intangible
assets. The residual proft is then distributed to the respective parties in proportion to
the value of the signifcant intangible assets that they own.
The TNMM as described in the Enforcement Order Articles 39-12 and 39-112 provides
three ways by which arms-length pricing may be determined:
TNMM by modifed resale price (8(ii)) computes the transfer price in a transaction
involving a controlled foreign entity as the taxpayers resale price minus the sum of:
1. The taxpayers resale price multiplied by the operating margin of the
comparable transaction; and
2. The taxpayers selling, general, and administrative expenses.
TNMM by full cost markup (8(iii)) computes the transfer price in a transaction
involving a controlled foreign entity as the sum of:
1. The taxpayers total costs, being the sum of costs of goods sold and selling,
general and administrative expenses; and
2. The taxpayers total costs multiplied by the full cost markup of the
comparable transaction (i.e. the ratio of operating proft to total costs of the
comparabletransaction.).
Under 8(iv), the transfer price in a transaction involving a controlled foreign entity
may be computed by reference to a method similar to those described under 8(ii) or
8(iii).
Other transactions
For transactions other than the sale or purchase of inventory (such as rent for the use
of tangible property, royalties for the use of or consideration for the sale or purchase
of intangible property, fees for services rendered, and interest on loans or advances)
the legislation provides that methods similar to the CUP, resale price, and cost plus
methods can be used. If these cannot be used in a given situation, a fourth or other
method can be used. This other method is to be a reasonable method as described in
the previous discussion.
Moreover, for inter-company service fees, the 1 June 2001 Circular was updated on
20 June 2002 and 22 October 2008 (paragraphs 2-9 and 2-10) to include specifc
reference to the treatment of intragroup services, largely as a reiteration of the OECD
commentary on intragroup services (Chapter VII, OECD Guidelines). Payment for
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such services is deductible by the recipient company if the recipient would need to
acquire the services from an unrelated party, or perform them itself, if they were not
provided by the related party. However, services provided by a parent company in its
capacity as shareholder are not treated as services performed for consideration and are
not deductible. These paragraphs apply equally to both Japanese parent and foreign
parent multinational companies. In addition, the 22 October 2008 update introduced
a provision enabling the tax examiners to treat payments for inter-company services
that cannot be supported by the Japanese payer as non-deductible donation expenses
under the domestic tax legislation, rather than as a matter of transfer pricing under
STML Articles 66-4 and 68-88. (It is the NTAs position that taxpayers subject to an
adjustment to taxable income under the domestic tax legislation are not entitled to
relief through mutual agreement procedures even if double taxation occurs as a result.)
The 1 June 2001 Circular was also updated on 20 March 2006 and 25 June 2007
to include new guidance on the appropriate treatment of Cost Contribution
Arrangements (CCAs) and transactions involving intangible property.
4303. Legal cases
Court cases
On 30 October 2008, the frst court case on the application of STML Articles 66-4 and
68-88 was won by the taxpayer on appeal to the Tokyo High Court (the decision at frst
instance was issued by the Tokyo District Court on 7 December 2007). The basis for the
High Courts decision related primarily to the selection of transfer pricing methodology
and the issue of comparability. The NTAs use of secret comparables, which was upheld
by the Tokyo District Court, was not addressed by the Tokyo High Court (see Section
4310). The NTA abandoned its right to appeal the decision of the Tokyo High Court.
Tribunal cases
On 2 February 2010, TDK announced that the National Tax Tribunal had reduced a
determination made by the Tokyo Regional Tax Bureau (RTB) against the company in
2006 arising from electronic parts transactions with foreign affliates in Hong Kong
and the Philippines. As it is extremely rare for a taxpayer to succeed in an appeal to the
National Tax Tribunal on purely transfer pricing grounds, this result was interesting in
itself. In addition, the size of the reduction made by the National Tax Tribunal in favour
of TDK was also signifcant. In fact, it is understood that the National Tax Tribunal
reduced the originally assessed amount of JPY 21.3 billion by about JPY 14.1 billion.
Assessments
Details of some of the adjustments that have been made by the tax authorities, along
with related issues regarding disputes with the authorities, have been published from
time to time. In recent years, the number of cases and value of assessments by the RTB
have increased signifcantly. Following are the most recent examples of some of the
matters publicised. Note that the cases described herein are initial assessments only
and that the assessment amounts may be reduced as a result of a taxpayers recourse
options (see Section 4307).
2005 Merrill Lynch
Income from derivatives transactions between taxpayers affliates in the US and
Europe, and its three branch offces in Tokyo, was allegedly not recognised in Japan.
An income adjustment of JPY60 billion was made.
Japan
2006 Mitsubishi Corporation
Mitsubishi received an assessment from the Tokyo RTB for the year ended March 2000
which resulted in additional tax liability of JPY 5 billion for the companys transactions
with a subsidiary and an affliate of the companys Energy Business Group in Australia.
The Tokyo RTB also plans to assess later fscal years (six years ending in March 2005)
but issued the assessment for the year ended March 2000 frst due to the impending
expiry of the statute of limitations period. Mitsubishi has recorded provisions for
expected income adjustments of JPY 23.4 billion for all six years.
2006 Takeda Pharmaceutical Co., Ltd.
Takeda received a notice of assessment from the Osaka RTB in relation to the six
fscal years through March 2005 in connection with transferring its earnings to TAP
Pharmaceutical Products Inc., a 50-50 joint venture between Takeda and Abbott
Laboratories, by setting an unreasonably low proft margin for the Prevacid peptic
ulcer drug that the joint venture sells in the US. The adjustment to income was JPY
122.3billion.
2006 Sony Corporation (Sony) and Sony Computer Entertainment Inc.
(SCEI).
Sony and SCEI received a notice of assessment from the Tokyo RTB for the six fscal
years through March 2005 for transactions between SCEI and its subsidiary Sony
Entertainment America Inc. (SCEA), and Sony for fscal years ended March 2004 and
2005 for transactions related to CD and DVD disc manufacturing operations with a
number of overseas subsidiaries. The adjustment to income was JPY 74.4 billion.
2008 Honda Motor Co., Ltd.
Honda received a notice of assessment from the Tokyo RTB for the fve fscal years
through March 2006 for proft earned by its subsidiary in China. The Tokyo RTB said
that royalties paid by the Chinese subsidiary to Honda for production technologies
were insuffcient. The adjustment to income was JPY 140 billion.
The Japanese legal system places the burden of proof in all taxation matters with the
government. Transfer pricing examiners consider that this requires them to obtain
detailed information regarding comparable transactions, although they also believe
that generally such information cannot be disclosed to a taxpayer, as this is prohibited
by taxpayer confdentiality requirements. This situation gives rise to the issue of so-
called secret comparables (see Section 4310). In practice, in any audit, the taxpayer
has a clear burden under the legislation to provide information and, in any case, as a
matter of examination management strategy, it could be potentially disadvantageous
to withhold information.
Companies are required to complete and return an annual corporation tax return.
As part of that return, Schedule 17(4) must be completed; this gives details of the
taxpayers foreign affliated parties and any transactions with those foreign-related
parties, including disclosure of the transfer pricing methodology adopted for each
transaction. A review of this form, in conjunction with the companys fnancial
statements and a review of the companys results may lead the tax authorities to select
a company for audit.
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Within the context of this review, the NTA is likely to be alerted to the possibility of
transfer pricing issues in cases where:
The volume of transactions with affliated foreign companies is notably large;
Inter-company prices, commission paid, and royalty rates charged are set but later
changed so that related foreign parties receive advantages or benefts;
A companys proft does not increase in proportion to expansion in the market for
its principal product or is not in proportion to the taxable income of comparable
companies;
Losses are made on the sale of products purchased from affliated
foreigncompanies;
Affliated foreign companies are making profts that do not refect the functions
they perform;
The functions performed by affliated foreign companies are not clearly identifed;
The basis on which royalty rates have been calculated are not identifed; and
The basis on which income is allocated between the company and affliated foreign
parties appears to be unreasonable.
The likelihood of a transfer pricing audit is the same for domestic or for
foreign-ownedcompanies.
Once a transfer pricing issue has been identifed, specialist examiners from the
appropriate RTB visit the taxpayers premises to conduct an investigation.
The tax authorities are entitled to request any information they consider necessary to
determine the appropriate transfer prices. The 1 June 2001 Circular sets out in detail
examples of the kinds of documents that may be requested by the examiners. These
include the books of account, records, and other documents, not only of the taxpayer
but also of the foreign affliate. As to requests for overseas information, the taxpayer is
required to endeavour to meet such requests. If a taxpayer fails to present or submit,
within a reasonable period of time information including overseas information that
is recognised to be necessary to determine an arms-length price, the authorities may
impute taxable income to the Japanese company on the cross-border transactions
with a foreign affliate by applying one of the prescribed methods. The prescribed
methods include either the resale price method, the cost plus method, or a proft split
method using a high-level global proft split (i.e. based on an allocation of the total
consolidated operating margin of the entire group to which the taxpayer belongs,
as disclosed in the groups annual report assuming that a segmented consolidated
operating margin including the transactions under audit is not provided in the annual
report). In calculating the additional taxable income, the tax authorities are to use
businesses comparable in terms of type, size, and other characteristics to the Japanese
taxpayer. The imputed method is a last resort and to date there has reportedly only
been one case where it has been applied by the tax authorities.
4307. Recourse options
There are three domestic methods and one bilateral method of recourse for tax relief
available to taxpayers upon receiving a notice of assessment:
1. Domestic Recourse:
Japan
a. Request for Reinvestigation to the applicable RTB;
b. Application for Review to the National Tax Tribunal; and
c. Litigation.
2. Bilateral Recourse under the Japan/Treaty Partner Nation Tax Convention
(competent authority negotiations).
Interest is charged on unpaid tax at the lower of 7.3% per annum or the sum of the
basic discount rate and basic loan rate (previously known as the offcial discount rate)
as of 30 November of the previous year (0.30% as of 30 November 2009), plus 4% (i.e.
total of 4.30% for interest accruing in 2010) for one year after the due date for fling,
and for the period from the issuance of the notice of assessment until the date on which
the additional tax is actually paid. The interest rate increases to 14.6% if unpaid tax is
not subsequently paid within three months of the date that a notice of assessment is
issued. This is statutory interest and is not deductible for corporation tax purposes.
There is an automatic penalty of 10% of additionally assessed taxes, plus 5% of
additionally assessed taxes exceeding the amount higher of taxes originally reported or
JPY 500,000. However, a 35% penalty is imposed on understatements where deliberate
tax evasion is judged to have taken place. These penalties are not deductible for
corporation tax purposes.
Effective 1 April 2007, in the event that a taxpayer fles a request for mutual agreement
procedures following a transfer pricing assessment, payment of national tax and
penalties pertaining to the assessment can be deferred until the completion of mutual
agreement procedures (one month after the day following the date of reassessment
based on mutual agreement, or should agreement not be reached, one month from the
day following the notifcation of this fact to the taxpayer), if requested by the taxpayer.
In addition, the taxpayer is exempted from delinquent tax for the deferral period. The
taxpayer, however, needs to provide collateral for the amount of taxes to be deferred.
The deferral provision was extended to local taxes in 2008.
Tokyo, Osaka, and several other RTBs each have a team of specialist transfer pricing
examiners who conduct investigations. Over the past several years, the NTA has
increased its transfer pricing enforcement by monitoring and expanding the scope
of its examinations. The NTA has been increasing the number of examiner positions
and the number of offces to be used to investigate transfer pricing strategies in order
to handle the increase in the number of transfer pricing cases and APA (see Section
4312) requests. Additionally, the NTA is educating its staff to identify red-fag issues to
consider when auditing corporations that are operating in Japan. Because of the NTA
becoming tougher, more experienced, and sophisticated in transfer pricing, it has made
some very large assessments against a number of companies in various industries,
including the pharmaceutical and medical equipment industries.
The Japanese tax authorities very strict compliance with the legislation leads the
auditors to review transfer pricing on an individual transaction basis (or product line
basis or business segment basis), focusing on the gross margin and not the operating
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margin. While the 1 June 2001 Circular issued by the NTA refers to the operating
proft margin in the context of an irregularity check, the NTAs and RTBs historical
preference for proft split analyses remains unchanged where such is used either as a
transfer pricing methodology itself or as a reasonableness check of the method used by
the taxpayer, depending on the situation. In addition, when it is not possible to conduct
a proft split analysis because of lack of fnancial data about the foreign affliate, the
practice followed by the examiners of relying on gross proft margins in establishing
arms-length prices for foreign-owned distributors remains essentially unchanged.
Given the tax authorities practice of reviewing transfer prices on an individual
transaction basis, they place heavy reliance on comparable transactions. In many
of the cases, these are external uncontrolled comparable transactions obtained by
reverse audit of the taxpayers competitors, (i.e. secret comparables). The 1 June 2001
Circular requires examiners to provide the taxpayer with an explanation of conditions
of selection of the secret comparables, the content of the comparable transactions,
and the method of adjustment for any differences between those transactions and
the taxpayer. However, the scope of such explanation is restricted by a confdentiality
requirement placed on examiners, and thus the identity of the secret comparables
remains undisclosed and can create major diffculties at audit. Indeed, this issue of
secret comparables is currently one of the most contentious issues in the Japanese
transfer pricing environment.
authority negotiations
All tax treaties concluded by Japan contain a provision for competent authority
negotiations. The Commissioners Secretariat of the NTA and the Deputy
Commissioner for International Affairs, who head the NTAs Offce of International
Operations and Offce of Mutual Agreement Procedures, are in charge of competent
authority negotiations.
If competent authority negotiations result in the Japanese authorities having to cancel
a portion of a proposed transfer pricing adjustment, the RTB will reduce the amount of
tax due accordingly (i.e. the taxpayer does not need to fle for a reassessment of tax).
Such reductions will have a corresponding effect on the amount of local taxes due,
since municipal and prefectural taxes are based on the amount of corporation tax paid.
As of 30 June, 2009, there were 325 ongoing cases under competent authority
negotiation (for both transfer pricing assessment and APA cases) and it is anticipated
that the number of cases will continue to increase. One of the major reasons for
diffculties in competent authority negotiations is the difference in tax policies relating
to the methodology that should be used in determining an appropriate arms-length
price. For example, as was evident in the bilateral US-Japan APA reported as obtained
by Komatsu (see Section 4312), it is understood the US IRS preferred to use the
comparable profts method (CPM) while the NTA preferred to use a proft split method.
The original Japanese APA system was called the pre-confrmation system (PCS) and
was instituted in April 1987, immediately following the introduction of transfer pricing
legislation. Japan was one of the frst countries to introduce such a system solely for
transfer pricing purposes.
Japan
A signifcant body of APA experience has developed since then, and in October 1999,
the NTA issued a formal circular on APA procedures, which in large measure brought
existing practice onto a more formal basis. That circular has since been integrated into
the 25 June 2001 Circular.
Under the 25 June 2001 Circular, there is a strong expectation that an APA will be
bilateral. Under an APA, a taxpayer submits its transfer pricing methodology to be used
to determine the arms-length price and its specifc content (together, the TPM) to the
relevant RTB. The RTB will evaluate the TPM and, if appropriate, confrm it or suggest
changes. As part of this process, if the APA is bilateral, coordination through the NTAs
Offce of Mutual Agreement Procedure will arrive at competent authority agreement.
Once a TPM is agreed upon (as long as tax returns comply with the agreed TPM),
pricing is regarded by the RTB as arms length. In principle, the period to be covered by
an APA is three to fve years.
The 25 June 2001 Circular recognises pre-fling conferences as an important part of
the process. The formal fling requires a body of detailed supporting documentation,
including a functional analysis, details of the transfer pricing methodology applied
for, standalone fnancial statements of the taxpayer as well as its foreign affliate
that is party to the transaction subject to the APA application, and an explanation of
the material business and economic conditions assumed. An amendment (effective
25 June 2007) to the 1 June 2001 Circular also strengthened the wording of the
application requirements. As a result, the inclusion of the standalone fnancial
statement of the foreign affliate into the APA application is a strict requirement to
be adhered by the taxpayer, and non-submission may result in the RTBs refusal to
process the APA application. Moreover, the same amendment also provides that an APA
application may not be processed if it results in proft in Japan being reduced without
reasonable economic grounds.
An APA application will not stop an ongoing transfer pricing examination, although
there is specifc clarifcation that roll-back the use of an agreed TPM for periods prior
to an APA being in force may be acceptable for bilateral or multilateral APAs. There is
also guidance relating to post-year-end adjustments to conform to a TPM.
Between 1987 and 1992, few PCS cases were fled and only a handful of these
were approved. Since 1992, however, transfer pricing legislation around the world
(particularly in the US) has developed considerably. In response to this, the NTA has
taken an even more proactive attitude towards the bilateral APA procedures. By 30
June 2009, some 729 bilateral APA applications had been fled, with over 441 APAs
completed up to that date. In addition, in 2007, the number of APA examiners at the
Tokyo RTB alone was doubled, from 27 to 52. Examples of reported APAs include:
Apple Computer Japan, Inc. was the frst foreign parent company to obtain a
bilateral APA with the NTA and IRS. It was reported that the proft ratios from
domestic sales of Apples personal computers were to be based on ratios that were
mutually agreed to by the NTA and the IRS;
Matsushita Electric Industrial Co. became the frst Japanese-parent taxpayer to
obtain an APA that was mutually agreed by the NTA and IRS;
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Komatsu Ltd. became the second Japanese-parent company to complete a bilateral
Japan-US APA. This APA was based on a hybrid method, which combines the
attributes of the CPM and the proft split, which are the methods most preferred
by the IRS and the NTA, respectively. It is now thought that this approach was an
exception rather than a precedent-setting example for wide subsequent use; and
Coca-Cola (Japan) is also known as having obtained a bilateral Japan-US APA
following the transfer pricing assessment on its royalty payment.
In 2005, the frst bilateral APA between Japan and China was completed.
4313. OECD issues
Japan is a member of the OECD.
Kazakhstan
44.
International Transfer Pricing 2011 525 Kazakhstan
4401. Introduction
Kazakhstan, unlike other Central Asian countries and Russia, adopted a separate law
concerning transfer pricing, which included the arms-length concept with effect
from 1 January, 2009 (transfer pricing law). Currently, Kazakhstans transfer pricing
legislation is regarded as the most detailed within the Commonwealth of Independent
States region.
This law has become the subject of much attention from both local and foreign
companies operating in Kazakhstan. This attention stems mainly from the fact that the
transfer pricing law, in certain aspects, signifcantly departs from the key principles
outlined in the OECD Guidelines. Thus, the transfer pricing law and corresponding
rules contain a number of unusual concepts, some of which have the effect of widening
the scope of the application of transfer pricing by the auditing authorities.
Furthermore, the transfer pricing law and the rules contain a number of ambiguous
provisions, which in turn impact the practice of how the authorities apply the law.
Scope
While the transfer pricing law focuses on cross-border transactions, it remains
extremely broad in scope primarily because transfer pricing control extends to certain
transactions involving unrelated parties. Thus, the relevant state authorities (i.e. tax
and customs) are empowered to control transfer prices in cross-border transactions of
the following types:
Between related parties;
Involving counter-claims and reducing claims;
With parties registered in tax havens;
With legal entities that have taxation privileges; and
With legal entities that have reported losses in their tax returns for the two tax
years preceding the transaction.
The control also may be carried out in respect of the transactions performed in the
territory of the Republic of Kazakhstan in case of their direct interrelation with
international operations:
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Kazakhstan 526 www.pwc.com/internationaltp
When minerals are sold by a subsoil user;
If one of the parties has tax exemptions; and
If one of the parties has losses for the two most recent tax periods, preceding the
year of the inter-company transaction.
Related parties
The transfer pricing law generally defnes related parties as individuals or legal entities
whose special mutual relations may allow the economic results of the transactions
to be infuenced. The transfer pricing law further sets out a comprehensive list of
parties (15 scenarios in total) that should be regarded as related for the purpose of the
transfer pricing law. The transfer pricing law also includes a somewhat unusual rule to
determine the related parties as follows:
When parties to a transaction apply a price that deviates from market price, as
determined based on a range of prices according to the data of one of the authorised
bodies, such transactions could be treated as those performed between related parties.
Therefore, the above provision allows the Kazakh authorities to treat any transaction as
a related party transaction based on their set of market prices.
Pricing methods
The tax authorities should determine the market price based on fve methods:
comparable uncontrolled price method, cost plus method, resale price method, proft
split method and net (comparable) proft method. In cases when it is impossible to
apply the CUP method, one of the above alternative methods should be used in the
sequence of order. Thus, Kazakh legislation attaches a clear priority on the use of the
CUP method.
The transfer pricing instruction is pending approval after the review of the
responsibleministries.
Kazakhstan has certain transfer pricing documentation requirements.
The transfer pricing rules establish the list of offcial sources of information on market
prices, and taxpayers whose transaction prices conform to prices from the offcial
sources appear to be safeguarded from transfer pricing adjustments in practice.
In February 2009, Kazakhstan introduced the Rules for Performance of Monitoring
of Transactions. According to these rules, the taxpayers involved in cross-border
transactions shall submit to the Tax Authority a special transfer pricing monitoring
declaration by 15 April of the year following the year when the controlled transaction
took place. There are two conditions for the above requirement:
A taxpayer should be included in the list of the 300 largest taxpayers; and
An item of the cross-border transaction is included in the monitoring list (i.e. oil
and gas products, marketing services, etc).
International Transfer Pricing 2011 Kazakhstan 527
Kazakhstan
4404. Legal cases
The most signifcant legal cases on transfer pricing matters involved appeals of
subsurface users working in Kazakhstan on the tax authorities transfer pricing
adjustments in relation to the export of oil and other commodities.
Generally, the transaction price is deemed to be the market price unless proved
otherwise by the tax authorities. However, in practice, it is often the case that the
burden of proof is shifted to the taxpayer to demonstrate that the applied price was at
market level.
The tax and customs authorities are responsible for controlling, monitoring and
evaluating cross-border transactions for transfer pricing purposes.
The tax authorities are generally responsible for monitoring transactions on certain
exported goods and services, maintaining an information database on market prices
for goods (works, services), conducting tax audits and assessing and collecting taxes
and penalties as a result of price adjustments.
The customs authorities are generally responsible for monitoring transactions on
certain imported goods, maintaining an information database on customs declarations,
providing information to the tax authorities on the monitored goods, participating
with the tax authorities in tax audits as well as assessing and collecting customs
payments and penalties as a result of price adjustments.
Transfer pricing audits are normally carried out within the scope of regular tax
audits. In practice, transfer pricing audits may last from 30 working days to as long as
oneyear.
Taxpayers have the right to appeal the transfer pricing adjustments at the higher
level tax authority, up to the Tax Committee of the Kazakhstan Ministry of Finance.
Should the outcome of the appeal with the tax authorities be unsatisfactory,
taxpayers may further appeal the assessments in Kazakhstan courts (taxpayers
have the right to appeal directly to courts as well). Certain foreign subsurface users
operating in Kazakhstan have the right to appeal through international arbitration
(e.g.UNCITRAL).
As a result of the application of the transfer pricing law, the tax authorities may
make adjustments to prices leading to the additional assessment of taxes, including
corporate income tax, value added tax, excise, rental tax on export, tax on production
of useful minerals, and excess profts tax for subsurface users, and customs payments.
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The Kazakhstan Code of Administrative Violations does not provide for specifc fnes
for the violation of transfer pricing legislation. Generally, as a result of transfer pricing
adjustments, the taxpayers are penalised based on the provision for underreporting
taxes in tax returns, which is calculated at 50% of the additionally assessed tax.
Interest penalties also apply at the annual rate of 17.5% (currently) for each day of
delay of the tax payment.
The tax and customs authorities carry out the transfer pricing control using the
following tools:
Monitoring of certain transactions (i.e. gathering detailed information on the sale/
purchase of certain goods and services);
Carrying out transfer pricing audits; and
Enquiries to the parties of the transaction, any third parties directly or indirectly
involved in the transaction as well as the competent authorities of the other
jurisdictions involved.
The tax and customs authorities also are maintaining databases on export/import
prices of goods and services. However, these are not available for public use.
The transfer pricing instruction establishes the list of offcial sources of information
on market prices, and taxpayers whose transaction prices conform to prices from the
offcial sources appear to be safeguarded from transfer pricing adjustments in practice.
However, these information sources mostly quote commodity prices. With respect
to other goods and services (including intangibles), the availability of comparable
information is limited or of a low quality.
Based on practical experience, the most risk-intense types of transactions from a
transfer pricing perspective involve subsurface-use operations (i.e. export of oil and
other commodities) and the fnancial sector.
Although the majority of double tax treaties concluded by Kazakhstan contain
provisions on competent authority proceedings, the Kazakhstan tax authorities have
not applied them regularly in practice. In part, this is due to the fact that Kazakhstan
transfer pricing legislation in many areas contradicts OECD Guidelines, thus making
the competent authority proceedings diffcult to achieve with the majority of
Kazakhstan trading countries.
International Transfer Pricing 2011 Kazakhstan 529
Kazakhstan
In February 2009 Kazakhstan introduced the Rules for Concluding of Agreements
on Application of Transfer Pricing (APA). These rules determine the procedures and
documents required for application to the Kazakh tax authorities for an APA.
The tax authorities have the right to review the taxpayers documents for up to 60
business days within the APA approval process. An APA could be concluded for the
terms up to three years.
It appears that the government is demonstrating a willingness to further develop
transfer pricing legislation. As a result, the deputies of the Kazakhstan Parliament
currently consider abolishing excessive rights of the Kazakh tax authorities in
determining related parties and market prices. There are also initiatives to provide
much detailed and clearer mechanism for pricing analysis and documentation.
Although the outcome is unclear, there appears to be growing acceptance among
certain deputies that the existing transfer pricing legislation requires a substantive
revision in accordance with the OECD principles rather than the cosmetic changes
contained in the current transfer pricing law.
Notable changes suggested in the new draft law developed with the assistance of
PricewaterhouseCoopers include:
Limitation of the transfer pricing control by the authorities to transactions between
related parties and transactions with companies registered in jurisdictions with
privileged taxation; and
Reference to the OECD Guidelines on transfer pricing where the law is silent
orunclear.
Although both tax and customs authorities are assigned as competent authorities
under the transfer pricing law, they do not appear to be effectively co-ordinated with
each other on transfer pricing matters in practice. This often results in assessments
of a different taxable base for customs and tax purposes (i.e. higher taxable base for
purposes of calculating customs payments and lower base for purposes of corporate
income tax deductibility).
4416. OECD issues
Kazakhstan is not a member of the OECD, and Kazakhstan tax and customs authorities
are not bound by OECD Guidelines on transfer pricing. However, due to the limited
transfer pricing provisions in the domestic legislation, the tax authorities might refer to
the OECD Guidelines for direction or alternative solutions (unoffcially).
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The Kazakhstan tax authorities may conduct joint investigations on transfer pricing
matters within the Eurasian Economic Community (EEC) along with Russia,
Kyrgyzstan, Tajikistan, and Belarus.
The Kazakhstan tax authorities may also request information on transfer pricing from
the competent authorities of other states with which Kazakhstan has signed double tax
treaties (currently 38 states).
Otherwise, the information on joint investigations is limited and not publicly available.
Kazakhstan tax authorities do pay attention to the interest rate levels deducted for
Kazakhstan corporate income tax purposes. Transfer pricing control is used in addition
to the debt to equity ratio limitations established in the Kazakhstan tax legislation.
In practice, the tax authorities were able to successfully challenge the interest rate
levels deducted by one of Kazakhstans largest banks in a well-publicised transfer
pricing court case.
In practice, management services are subject to scrutiny by the tax authorities.
However, we have not seen large transfer pricing adjustments in respect of
management services. This is likely because the Kazakhstan tax authorities have
limited experience in evaluating the pricing of services and intangibles.
Korea
45.
International Transfer Pricing 2011 531 Korea
4501. Introduction
Since the introduction of the Korean transfer pricing regulations, transfer pricing
has become one of the most important international tax issues concerning taxpayers
engaged in cross-border inter-company transactions. The Korean transfer pricing
regulations are based on the arms-length standard and are generally consistent
with the OECD Guidelines. The Korean transfer pricing regulations prescribe
transfer pricing methods, impose transfer pricing documentation requirements, and
contain provisions for advance pricing agreements (APAs) and mutual agreement
procedures(MAPs).
Numerous amendments have been made to the transfer pricing regulations over
the years. Signifcant revisions have included expansion in the defnition of special
relations (i.e. scope of related parties), introduction of the concept of an arms-length
range, introduction of formal regulations on cost-contribution arrangements, transfers
of intangible assets and intragroup services, and changes to provide taxpayers with
increased fexibility on tax appeals, APAs and MAPs.
In recent years, the National Tax Service (NTS) has made the enforcement of transfer
pricing compliance a high priority. Field examiners have undergone training to
enhance their transfer pricing examination and audit capabilities. Transfer pricing has
become a routine part of a tax audit.
The Korean transfer pricing regulations are contained in the Law for the Coordination
of International Tax Affairs (LCITA), which was enacted on 1 January 1996. The LCITA
stipulates that transfer prices should be consistent with arms-length prices.
The transfer pricing methods specifed in the LCITA and underlying Presidential
Enforcement Decree are listed in order of priority below:
Comparable uncontrolled price method, resale price method or cost plus method;
Proft split method and transactional net margin method; and
Other unspecifed methods.
Transfer prices should be supported by the most reasonable transfer pricing method,
while giving consideration to the order of method priority.
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Korea 532 www.pwc.com/internationaltp
The regulations also contain primary and secondary transfer pricing documentation
requirements. Primary documentation requirements relate to transfer pricing
documentation that taxpayers are required to submit each year as part of their
corporate income tax return. Primary documentation forms include:
Declaration of Transfer Pricing Method;
Summary of International Transactions; and
Summary of Income Statements of Overseas Affliates.
The Declaration of Transfer Pricing Method form requires the taxpayer to report the
transfer pricing method or methods used to set or determine its transfer prices. In
addition, the taxpayer is also required to provide an explanation of why that particular
method was selected. The transfer pricing method should be the most reliable method
among those available and should justify the arms-length nature of the taxpayers
transfer prices. Separate declaration forms are required for transactions involving
transfers of intangible property, services and cost-sharing arrangements.
The Summary of International Transactions form provides the NTS with a summary
of the taxpayers inter-company transactions, according to transaction counterparty
and type of transaction. Taxpayers are required to report the following: (a) the name
of each overseas related party with which the taxpayer engages in transactions; (b) the
relationship between the taxpayer and the overseas related party; (c) the nature of the
transaction (e.g. tangible goods, service, fnancing, investment); and (d) the amount of
the transaction.
Effective from 1 June 1998, the Summary of Income Statements of Overseas Affliates
requires a taxpayer to submit the income statement of each overseas affliate with
which it engages in transactions. The overseas affliate income statements should be
submitted for the most recent tax year and should be prepared to the proft-before-tax
level. In addition, the taxpayer should indicate the primary business activities of the
overseas related parties and the taxpayer.
Although there is no concept of immateriality (or a de minimis transaction) in the
Korean regulations, a taxpayer is not required to submit the Declaration of Transfer
Pricing Method form at the time of fling the corporate income tax return if the
taxpayer is engaged in cross-border inter-company goods (or service) transactions
that accumulatively amount to below KRW5 billion (KRW500 million for service
transactions) or amount to below KRW 1 billion (KRW 100 million for service
transactions) per transaction party. Likewise, the Summary of Income Statements
of Overseas Affliates is not required to be submitted if the taxpayer is engaged in
cross-border inter-company goods (or service) transactions that amount to below
KRW1 billion (KRW100 million for service transactions) per transaction party or if
the taxpayer has submitted a list of overseas affliates and their summarised fnancial
statements in accordance with the Corporate Income Tax Law (CITL).
Taxpayers are also required to provide the NTS, upon request, with other
documentation that supports the arms-length nature of their transfer prices.
Secondary documentation includes inter-company agreements; corporate transfer
pricing policies; organisational charts; fnancial statements segmented by business,
product line or function; description of business; selection and application of the
transfer pricing method; and any other documents that may be useful to evaluate the
arms-length nature of a taxpayers transfer prices.
International Transfer Pricing 2011 Korea 533
Korea
Taxpayers are required to submit transfer pricing documentation to the NTS within 60
days of the request; although, a one-time 60-day extension is allowed upon application.
During a tax audit, however, secondary documentation as well as other supporting
documentation must be provided promptly, because the duration of tax audits are
often very short and the auditors want to resolve all issues within the short timeframe.
In addition to transfer pricing, the LCITA also covers:
Interest paid to a controlling overseas shareholder;
Corporate income retained in a tax haven;
Offshore gifts; and
International cooperation by the tax administration.
On 26 December 2008, Korea introduced provisions to provide penalty relief to
taxpayers maintaining contemporaneous documentation. The penalty waiver provision
stipulates that the underreporting penalty (i.e. 10% of the additional corporate
income tax) may be waived in the event of a transfer pricing adjustment, if a taxpayer
has maintained contemporaneous transfer pricing documentation (i.e. at the time of
fling of the corporate income tax return) and the transfer pricing method has been
reasonably selected and applied.
A taxpayer who wishes to obtain penalty relief should maintain the following
documentation and submit the documentation within 30 days when requested by the
Korean National Tax Service (NTS):
General descriptions of the business (including analysis of the factors that may
affect the prices of assets and services);
Information that may affect the transfer price, including information on foreign
related parties and their relationship with the taxpayer (group organisation
structure); and
The following documentation which supports the selection procedure of the
transfer pricing method stated on the taxpayers corporate income tax return:
1. Economic analysis and forecast data supporting the selection of the most
reasonable transfer pricing method stated at the time of fling the corporate
income tax return;
2. Proftability of the selected comparable companies and the descriptions of
adjustments applied during the analysis of the arms-length price;
3. Descriptions of other potentially applicable transfer pricing methods and the
reasons why these transfer pricing methods could not be selected; and
4. Additional data prepared to determine the arms-length price after the end of
the tax year and within the fling period of the corporate income tax return.
In addition, the assessment of whether a taxpayer has reasonably determined the
arms-length price is determined by considering the following factors:
Data on proftability of comparable companies obtained at the end of the tax year
should be representative and not wilfully exclude the proftability of a certain
comparable company in order to derive an arms-length price favourable to
thetaxpayer;
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Collected data should have been systemically analysed to select and apply the
transfer pricing method; and
If the taxpayer has selected and applied a transfer pricing method different from
the one applied in an APA concluded during the previous tax year or a transfer
pricing method selected by the tax authorities during a previous tax audit, then
there should be a valid reason as to why the different transfer pricing method
wasapplied.
The penalty waiver provision is effective on transfer pricing adjustments occurring on
or after 1 January 2009.
The LCITA supersedes all previous domestic corporation tax laws and transfer pricing
guidelines published by the NTS.
On 15 June 2004, the NTS issued basic tax rulings under the LCITA which are intended
to provide guidelines for interpretation of the LCITA in accordance with internationally
accepted rules and standards for taxation. These basic tax rulings consist of 29 sections
and are the frst to be applicable to the LCITA since its enactment. The key highlights
of the basic tax rulings include sections on deductibility of management service fees,
factors when selecting comparable transactions, applying the comparable uncontrolled
price method or the resale price method, situations for applying the Berry ratio, and
use of the interquartile range. These basic tax rulings are effective from 15 June 2004.
In addition, the NTS issues offcial rulings upon request by taxpayers. Although these
rulings are interpretations of the law for a specifc case and are not legally binding,
they are usually applied to other similar cases. The rulings, therefore, provide useful
practical guidelines and are very infuential.
4504. Legal cases
A handful of legal cases involving transfer pricing have been brought, but very little
information on these cases is publicly available. Some cases have been settled out of
court, some cases are currently pending in domestic appeals, and other cases have
proceeded to competent authority.
Korean tax law does not clearly specify where the burden of proof lies with regard to
supporting or challenging transfer prices. By law, however, a taxpayer is required to
report and justify the transfer pricing method(s) used to set or evaluate its transfer
prices each year, at the time of fling its corporate income tax return. If the taxpayer
has submitted proper documentation, the NTS must demonstrate why the taxpayers
transfer prices are not at arms length and propose a transfer pricing adjustment in
order to challenge the transfer prices of a taxpayer. Once the NTS has proposed an
alternative transfer pricing method and adjustment, it is then up to the taxpayer to
defend the arms-length nature of its transfer prices.
In the event that a taxpayer does not provide the NTS with proper transfer pricing
documentation at the time of fling its corporate income tax return, the burden of proof
falls on the taxpayer to demonstrate the arms-length nature of its transfer prices.
Korea
In general, the NTS reviews corporate income tax returns, including transfer-pricing-
related documentation, to identify taxpayers that demonstrate a high likelihood of
noncompliance with transfer pricing regulations. The NTS then requests further
information from these identifed taxpayers for review. Failure to submit transfer-
pricing-related data required by the LCITA increases the likelihood of selection for
audit. Taxpayers are also generally subject to audit every fve years based on the tax
statute of limitations.
the tax authorities
Tax authorities can request any relevant information for their audit (e.g. contracts,
price lists, cost data of manufactured goods, accounting principles used, organisation
charts, mutual investment agreements).
Since it is likely that the attitude of the taxpayer will affect both the outcome of
the audit and/or the size of any adjustment, it is important during the negotiation
process that taxpayers do not offend the tax authorities by being uncooperative. Thus,
taxpayers are effectively obligated to provide the requested information to avoid
possible adverse consequences, which could otherwise arise.
A uniquely problematic aspect of the Korean transfer pricing regulations is the concept
of secondary adjustments. Secondary adjustments are additional tax treatments that
occur if a transfer pricing adjustment is not repatriated back to Korea. Most secondary
adjustments are treated as deemed dividends subject to withholding taxes at the rate
specifed in the corporate tax law or applicable treaty.
Transfer pricing review committee
On 30 June 2005, the NTS announced the establishment of a Transfer Pricing
Review Committee (TPRC) to review proposed transfer pricing adjustments prior
to fnalisation of a tax audit. Under the auspices of the Assistant Commissioner for
International Taxation, the TPRC is intended to help ensure that taxpayers are treated
fairly and consistently with respect to transfer pricing assessments. The TPRC is
responsible for reviewing proposed adjustments that are in excess of KRW5 billion
or disputed by a taxpayer. The TPRC may also review proposed transfer pricing
adjustments arising in other situations on a case-by-case basis.
4507. Domestic tax appeals procedure and mutual
agreement procedures
A variety of domestic appeal options are available to taxpayers, including Pre-
Assessment Notice Protest to district, regional or head offce of the NTS, Request for
Investigation to the NTS, Request for Adjudication to the National Tax Tribunal (NTT),
or Appeal to the Board of Audit and Inspection (BOAI). The most common forum for
domestic tax appeals is the NTT. Taxpayers may pursue court litigation only after an
appeal to the NTS, NTT or BOAI.
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For several reasons, most transfer pricing disputes go to mutual agreement procedures
(MAPs). First, taxpayers initiating MAPs may apply for a suspension of the payment
of a tax assessment. This option is not available to taxpayers pursuing domestic tax
appeals, except in very limited circumstances. Second, pursuing MAPs increases the
likelihood of obtaining relief from double taxation and waiver of underreporting
penalties. Finally, MAPs are generally more compelled to rely on generally accepted
rules and standards.
The tax law provides for penalties where there is an understatement of the tax base
and an underpayment of corporate tax. These rules also apply in the case of transfer
pricing. However, the LCITA provides that the penalty for understatement does not
apply in situations where a taxpayer has taken due care, and that care is proven or
verifed during MAPs.
The following penalties may be imposed, depending on the type of taxpayers
obligations under related tax laws which the taxpayer failed to fulfl.
Failure to fle corporate income tax returns or to keep books of account
If the taxpayer does not fle corporate income tax returns within the time limit
prescribed by the CITL, or the obligationto maintain or keep books of account has not
been performed, the taxpayer is subject to the following penalties:
In cases of intentional failure to fle corporate income tax returns, the penalty is the
larger of:
1. 40% of the computed corporate income tax amount determined by the
government; and
2. 0.14% of the revenue.
In cases other than the above, the penalty is the larger of:
1. 20% of the computed corporate income tax amount determined by the
government; and
2. 0.07% of the revenue.
Underreporting of the tax base
Penalty tax on the underreported tax base is imposed on the difference between the
correct tax base, which should have been reported under the CITL, and the tax base
actually reported at the time of fling the corporate income tax return. The amount of
penalty to be imposed is as follows:
In cases where the total reported tax base has been intentionally reduced, the
penalty is the larger of:
1. 40% of the corporate income tax corresponding to the total underreported tax
base; and
2. 0.14% of the total underreported tax base.
In cases other than the above, the penalty imposed is 10% of the taxes on the
underreported tax base. If there i no tax calculated, however, no penalties
areimposed.
Korea
Penalty for non-payment or insuffcient payment
If a taxpayer fails to pay tax or underpays taxes due, the taxpayer is subject to
penalties as determined by applying the interest rate prescribed by the CITL, which is
determined in consideration of the default interest rate of fnancial institutions and
number of days that the taxes have not been paid. The current applicable interest rate
is 10.95% per annum.
Penalty on noncompliance with the request for submission of information
The LCITA stipulates penalties for the failure to comply with a request for submission
of information.
If a taxpayer is requested to submit transfer-pricing-related information but fails to do
so, the NTS denies the submission of this information at a later time (i.e. when fling a
tax appeal or in the course of MAPs).
In addition, if a taxpayer is requested to submit transfer-pricing-related information
but fails to do so within the due date without any justifable reason or submits false
information, the taxpayer is subject to a penalty for negligence up to KRW30 million for
each instance of failure.
Penalties in practice
Under the CITL, the government automatically imposes related penalties when
taxpayers fail to meet specifed obligations. Generally, no exceptions are made (i.e.
little chance of negotiating penalties between taxpayers and the government). Under
the LCITA, however, it is more likely that the NTS will consider the taxpayers situation
and good-faith efforts when imposing penalties.
The Division of International Taxation is an offce of the NTS which provides support to
the regional tax offces on transfer pricing matters. Investigations are conducted with
the assistance of the relevant department experts.
Taxpayers may use various forms of comparable information to support their transfer
pricing policies, including internal as well as third-party data. Several company
directories and electronic databases are available in Korea which contain detailed
information and data on Korean companies.
The LCITA states that any transaction with an overseas affliate may be subject to a
transfer pricing adjustment. Recently, the NTS has aggressively challenged royalty
payments and management service fees. The NTS also closely scrutinises transactions
with affliates located in tax haven countries and conducts industry-wide tax audits
(pharmaceutical, tobacco, newspaper, private equity, etc.). Certain other situations
draw the attention of the tax authorities, such as distributors incurring operating losses
or changes in transfer pricing policy which reduce the amount of taxes paid.
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4512. Limitation of double taxation and MAPs
The LCITA contains detailed mutual agreement procedures (MAPs). Taxpayers may use
these procedures to seek relief from double taxation.
The Korean APA programme was launched on 1 January 1997. Taxpayers may apply
for unilateral or bilateral APAs. An APA can cover any number of years, but most
applications are for a fve-year period. For taxpayers seeking a bilateral APA, it may also
be possible to roll back the results of the APA to open tax years.
A taxpayer must apply for an APA by the end of the frst taxable year for which the APA
is being sought.
To apply for an APA, a taxpayer must complete and submit a formal application that
describes the transactions for which the APA is being requested, the overseas affliates
involved, the transfer pricing method to be applied, and the period requested to be
subject to the APA. In addition, the taxpayer must provide a description of its business
activities and organisation structure as well as the fnancial statements and tax
returns for the parties to the transactions for the most recent three years. The taxpayer
may avoid having to submit some information if it can clearly demonstrate that the
information is irrelevant.
Note that after the terms of the APA have been fnalised, the results are legally binding
on the NTS but not the taxpayer. In other words, if the taxpayers transfer prices are
determined to be within the range previously agreed to with the NTS, the NTS cannot
make an adjustment. The taxpayer, however, is not required or bound to meet the
conditions of the APA.
The taxpayer has the right to withdraw or modify the request for the APA at any time
prior to obtaining the NTS fnal approval. In the event that a taxpayer decides to
withdraw the application for the APA, all submitted data is returned to the taxpayer
without further consequences.
APA requests are completely confdential and data submitted to the NTS is used only
for the purposes of reviewing APA requests and performing follow-up management.
As in other countries, APAs allow Korean taxpayers to obtain certainty on the
acceptability of transfer prices, eliminating the risk of penalties and double taxation.
Additional benefts of applying for APAs include the possibility of obtaining the
assistance of foreign tax authorities to help persuade the NTS of the reasonableness
of the request, and the opportunity to negotiate with high-level NTS staff rather than
regional tax offce personnel (as in the case of an audit). In addition, the NTS is much
more willing to negotiate during a request for an APA than during a tax audit or MAP.
The number of APA requests is anticipated to increase signifcantly over the next
several years, as they are actively promoted by the NTS.
Korea
Each year, the NTS releases revisions or updates to the LCITA based on feedback it
receives from taxpayers and tax agencies.
While the NTS and Korea Customs Service both fall under the jurisdiction of the
Ministry of Strategy and Finance, there is no formal connection between the two
agencies. As such, transfer prices are evaluated by the Korean tax and customs
authorities, independent of each other. Both authorities, however, have expressed a
strong willingness to work together for consistency and reconcile differences.
4516. OECD issues
Korea is the 29th member of the OECD. The Korean transfer pricing regulations are
largely based on the OECD Guidelines.
It does not appear that the NTS has teamed up with other tax authorities for the
purposes of undertaking a joint investigation into transfer prices.
The LCITA covers the payment of interest to a controlling overseas shareholder.
Latvia
46.
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Latvia
4601. Introduction
The adoption of the Latvian Corporate Income Tax (CIT) Act in 1995 established
a requirement that transactions with related parties comply with the arms-length
principle. Since then, the development of transfer pricing (TP) law has been relatively
slow. However, recently the Latvian State Revenue Service (SRS) has started to tackle
the TP issue actively by developing a set of supporting regulations. Accordingly, the
Latvian TP legislation and practice are currently at a developmental stage.
The TP area in Latvia is governed by the following legislation:
The Taxes and Duties Act (Section 23);
The CIT Act (Section 12);
The Commercial Code (Section 182); and
The Cabinet of Ministers 4 July 2006 Rule 556, Application of the CIT Act
(CITrule).
Transactions
Latvian law requires that foreign-related party transactions meet the arms-length
standard. Furthermore, the CIT Act requires TP adjustments for a noncompliant
transaction between two Latvian companies that belong to the same group (i.e. direct
or indirect ownership of at least 90% is required).
Taxable income specifcally for CIT purposes must be adjusted if the price applied to
any of the following related party transactions differs from its arms-length value:
Fixed assets, goods or services sold at below-market prices; and
Fixed assets, goods or services bought at above-market prices.
The Taxes and Duties Act states in determining the market price or value of a
transaction that any discounts and markups applied to transactions between unrelated
parties should be taken into account, as well as any pricing changes driven by the
following factors:
Demand fuctuations due to seasonality or other factors;
Differences in the quality or characteristics of goods or services;
Expiry of the sell buy date;
International Transfer Pricing 2011 Latvia 541
Latvia
Marketing policy on placing new products in the market or placing products in a
new market; and
Sales of samples and demo versions to attract customers.
The Taxes and Duties Act provides for a wider application of the arms-length principle
than only between foreign-related parties. A tax audit may examine and adjust the
price of the following transactions:
Transactions between related parties;
Barters and set offs;
Price deviations exceeding 20% of prices that a taxpayer had applied to similar
goods or services over a short period; and
Exports and imports.
Calculating an arms-length price
The CIT rule prescribes fve TP calculation methods that are consistent with the
OECDGuidelines:
Traditional transaction-based TP methods:
1. The comparable uncontrolled price method;
2. The resale price method; and
3. The cost-plus method.
Transactional net proft methods:
1. The transactional net margin method; and
2. The proft split method.
Along with the OECD Guidelines, the CIT rule gives a preference to the three
traditional transaction-based methods, whereas the transactional proft methods are
to be used only when all of the traditional transaction-based methods are inadequate
orinapplicable.
TP documentation requirements
Latvian law currently does not require Latvian companies to have appropriate TP
documentation in place that provides a reasonable calculation of prices applied to
related party transactions. In practice, taxpayers are expected to provide the TP
documentation within 10 to 30 days after a request from the tax authorities.
It was expected that the specifc documentation rules would be adopted in early
2008; however, these are still in preparation and the prospective adoption of the
documentation rules is unknown.
Reporting related party transactions
Latvian taxpayers are required to report transactions with related parties on a special
form as an attachment to their annual CIT return.
4604. Legal cases
Latvia has no established TP practice as the Latvian tax authorities are still
experiencing a learning curve in this feld. The SRS has made several TP adjustments,
but there are no legal cases on TP issues yet.
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The Tax and Duties Act places the burden of proof in tax matters, including TP,
frmly on the taxpayer. A tax decision issued by the SRS has to state only the basis for
adjusting tax payment and calculating penalties. The taxpayer then has to provide
proof to challenge the decision.
In Latvia, TP is audited as part of a regular tax audit, which generally may cover up
to three previous tax years. The SRS generally tends to challenge TP with taxpayers
showing low profts.
The SRS must give a taxpayer 10 days written notice of a decision to conduct a tax
audit. The notice must state the commencement date and duration of a tax audit, as
well as taxes and duties and tax periods subject to the tax audit.
A tax audit may not take longer than 90 days, unless the SRS director general sanctions
an extension. The duration of a tax audit may be extended by 30 days if additional
information is required and by 60 days if such additional information has to be
requested from foreign tax authorities or foreign companies. Any period between the
date an information request is made and the date it is received will be excluded from
the extension.
These temporal limitations do not apply to simultaneous tax audits in which the SRS
liaises with the tax authorities of a foreign country in which the related party of a
Latvian entity is registered as a taxpayer.
Upon completion of a tax audit, the SRS must provide the taxpayer with an audit
report that sets out the results of the audit. If any tax offence is identifed, the SRS
will prepare a decision about increasing the tax liability to include additional taxes
andpenalties.
If a tax audit has resulted in an additional liability, the taxpayer must pay it, together
with any penalty, within 30 days of receiving a tax decision, or the taxpayer may
challenge the decision by appealing to the superior offcial. If the taxpayer does not
agree with a decision of the SRS director general, the highest tax offcial, then the
decision may be taken to court.
From 1 January 2007, a new tax penalty system has been established by the Taxes and
Duties Act and from 4 March 2008, tax penalties have been slightly reduced prescribing
the following penalty levels:
If the tax charge for the period under review has been understated by one of
thefollowing:
1. Up to 15% of the tax charge, there is a possible penalty of 30% of the total tax
liability that should have been reported; and
Latvia
2. More than 15% of the tax charge, there is a possible penalty of 50% of the total
tax liability that should have been reported.
If the revenue authorities fnd that the taxpayer has previously understated a tax
charge (a repeat offence), there is a possible penalty of 70% of the total tax liability
that should have been reported; and
If a taxpayer who has already committed a repeat offence commits one or more
similar offences within three years, there is a possible penalty of 100% of the tax
that should have been reported for each of these subsequent offences.
To make taxpayers less willing to undertake last-minute corrections to their tax returns
right before a tax audit, the law imposes a penalty of 10% of any understated tax
liability on a taxpayer that submits an adjustment and pays the outstanding tax and
interest only after receiving a notice of the start of a tax audit. The penalty must be
paid to the tax authorities before the date the tax audit starts.
The SRS director general may decide to reduce the penalty if the taxpayer admits an
offence and pays the unreported tax and penalty of 15% of the total tax liability that
should have been reported within 30 days of receiving the SRS decision on the tax
audit results.
The SRS has established a separate central team specialising in TP issues. If regional
tax auditors face a diffcult TP issue or if their decision is appealed, then they may seek
assistance from the central TP team.
The SRS has acquired the Van Dijk Bureau database Analyse Major Databases from
European Sources (AMADEUS) to be able to perform independent benchmarking.
The Taxes and Duties Act also provides that if the price of a transaction is not at arms
length, then the tax authorities may determine during a tax audit the market price of
the transaction, relying on the following methods and information sources:
Internal comparables of the taxpayer;
Prices and values that independent companies have applied in similar transactions;
Calculating the costs of the transaction and adding a markup calculated in line
with the industry average fnancial results derived from either the Latvian Central
Statistical Offce database or the tax authorities own databases;
Using the average price of similar goods as provided by the Central Statistical
Offce; and
Engaging an independent valuation expert.
In the absence of developed TP auditing practices, there is no particular industry
or transaction having any larger TP risk than others, qualifying for exemption, or
governed by stricter rules than others.
However, transactions involving a related provider of services, especially management
services, or intellectual property are more likely to be scrutinised. These transactions
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typically are challenged on the grounds that the underlying contracts or other
supporting documents are inadequately formalised.
Recent cases show that tax authorities tend to challenge the TP adjustments of
taxpayers even if the TP documentation is in place.
Almost all double tax treaties contain a clause relating to competent authority
proceedings, (i.e. mutual agreement procedures). However, there is no information
about the SRS involvement with competent authority proceedings because no such
information is published.
There are no provisions enabling taxpayers to enter into APAs with the SRS.
However, the Cabinet of Ministers has drafted a rule that prescribes an APA
applicationprocedure.
The Administrative Proceedings Act entitles a person to seek an advance ruling
regarding the exercise of his rights in specifc legal circumstances, including the
application of TP law.
In practice, however, this procedure is more likely to be used to substantiate the
application of a particular TP method or provision of law rather than negotiating
advance approval for a specifc TP situation.
An advance ruling is not binding on the requesting party, but it is binding on
the issuing government agency, which may not change its position to one that is
less favourable for a taxpayer, even if the legal opinion contained in the ruling is
subsequently shown to have been incorrect.
As stated above, the Cabinet of Ministers has two draft rules in preparation,
one of which prescribes an APA application procedure and the other governs TP
documentation requirements. However, it is unknown when the rules might be passed.
The State Revenue Service is the main body for tax administration and customs
authority. Thus, there are no obstacles to cooperation and information exchange
between tax authorities and customs authorities.
4616. OECD issues
Latvia is not yet an OECD member but has committed to join the OECD in the
foreseeable future.
Given that the arms-length principle and Latvian TP rules are borrowed from the
OECD Guidelines, the SRS has expressed its willingness to adopt the principles set out
Latvia
in the guidelines. As a result, the CIT rule that came into force on 1 July 2006 contains
a paragraph stating that the OECD Guidelines may be used in selecting and applying
methods for determining the arms-length price or value.
The SRS practices information exchange with foreign tax authorities in line with
Latvias double tax treaties. However, there is no publicly available information about
the results of joint investigations that took place as a result of information exchange.
Latvian thin capitalisation rules are contained in the CIT Act to prevent companies
from being highly leveraged and distributing profts through interest payments to
shareholders and third parties. A taxpayer must comply with the following restrictions
on interest deductions:
Taxable income should be adjusted for interest payments exceeding the amount
of interest calculated by applying to the interest bearing liability 1.2 times the
average short-term interest rate of credit institutions as determined by the Central
Statistical Offce for the last month of the tax year; and
Taxable income should be adjusted for the amount of interest in proportion to the
excess of the average interest bearing liability over an amount equal to four times
shareholders equity at the beginning of the tax year, less any revaluation reserve.
If the shareholders equity is negative, for calculation purposes it is assumed to
bezero.
If taxable income must be adjusted under both criteria, the larger of the two adjusted
amounts would apply.
These rules are neither applied to credit institutions and insurance companies,
nor to payments of interest on loans acquired from EEA credit institutions, the
State Treasury, the World Bank group, the Nordic Investment Bank, the European
Reconstruction and Development Bank, the European Investment Bank, the Council
of Europe Development Bank, and residents of countries with which Latvia has double
taxtreaties.
The second restriction is also not applied to interest paid to a fnancial institution
provided that it is a resident of EEA or of a country with which Latvia has a double
tax treaty and provides crediting or fnance lease services that are supervised by the
respective states credit and fnancial institutions controlling body.
These rules apply as from the tax year 2010.
When auditing intragroup services, tax auditors will analyse two key questions, namely
(1) whether an intragroup service has in fact been provided and, if so, (2) what charge
for that service is consistent with the arms-length principle.
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To prove the existence of a management services transaction, a contract and/or an
invoice might be insuffcient. The taxpayer also should prepare a memorandum of
delivery and acceptance explaining the nature and amount of service and confrming
that the services have been acquired and approved by both parties. Also, it is useful to
retain other documents, such as meeting notes or reports prepared during or as a result
of consultation.
Lithuania
International Transfer Pricing 2011 547
47.
Lithuania
4701. Introduction
The arms-length principle was introduced in Lithuania by the Corporate Tax Act of
20 December 2001. Little attention was paid to transfer pricing before this time. The
OECD Transfer Pricing guidelines have been carried over into Lithuanias domestic
transfer pricing legislation, although in a more condensed form and with a somewhat
clearer stance on a number of questions.
The defnition of related parties includes, inter alia, a) members of a group consisting
of a parent and one or more of its 25% or greater subsidiaries, b) two entities if one of
them directly or indirectly controls more than 25% of the shares in the other entity, or
has the right to more than 25% of voting rights of the other entity, or has an obligation
to coordinate its business decisions with that entity, or is under an obligation to third
parties for the obligations of the entity, c) two entities where one has the right to make
decisions that bind the other. The term associated parties, to which transfer pricing
rules also apply, covers all entities that may infuence each other as a result of which
conditions in transactions between them differ from those that would occur if each
entity were acting to maximise its own proft (i.e. there is no requirement to have
shareholding or voting ties).
In 2007, the tax authorities issued offcial recommendations on transfer pricing for
taxpayers. These recommendations are based on the OECD Transfer Pricing guidelines.
4704. Legal cases
There are no prior court cases relating to transfer pricing.
By law, the tax authority needs to make a case for an adjustment. In practice, however,
it is often the case that a comparatively simple opening argument results in the
taxpayer having to make substantial effort to build a defensive case.
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Tax audits are more likely following a refund claim, a tip-off or liquidation. The tax
authorities primarily choose to audit the transfer pricing of the companies that have
incurred taxable losses for few years and have substantial volume in international
transactions. There are two types of procedures limited and full. Either procedure can
cover either a specifc tax or the whole range of taxes. There is a standard 90-day time
limit on the duration of any investigation, although this may be extended. There is a
fve-year statute of limitations.
The appeals process is frstly to the offcer conducting the investigation, then to a more
senior person at the tax offce, followed by the commission for tax disputes and fnally
the courts. In practice, however, most disputes over reasonably grounded differences in
interpretation are settled in compromise without litigation.
There is a penalty of between 10% and 50% of the tax for incorrect declaration, the
exact amount being discretionary. A penalty may be limited if there is no overall loss to
the state budget, for example through a corresponding adjustment. In addition, there
would be penalty interest calculated as 0.04% of the unpaid tax per day.
There are only a few persons specialising solely in transfer pricing within the tax
authorities. This indicates that the authorities are not as experienced as many other
EU tax authorities. There have been comparatively few public statements or high-
profle investigations to date. However, since 2008 they have started requesting the
companies to submit the transfer pricing documentations for review within a 30-day
(statutory)period.
The authorities already have direct access to the AMADEUS database. They focus on
adjustments to internal comparable uncontrolled prices, including analysis of margins
and markups on transactions between the taxpayer and unrelated parties. However,
they are already reviewing the benchmarking studies as well. Lithuania is not an OECD
member, and local rules allow the use of secret comparables in certain cases.
At present the most notable risk transactions are those involving various types of
services, management fees or fnancial instruments. The local tax authorities usually
challenge the interest-free or low-interest loan transactions. There are a number of
beneft tests, and emphasis is placed on demonstrating the actual performance of
aservice.
International Transfer Pricing 2011 Lithuania 549
Lithuania
Competent authority proceedings have not yet been frequently requested by taxpayers.
There is a tax ruling procedure that may be used to avoid penalties, and the system is,
in general, suffciently fexible to cover many aspects of transfer pricing. Currently, the
tax rulings are not binding and the tax authorities usually try not to provide detailed
answers to the questions. However, work continues at the level of the Ministry to set up
the framework for a more formal APA system.
At present, there are no penalties for failure to comply with documentation rules,
but this may change. From 1 January 2011, binding ruling procedures will be
introduced, i.e. companies will have the possibility to obtain binding rulings from the
Lithuanian Tax Authorities for application of certain provisions of tax legislation for
futuretransactions.
There is minimal interaction between inspectors responsible for direct tax and their
colleagues in customs.
4716. OECD issues
Lithuania is not an OECD member but follows the organisations guidelines closely
with respect to interpretation of double tax treaties. However, for transfer pricing, local
rules take precedent in the event of confict with the OECD Guidelines. One example is
the use of secret comparables, which is permitted by local legislation in certain cases.
At present, there is no indication that Lithuanian tax authorities are involved in
projects in which specifc transfer pricing information is exchanged with foreign tax
authorities. However, there is exchange of information with foreign tax authorities in
projects related to other tax issues.
Very broadly, interest on debt exceeding a 4:1 debt-equity ratio is disallowed (unless
it can be proved that an unrelated party would have lent at higher gearing). Debt from
persons who on their own or together with related parties own directly or indirectly
50% of the payer is considered. For the purposes of the calculation, year-end balances
are used (unless the tax authorities deem these unrepresentative), and the defnition
of equity is the balance on the last day of the tax period, excluding the fnancial result
of the period and certain revaluation reserves. Interest from unrelated banks is not
subject to thin capitalisation restrictions, unless an associated enterprise guarantees
the debt.
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Management services fall under particular scrutiny as historically, over the past
15 years, they have been seen by investors as simply a repatriation tool that does
not require the legal procedures of a dividend and also offers a tax deduction. Tax
authorities lacked the resources and commitment to challenge this practice effectively.
For this reason, shared service centres and headquarters are facing increased
documentation burdens, and Lithuanian fnance personnel are increasingly reluctant
to take responsibility for the effects of any such charge, sometimes even adding it back
for tax purposes regardless of substance.
The law specifcally states that taxpayers should demonstrate that services were
actually rendered, normally meaning objective tangible evidence such as reports or
travel documents. There is also a beneft test, which appears to be an either/or rather
than a cost to beneft comparison. Duplication of services is not permitted, which may
inadvertently lead to diffculties in services that support or build on existing resources.
Also of note is the non-deductibility of costs related to services that are deemed to
arise from merely being a participant in a group, possibly referring to the benefts
of centralised purchasing and similar functions, although there is yet little practical
experience of how this rule will be applied.
4720. Benchmarking study
Our experience shows that the tax authorities very thoroughly test benchmarking
studies in terms of comparability of activities, fnancial data (e.g. operating revenue or
fxed assets) and functions performed by the transactional parties, taking into account
industry sector and geographic location.
Luxembourg
48.
International Transfer Pricing 2011 551 Luxembourg
4801. Introduction
Luxembourg has enacted tax legislation that addresses transfer pricing but has been
little used to date.
4802. Statutory rules, other guidelines and legal cases
The statutory rule on transfer pricing is found in Article 56 of the Luxembourg Income
Tax Code. This provides that where there is a transfer of proft rendered possible by
the fact that a Luxembourg taxpayer has a special economic relationship with a non-
resident, then the tax authorities may estimate the fnancial result. It is to be assumed
that this provision would be applied only in a situation where the transfer of proft was
away from Luxembourg. For example, this might be the case if a Luxembourg company
paid heavily in excess of the market rate for a service it received.
A further situation where intragroup pricing arrangements might be of concern to
the Luxembourg tax authorities is where an advance agreement is to be sought from
the tax authorities and such agreement is based on an assertion that one or more
intragroup transaction fows will be undertaken at arms length.
Furthermore, if a shareholder receives an advantage from a company that the
shareholder would not have received if there had not been a shareholding relationship,
then this could be characterised under the Luxembourg Income Tax Code as a
hidden distribution. Again, this might occur in a case where a shareholder charged a
Luxembourg company heavily in excess of the market rate for a service provided by
the shareholder. Such a hidden distribution would result in an add-back to the taxable
profts of the Luxembourg company, and also possibly an obligation to account for
withholding tax on the deemed distribution. The rate of withholding tax on a hidden
distribution of dividends is 15% of the gross amount received (thus 17.65% of the
net amount), unless reduced under the application of a double tax treaty or the EC
ParentSubsidiary Directive. An abnormal advantage granted by a shareholder to an
affliate could be seen as a hidden contribution and taxed at the level of a Luxembourg
subsidiary. However, profts corresponding to such hidden contribution could still
be deductible against relevant accounting year expenses and offset against losses
carriedforward.
The Luxembourg legislation does not give further guidance on how any transfer of
proft or advantage to a shareholder is to be quantifed, or what constitutes an arms-
length arrangement. Nor is there any case law on these issues.
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Luxembourg 552 www.pwc.com/internationaltp
However, it can reasonably be assumed that in any situation where the non-
resident entity or shareholder is located in another OECD member country, then
the Luxembourg legislation should be construed in conformity with the associated
enterprises article of the relevant double tax treaty. Where the wording of such an
associated enterprises article follows closely Article 9(1) of the OECD Model Tax
Convention (which would normally be the case in double tax treaties concluded by
Luxembourg), then further guidance given by the OECD on the use and interpretation
of this article can be assumed to have authority, and hence the OECD Guidelines
should be regarded as giving important guidance in the Luxembourg environment in
the case of any dispute.
Intellectual property regime
As part of its commitment to boost and foster research and development (R&D)
activities in Luxembourg, to encourage technical and scientifc cooperation as well
as technology transfer between the public and private sectors and to stimulate new
economic activities, the Luxembourg government has passed a law aimed more
specifcally at encouraging R&D activities and the creation of intellectual property.
The intellectual property rights covered under the regime are copyrights related to
software, patents, trademarks, designs, models and domain names. A Luxembourg
company or branch can beneft from an exemption of 80% of the income from
intellectual property acquired or created after 31 December 2007. The 80% exemption
applies to net income derived from the intellectual property and capital gains realised
on the sale of intellectual property resulting in an effective tax rate of 5.7% for
2010. Deductible expenses include (amongst others) R&D costs, depreciation, and
impairment of the value of the intellectual property.
In the case of self-developed patents used by the taxpayer in its own activity, it would
receive an 80% notional deduction of a deemed net income from a third party as
consideration for the right to use the said patent. Further, full net wealth tax exemption
is available for the qualifying intellectual property rights.
One of the conditions to be fulflled is that the intellectual property should not have
been acquired from a person who is assimilated to an affliated company. Company A
is considered as affliated to Company B in the meaning of the law if:
It directly holds at least 10% of the share capital of B;
B holds at least 10% of its share capital; and
At least 10% of the share capital of A and of B is directly held by a third company.
For the disposal of the intellectual property, the valuation could be determined
according to any well-accepted method for the valuation of intellectual properties or
the available market value. In the case of small- and medium-size enterprises, they are
entitled to value the intellectual property at 110% of the expenses that have reduced
their tax base for the tax year of the disposal and of any previous tax year.
The regime thus addresses two objectives. It allows a full deduction of all R&D
expenses for projects that do generate any commercial results. However, successful
R&D projects are not penalised through excessive taxation once they come to fruition.
In addition to the tax incentives, other non-tax incentives are offered by the
Luxembourg government. Any company, private research organisation or public
International Transfer Pricing 2011 Luxembourg 553
Luxembourg
organisation can beneft from incentives (generally subsidies or interest-rate subsidies)
ranging from 25% to 100% to fnance an R&D project.
4803. Tax audits and resources available to the
taxauthorities
Due to the relatively low profle of transfer pricing in Luxembourg, the tax authorities
have no specialist resources for dealing with any transfer pricing issues. If any transfer
pricing issues do arise, then they will be dealt with by the tax bureau that normally
handles the taxpayers affairs. However, the transfer pricing of all transactions and all
industries is open to challenge, and in the event that the tax authorities seek to adjust
a taxpayers tax return, then the burden of proving that the adjustment is not valid lies
with the taxpayer.
Transfer pricing adjustments
A local tax inspector (there is no central Luxembourg team of transfer pricing
auditors) can scrutinise all transactions of all sectors of business and have the power
of investigation, including requesting information from third parties. Should such an
audit result in an amendment of the taxpayers tax return, the burden of proof will
be reversed, and it will thus be up to the taxpayer to prove the arms-length nature
of the transaction targeted by the tax authorities. Potential adjustments could result
in penalties of 0.6% per month on the tax assessed for the taxpayer. However, there
is a very limited experience of litigations. No cases have been taken up for a mutual
agreement procedure.
In practice, the Luxembourg tax authorities may accept compensating adjustments
under certain conditions.
The adjustment has been made by the other tax authority on sound technical
grounds with supporting documentation to evidence the calculation and adjusted
pricing of the transaction, rather than on an overall ad hoc basis;
The adjustment does not result in a loss for the Luxembourg company, especially in
cases where the Luxembourg company had been characterised as a low-risk entity
and therefore remunerated on a cost-plus basis;
Year of accepting an adjustment:
The adjustment will be effected only for open tax assessment years and not
where the assessment has been completed;
Where the adjustment was made by the other tax authority for a completed
assessment year, there may be a possibility to make an adjustment for the prior
year in the year the assessment is yet to be completed in Luxembourg;
Where the fnancial statements of a year have been signed and fled, without
the inclusion of the adjustment, but the return is yet to be submitted, the
adjustment only in the return may be acceptable; and
In all of the above-mentioned situations, if the adjustment is made only on the
tax return for any period without a corresponding accounting adjustment, the
Luxembourg tax authorities are likely to require both that the fnancial statements
of the frst subsequent period for which accounts have not yet been signed and
fled show a prior-year adjustment to refect the aggregate transfer pricing
adjustments, and that the settlement between the parties is made to implement the
amendedpricing.
Luxembourg 554 www.pwc.com/internationaltp
L
It is yet to be tested whether the tax authorities would accept a compensating
adjustment in cases where a minimum taxable proft has been agreed on transactions
as part of a unilateral tax agreement.
Elimination of double taxation
Most of the tax treaties concluded by Luxembourg provide for an exchange of
information procedure and contain mutual agreement procedure (MAP) provisions.
With the law passed on 24 April 1993 and subsequent amendments, Luxembourg had
approved the adoption of the EU arbitration convention and follows the EU Council
Code of Conduct for the effective application of the arbitration convention.
4804. Availability of comparable information
Luxembourg companies are required to make their annual accounts publicly available
by fling a copy with the local court. However, the accounts do not necessarily provide
much information on potentially comparable transactions or operations because they
do not normally contain much detailed fnancial information.
While there is no procedure for obtaining a formal APA, the tax authorities are quite
fexible in this area, and advance agreements in writing are regularly obtained on an
individual basis. Administrative circulars on the calculation of the cost-plus tax basis
for coordination centres, and on group fnance companies, have been withdrawn.
It is, however, possible to agree on a case-by-case basis with the tax authorities, an
acceptable arms-length result for a spread on fnancing operations, or for other
fnancing-related transfer pricing issues as well as appropriate fee levels for intragroup
services in the investment management and banking industry, if necessary, prior to
the completion of a transaction. Similarly, advance agreements on royalty rates and
other aspects of the structuring of intellectual property holdings are also possible.
In discussing any advance agreement, it should be recognised that while the tax
authorities have few resources at their disposal, their awareness of the commercial
environment is strongly developed. Hence, in presenting any proposals for negotiation,
well-thought-through but succinct documentation, supporting the reasonableness of
the desired result, is always going to be of beneft.
It is not clear whether the Luxembourg tax authorities would be prepared to negotiate
a bilateral APA. No such APAs have been negotiated.
Malaysia
49.
International Transfer Pricing 2011 555 Malaysia
4901. Introduction
With the rapid development in transfer pricing legislation globally and regionally,
the Malaysian Inland Revenue Board (MIRB) introduced the Malaysian Transfer
Pricing Guidelines in July 2003. The transfer pricing guidelines provide further
guidance to taxpayers on the application of the arms-length principle espoused in
the anti-avoidance provisions within the Malaysian Income Tax Act of 1967 (MITA).
Consequently, taxpayers have a clearer direction in terms of acceptable transfer pricing
arrangements as well as the extent of documentation required to be maintained.
The introduction of the transfer pricing guidelines was followed by the setting
up of a specialist group within the MIRB to deal with transfer pricing issues. The
specialist group has recently been further strengthened by establishing divisions
or segments specialising in different areas of transfer pricing. This is elaborated
further in paragraph 4905 below. Given the above focus by the MIRB, multinational
companies (MNC) should ensure that their transfer pricing policy with regard to their
Malaysian entities meets the arms-length standard, and they should have appropriate
documentation maintained as outlined in the transfer pricing guidelines.
The legislative reference to transfer pricing in Malaysia can be found in the anti-
avoidance provisions in Section 140 of the MITA, which deals with the concept of
dealing with one another at arms length and Section 140A, which deals with the
power to substitute prices. These provisions provide suffcient basis in ensuring that
transfer prices between related parties are at arms length.
The key implications of Section 140 in relation to transfer pricing can be summarised
asfollows:
The section is extremely wide and open for application by the MIRB in a multitude
of situations involving both local and cross-border transactions;
Section 140(6) is a deeming section, and consequently, if the MIRB can
demonstrate that a transaction falls within the ambit of this section, the
anti-avoidance provisions in Section 140(1) can be automatically invoked;
Although the burden of proof is on the MIRB, it can easily be shifted to the
taxpayer; and
There is no defnition of the term arms length in the MITA.
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Malaysia 556 www.pwc.com/internationaltp
Section 140 of the Malaysian income tax legislation will be used by the Malaysian
tax authorities in adjusting any transfer pricing abuses. Section 140 allows the
director general to disregard transactions believed not to be conducted at arms
length and make the necessary adjustments to revise or impose tax liability on the
personsconcerned.
Rather than using the general anti-avoidance Section 140, the MIRB introduced a new
section, Section 140A, effective from 1 January 2009. This provision is established to
empower the director general to make adjustments on transactions of goods, services
or fnancial assistance carried out between related companies based on the arms-
length principle.
The key implications of Section 140A can be summarised as follows:
Section 140A(2) requires that arms-length price be determined and applied where
a person enters into a transaction with an associated person for the acquisition or
supply of property or services;
Section 140A(3) allows the director general to substitute transfer prices that are not
arms length for any related party property or services acquired; and
Section 140A(4) and 140A(5) allow the director general to disallow any interest,
fnance charge, other consideration payable for losses suffered in respect of all
excessive related party fnancial assistance in relation to fxed capital, thereby
introducing the concept of thin capitalisation.
It is expected that, shortly, detailed transfer pricing rules for determining the arms-
length price will be issued by the tax authorities. At present, the MIRB continues to
resort to the transfer pricing guidelines in this regard.
The tax authorities have indicated that they would expect companies to prepare
contemporaneous transfer pricing documentation to support their transfer pricing
position. In practice, this would mean having transfer pricing documentation in place
at the time of submission of a companys tax return.
As there is no defnition in the MITA of what is meant by arms length, the transfer
pricing guidelines provide clarity on both the concept and its application. The transfer
pricing guidelines acknowledge the arms-length principle as the preferred basis to be
adopted in related party transactions, and this is consistent with the internationally
accepted arms-length principle advocated in the Organisation for Economic Co-
operation and Development Transfer Pricing Guidelines (OECD Guidelines).
Meaning of control and associated persons
To trigger any form of transfer pricing attention, the transactions under scrutiny
need to be between associated persons or colloquially referred to as related parties.
Generally, the relationship entails one party having control over the other, either
directly or indirectly. There is no centric focus in the transfer pricing guidelines on
defning terms; however, paragraph 4.3 of the transfer pricing guidelines refers to the
defnition of control in the MITA.
The defnition of control lies in Section 139, which relates to persons who are
associated with each other to an extent that control can be imputed.
International Transfer Pricing 2011 Malaysia 557
Malaysia
For the purposes of Section 2 of the MITA (Interpretation Section), a controlled
company is one having not more than 50 members and controlled, in the manner
described by Section 139, by not more than fve members.
The transfer pricing guidelines offer a wider meaning to the term associated
enterprise than the MITA. Under the transfer pricing guidelines, two enterprises are
associated enterprises with respect to each other if one of the enterprises participates
directly or indirectly in the management, control or capital of the other enterprise;
or the same persons participate directly or indirectly in the management, control or
capital of both enterprises.
1

Based on the above, to be considered an associated enterprise or to infer control
appears to be fairly easily caught within the lattice of the MITA or transfer
pricingguidelines.
Scope of the transfer pricing guidelines
The scope of the transfer pricing guidelines clearly states that they are applicable
to transactions between associated enterprises within a multinational where one
enterprise is subjected to tax in Malaysia and the other enterprise is located overseas.
2

The transfer pricing guidelines also state that the scope covers transactions between a
permanent establishment (PE) and its head offce or its other related branches, as for
purposes of the Malaysian guidelines, the PE will be treated as a distinct and separate
enterprise from its head offce or its other related branches.
3
However, in practice,
transfer pricing transcends to all entities that have transactions with another related
entity, irrespective of geographic location. This would include transactions between
two related entities within Malaysia, especially in instances where the two entities have
different tax attributes (e.g. tax losses, incentives). It should also be noted although the
transfer pricing guidelines do not carry the legislative authority, the disclosure in Form
C as discussed below implicitly requires taxpayers to follow the principles set out in the
transfer pricing guidelines to meet the arms-length standard as stipulated in Section
140(6) and Section 140A.
With the introduction of the new Section 140A dealing specifcally with transfer pricing
situations, it is expected that the MIRB will shortly issue updated and detailed transfer
pricing guidelines.
4903. Legal cases
No legal cases concerning transfer pricing have been decided by the courts to date.
However, recently there have been a couple of cases that have gone to court and are
awaiting hearing. Most of the cases involving disputes on transfer pricing issues have
been settled out of court, and the details have not been published.
Under the Self Assessment System, the burden of proof lies with the taxpayer to clear
any tax-avoidance allegation and/or alleged transfer pricing abuse. The intention of
the transfer pricing guidelines is to assist taxpayers in their efforts to determine arms-
1
Paragraph 4.3.2 of the Transfer Pricing Guidelines.
2
Paragraph 3.1 of the Transfer Pricing Guidelines.
3
Paragraph 3.2 of the Transfer Pricing Guidelines.
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length transfer prices and at the same time comply with the local tax laws and the
administrative requirements of the MIRB.
In this connection, upon a tax audit or enquiry, the relevant taxpayers with related
party transactions must be able to substantiate with documents, and to the MIRBs
satisfaction, that its transfer prices have been determined in accordance with the arms-
length principle and that there has not been any abuse of the transfer prices resulting
in an alteration of the incidence of tax in Malaysia.
Form C
In submitting their annual tax returns (i.e. Form C for companies), all taxpayers that
have transactions with their related parties are required to complete Section N to
declare their related party transactions for the year in the following categories:
Total sales to related companies in Malaysia;
Total sales to related companies outside Malaysia;
Total purchases from related companies in Malaysia;
Total purchases from related companies outside Malaysia;
Other payments to related companies in Malaysia;
Other payments to related companies outside Malaysia;
Loans to related companies in Malaysia;
Loans to related companies outside Malaysia;
Borrowings from related companies in Malaysia;
Borrowings from related companies outside Malaysia;
Receipts from related companies in Malaysia; and
Receipts from related companies outside Malaysia.
In addition, if the taxpayer is a controlled company, it will need to disclose the details
of its fve main shareholders in Part P of the Form C. The information provided will
be used as one of the resources by the Malaysian tax authorities in selecting whether
the company is a potential for a transfer pricing audit or tax audit. As the disclosure of
related party transactions is part of the taxpayers income tax return, failure to properly
disclose information on its related party transactions could result in an incorrect
taxreturn.
The Malaysian tax authorities have set up a special transfer pricing multinational
division that principally focuses on four segments, namely, transfer pricing desk audits,
transfer pricing feld audits, advanced pricing agreements (APA)/ mutual agreement
procedures (MAP) and on transfer pricing policy. The selection of taxpayers for a
transfer pricing audit is normally undertaken by the tax headquarters.
Transfer pricing/tax audits can be triggered by a number of different factors, including:
Information disclosed in the Form C;
Outstanding tax enquiries;
Sustained losses;
Use of tax havens;
Comparison of various fnancial ratios achieved by a similar company within the
same trade or industry;
Malaysia
Fluctuations in profts from year to year;
Desk audit referrals;
Companys past compliance record;
Third-party information;
Company is in a specifc industry currently targeted by tax authorities;
Company is in the process of liquidation; and
Company has not been tax audited in the past six years.
Other relevant information from public sources, such as newspaper reports, can also
trigger audits.
the tax authorities
Pursuant to the MITA, the taxpayer must keep and retain in safe custody suffcient
records for a period of seven years from the end of the year to which any income from
that business is related to. This enables income from the business for each year of
assessment or the adjusted loss from the business for the basis period for any year of
assessment to be readily ascertained by the Malaysian tax authorities.
The Malaysian tax authorities have the right of full and free access to all buildings,
places, books, documents and other papers for the purposes of the MITA. The
Malaysian tax authorities may make requests for information with which the taxpayer
must comply within a negotiated time frame. The companys level of cooperation in
an audit is likely to infuence the level of penalties imposed should a transfer pricing
adjustment be made.
Whilst there are no specifc transfer pricing documentation requirements in the MITA,
the general provision in the MITA (specifcally Section 82) requires taxpayers to
maintain appropriate documentation to support their transactions. Such records must
be retained for a period of seven years.
The transfer pricing guidelines have clearly stated the list of documents required for
purposes of supporting and explaining the companys transfer prices.
However, the list is not meant to be exhaustive, and the Malaysian tax authorities could
request more documents, depending on the specifc circumstances of the taxpayer.
In that event, the taxpayer is advised to be prepared to provide relevant additional
information or documents from what is already listed in the transfer pricing guidelines.
Briefy, the list of documents stated in pages 30 to 31 of the transfer pricing guidelines
is divided as follows:
Company details ownership structure, company organisational chart, and
operational aspects of the business;
Transaction details summary of the related party transactions, pricing policy,
price breakdown, terms of the transaction, economic conditions at the time of the
transaction, and any independent comparable transactions; and
Determination of arms-length price selection of pricing methodology, functional
analysis and comparability analysis.
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Although the transfer pricing guidelines do not specify when such documents need
to be prepared, under the Self Assessment System, taxpayers generally are expected
to have appropriate and suffcient documentation when they submit their tax return
(usually within seven months from their year-end). Moreover, with the introduction
of Section 140A(2), the MIRB now expects that contemporaneous transfer pricing
documentation be maintained. The transfer pricing documentation does not have to be
submitted together with the tax returns but will have to be made available to the MIRB
upon request. Such requests are usually a precursor to a desk audit or feld audit to
review the companys transfer prices.
In addition to the above documentation, the MIRB usually will request additional
supporting documents such as agreements, samples of transaction documents
(invoices, purchase orders, shipping documents), as well as any other information
relating to a specifc transaction.
The Malaysian tax authorities also have noted that, in the context of a transfer pricing
audit or tax audit, the Malaysian tax authorities may seek information from a treaty
partner under an Exchange of information article, which facilitates the process of
reviewing a taxpayers compliance with the arms-length principle.
As part of the Self Assessment System, the MIRB is expected to carry out tax audits,
including transfer pricing audits, on taxpayers. One distinguishing factor under the
Malaysian regime is that the transfer pricing review process tends to be carried out
in conjunction with a feld audit, whereby there is greater scrutiny of transactions as
opposed to the practice in other established countries where documentation review is
generally carried out via a desk audit.
Desk audit
The transfer pricing audit process is generally initiated by a request for fnancial
and management information such as the statutory accounts, tax computation,
management accounts and transfer pricing documentation, amongst other things.
Based on the information provided, the MIRB will carry out a review of these
documents and decide whether a more detailed review is required.
In straightforward cases, the MIRB will either correspond with the taxpayer or request
for a meeting to discuss any issues and work towards a closure of the case.
Field audit
If the MIRBs initial fndings from the desk audit review warrant a feld visit, the MIRB
will inform the taxpayer accordingly of the purpose of its visit, the offcers who will be
carrying out the audit process, the duration of the visit and the documents that need to
be made available for their review. Generally, feld audit visits are carried out by four
to six tax offcers during a one-week period. The offcers will examine any fnancial
documents, supporting documents and agreements that are linked to a taxpayers
business operations. As part of the feld visit, the offcers also will conduct interviews
with the key personnel of the taxpayers business to have a better understanding of the
functional profle of the company and the pricing basis adopted. At the end of the feld
audit, the MIRB will summarise its initial fndings and arrange for a follow-up meeting
at its offces to discuss the case.
Malaysia
The process is fairly structured with a reasonable timeframe provided for the
submission of documents and information as the MIRB is cognisant of taxpayers
concurrent business obligations. Furthermore, with the increasing number of audits
carried out nationwide on a yearly basis, the review process is becoming routine for the
MIRB even though the concept may still be novel to many taxpayers.
The diagram below depicts a typical audit process, although there may be exceptions to
the process depending on the taxpayers circumstances.
Audit Process
Learning points from audits
Some common areas of focus and issues that emerge during audits include:
Losses
Where a taxpayer has genuinely made losses or a low proft due to special
circumstances such as production problems, unavailability of resources or lower than
expected throughput, documentary evidence relating to such circumstances should be
compiled to support the transfer pricing documentation. Without such documentary
evidence, it might be diffcult to justify any results attributable to such special
circumstances.
Use of year-on-year data
In the absence of specifc guidance in the transfer pricing guidelines on how the
comparables data is to be applied, taxpayers have a number of options such as using
weighted average results of the comparables over a period of time to be compared
against the taxpayers weighted average results for a similar period. In practice, this
might not be acceptable as the MIRB would prefer to test the results of the taxpayer for
each year rather than the weighted average for a given period.
Management fees
One transaction that is regularly scrutinised is the payment of management fees or
head offce charges to parent companies or affliates. In order to justify the charge
is at arms length, taxpayers are expected to have agreements detailing the type of
services and the basis of charge. Additionally, details of how the charge is calculated or
provided, how the costs are allocated together with evidence of the services received
during each period and how these services benefted the local entity also will be
required. As such, in addition to a charging policy that is robust and meets the arms-
length standard, it is equally important to retain evidence of actual services received
and how those services beneft the local entity. Such evidence could take the form of
e-mails, notes of meetings, visit details, etc.
As more Malaysian companies are venturing abroad, management fees are also
charged out of Malaysia. In such situations, similar supporting documentation needs
to be maintained to ensure that costs relating to services provided for the affliates are
charged out accordingly.
If a taxpayer is not satisfed with a transfer pricing adjustment or assessment, the
available avenues of appeal mirror the normal tax appeal procedures. To appeal, the
taxpayer must fle an appeal with the MIRB within 30 days of receiving the Notice of
Assessment. This culminates in the MIRB either agreeing to the appeal or routing the
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matter to the Special Commissioners. Failing at that level, the ultimate decision resides
in the High Court (or Court of Appeal), if the taxpayer or the MIRB so desire to proceed
to such authority.
Before proceeding with the appeals process, the taxpayer is required to pay the
assessed tax and penalties.
An alternative avenue available to taxpayers via the double taxation treaties is the
MAP, which is a mechanism that caters for equitable tax treatment on transactions
that involve multiple tax administrations. In some instances MNCs recognise the need
for the use of this type of dispute resolution procedures to ensure the elimination of
double taxation. Currently, Malaysia has concluded 70 double tax agreements globally.
Currently, there are no specifc provisions for noncompliance with the transfer
pricing guidelines or not having prepared transfer pricing documentation. However,
if a transfer pricing adjustment is made, any additional taxes resulting from such an
adjustment usually will be subject to the normal penalties imposed under the Self
Assessment System. According to the new Tax Audit Framework, which came into
effect from 1 January 2009, the penalty rates are summarised as below:
Penalty Rates
Period Penalty rates
Voluntary disclosure before case is
selected for audit
Within 60 days from the due date for
furnishing the return form
10%
More than 60 days but not later than
six months from the due date for
furnishing the return form
15.5%
six months one year 20%
one three years 25%
> three years 30%
Voluntary disclosure after being
informed of case selection but before
commencement of audit
35%
Findings during audit visit (rst offence) 45%
Given that transfer pricing can be subjective and the conclusion of what is arms length
by the taxpayer might differ from that of the MIRB, the rate of penalty imposed on
transfer pricing adjustments may be reduced if the taxpayer is able to demonstrate
that its transfer prices were arrived at using a reasonable basis of support with the
necessary documentation and the transfer pricing documentation was submitted upon
request by the tax authorities.
Since the transfer pricing guidelines were issued in Malaysia in July 2003, the MIRB
has set up a team at its head offce that specialises in transfer pricing audits. To date,
this has been further enhanced with the setting up of separate transfer pricing teams in
the various tax audit assessment branches of the MIRB across the country.
Malaysia
With the additional disclosure information requested in Parts N and P of the Form C,
the tax authorities have information to make a reasonable selection of companies for a
tax or transfer pricing audit. Additionally, the tax authorities digitise the information
disclosed by companies in their tax returns. This electronic database of information
allows the tax authorities to effectively identify companies for audit, conduct trend
analyses of a companys results as well as benchmark the companys performance
against its industry.
The majority of the tax offcers have experience handling tax investigations and tax
audits. The offcers are continually updating their knowledge through dialogues with
other tax administrations in the region, in addition to attending and participating
in training conducted by foreign and international tax authorities/bodies such as
theOECD.
In order to demonstrate that the pricing outcomes being examined are arms length, a
company will need to demonstrate, through adequate documentation, that the transfer
prices meet the arms-length test for Malaysian tax and transfer pricing purposes.
Tax authorities
The tax authorities usually will obtain comparable information within their internal
database. Each year, companies are required to submit their tax returns and other
associated work papers to the tax authorities. This forms part of the internal
comparable information available to the tax authorities as well as information obtained
from other tax audits performed.
Taxpayers
As a starting point, the taxpayer should determine whether internal comparable
information can be found within the company. In the event internal comparable
information is unavailable, the tax authorities would expect companies to have carried
out an external comparable study using local comparables. Only in the event local
comparables cannot be found, the tax authorities are willing to consider overseas
comparables on a case by case basis.
In carrying out the search for local comparable studies, public directories and
databases are used. Most Malaysian companies (private and public) except for exempt
private companies must prepare audited accounts, which can then be obtained from
the Companies Commission of Malaysia. The process of retrieval of such information is
done manually and is therefore time-consuming.
In deciding the arms-length price, the transfer pricing guidelines do not specify
a preference for a single fgure or a range of fgures to be used. Therefore, the tax
authorities have the fexibility to decide whether a single fgure or use of a range of
fgures is appropriate in determining whether the taxpayer has adhered to the arms-
length position.
No particular industry is more at risk of receiving a tax audit than another. Past
experiences indicate that once the tax authorities have had substantial success
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in a particular company or industry, other companies in the same industry have
beentargeted.
The tax authorities are beginning to focus on the following related party transactions
as part of their audit selection:
Sales and purchases of goods, assets and services;
Transfer and use of know-how, copyrights and trademarks;
Loan and interest payments;
Cost-sharing arrangements;
Management and administrative fees;
Unusual economic transactions and arrangements;
Research and development expense allocation; and
Sale, purchase and other commission payments.
Other issues that may alert the tax authorities include:
Reduction of profts in a post-tax holiday period;
Losses made on the sale of products or assets to related companies;
Physical delivery of goods and invoicing to customers are performed by different
group companies located in different tax jurisdictions;
Consistent losses or very low profts compared with other
independentcomparables;
Constantly fuctuating proft margins;
Signifcant differences in sales or purchase prices on transactions between related
companies and independent third parties; and
Frequent changes in prices on transactions between related companies.
As the Malaysian tax authorities get more experienced in transfer pricing matters, the
taxpayers will need to be better prepared to defend their transfer pricing position with
adequate documentation.
In addition to the limited agreements dealing with the taxation of international traffc
of ships and aircraft, Malaysia has a fairly extensive network of comprehensive double
tax agreements modelled on the OECD convention.
Most Malaysian treaties have the automatic relief, and this is a standard article not a
limitation issue. Malaysias treaties generally contain an Associated Enterprise article
and a MAP article.
The move towards setting up an APA programme in Malaysia needs to be initiated by a
request from a taxpayer for either a unilateral APA or a bilateral APA.
The tax authorities are now encouraging taxpayers to apply for an APA. In this regard,
if any taxpayer is interested in applying for an APA, they can initiate discussions with
the tax authorities.
Malaysia
There are a few APAs currently in negotiation with the tax authorities although the
prescribed form for the APA process is yet to be issued. It is presently unclear as to how
the detailed procedures in implementing and operating APAs will be carried out. It is
expected that the MIRB will issue guidelines to formally set out the procedure for the
application and implementation of APAs.
Information obtained by the income tax authorities is confdential and may not be
exchanged with the customs authorities. However, import/export documents on the
taxpayers business premises can be taken by the income tax authorities in the course of
a tax audit.
4915. OECD issues
Malaysia is not a member of the OECD. However, the tax authorities generally have
adopted the arms-length principle and use the transfer pricing methodologies
endorsed by the OECD Guidelines. Preference is given to the traditional transaction
methods, namely comparable uncontrolled price (CUP) method, resale price method
(RPM) and cost plus (CP) method. Transactional net margin method (TNMM) and
proft split method (PSM) are acceptable to the MIRB as a last resort.
Malaysia would partake in a joint investigation of a multinational group with another
country, if both countries would beneft from the investigation. Joint investigations
involving the Malaysian authorities have taken place in the past.
Thin capitalisation was introduced into the legislation via Section 140A(4) with effect
from 1 January 2009. As mentioned earlier, this provision allows the director general
to disallow any interest, fnance charge, other consideration payable for or losses
suffered in respect of all excessive related party fnancial assistance in relation to fxed
capital. However, the MIRB is yet to issue the rules elaborating the application of thin
capitalisation norms.
Mexico
50.
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Mexico
5001. Introduction
Mexico did not apply international standards to its transfer pricing legislation until
1997. However, in December 1996, the Mexican Congress enacted signifcant tax
reform, introducing transfer pricing rules consistent with OECD Guidelines, controlled
foreign company legislation, and other anti-avoidance measures. Several minor
reforms regarding transfer pricing have been enacted, but the bulk of the rules of
application are included in the OECD Guidelines since Mexican Income Tax Law
(MITL) specifcally requires the application of the OECD Guidelines to the extent
consistent with the MITL and any applicable treaty. In addition, the Mexican transfer
pricing tax authorities have become relatively sophisticated in a short period.
Most of the transfer pricing rules are included in Articles 86 (Sections XII, XIII and
XV), 215, 216 and 216-BIS of the MITL. Under these rules, taxpayers are required
to produce and maintain documentation demonstrating that gross receipts and
allowable deductions for each fscal year (FY) arising from international inter-
company transactions are consistent with the amounts that would have resulted
had these transactions taken place with unrelated parties under similar conditions.
Moreover, documentation of inter-company transactions should be completed on a
transactionalbasis.
The documentation requirements in Article 86 section XII of the MITL include the
following elements:
General information such as the name of the company, address, taxpayer
identifcation number, name of the related parties and a description of the
taxpayers ownership structure covering all related parties engaged in transactions
of potential relevance;
An overview of the taxpayers business, including an analysis of the economic
factors that affect the pricing of its products or services, such as a description of the
functions performed, assets employed and risks borne by the taxpayer for each type
of transaction;
A description of the controlled transactions and the amount of the transactions
(including the terms of sale) for each related party and on a transactional basis
according to Article 215 of the MITL; and
A description of the selected methodology applied as established in Article 216
of the MITL, including information and documentation of each type of inter-
companytransaction.
International Transfer Pricing 2011 Mexico 567
Mexico
All inter-company transactions between related parties must be reported at arms-
length prices for income tax purposes. This general rule makes the arms-length
principle the cornerstone of the income tax system because it covers transfers of
tangible and intangible property, services, domestic and cross-border transactions and
transfers of shares (whether publicly traded or not), entered into by individual and
corporate taxpayers.
The Mexican transfer pricing documentation requirements are consistent with
OECDGuidelines.
This documentation requirement applies to all corporations and taxpayers engaged in
business activities with annual gross receipts exceeding MXN13 million (approximately
USD1.04 million) during the previous fscal year. In the case of taxpayers providing
professional services, the documentation requirement applies unless the gross receipts
from those services do not exceed MXN3 million (approximately USD240,000).
Given that the income tax is determined annually, and since the statute references the
gross receipts and the allowable deductions are considered in determining the income
tax liability, the documentation must test the arms-length character of the inter-
company transactions of the taxpayer for each year.
Taxpayers are required to determine tax obligations and report on a calendar-year
basis for income tax purposes. There is no specifc deadline for preparing transfer
pricing studies. Nevertheless, a recent Supreme Court case decision in 2007 held
that the deadline to comply with the transfer pricing documentation requirement
is the date the corporation fles its income tax return (normally no later than 31
March of the following applicable calendar year), and failure to do so would result
in the disallowance of deductions pertaining to payments to related parties. There
are no sizeable immediate penalties in case of failure to prepare the documentation.
Compliance with this obligation may only be reviewed by the tax authorities for full
taxable years, and thus, the tax authorities may not request the documentation before
the taxable year ends.
Moreover, the federal tax code obliges most taxpayers to have their fnancial
statements audited by a certifed public accountant (CPA) in Mexico. The CPA must
fle the audited fnancial statements with the tax authorities along with a tax report
that includes an opinion as to whether the taxpayer has complied with its federal tax
obligations (dictamen fscal), which is usually required to be fled by June following the
end of the calendar year. If the transfer pricing documentation has not been prepared,
such failure must be disclosed in the dictamen fscal.
The Tax Administration Service (TAS) may request the documentation as early as
January of the following year, but in practice the documentation is not likely to be
requested before the tax return is fled or even before the date of the issuance of the
dictamen fscal. We are aware of situations in which the TAS has requested the transfer
pricing documentation after the tax return was fled and before the dictamen fscal is
due, but this is unusual.
The transfer pricing documentation is considered part of the taxpayers accounting
records. The MITL imposes the obligation to maintain the documentation as part of
the accounting records and to identify related party transactions with non-residents.
Mexico 568 www.pwc.com/internationaltp
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As in the past, the transfer pricing documentation must be kept at the tax domicile of
thetaxpayer.
It should be noted that the transfer pricing documentation is not fled with the tax
authorities. Rather, it must be prepared and maintained by the company, in general,
for a fve-year period. In the course of a tax audit, the taxpayer must make the transfer
pricing documentation available upon request.
The MITL does not explicitly require taxpayers to produce documentation regarding
domestic related party transactions, but these transactions must be reported on an
arms-length basis. Furthermore, at the beginning of fscal year 2002, the law stated
that the transactions must be determined based on the arms-length principle (i.e.
comparable transactions between unrelated parties) and the international transfer
pricing methods must be used for this purpose.
Consequently, it is generally considered that taxpayers must create transfer pricing
documentation to establish comparability and the propriety of the domestic related
party transfer pricing methods to satisfy the requirements of an independent CPA, who
would provide the dictamen fscal. Additionally, the Article 86, Section XIII establishes
an obligation of fling jointly with the return for the fscal year, on the offcial form
approved by the tax authorities for the purpose, information on all operations
performed in the next preceding fscal year with parties in a relationship residing
abroad (referred to as the DIM for its acronym in Spanish).
Taxpayers are required to report the amounts they would have accrued according to
the arms-length principle for income tax fling purposes, notwithstanding that the
prices used in transactions between related parties might differ.
The law broadly defnes related parties as parties that are directly or indirectly
managed, controlled or owned by the same party or group of parties. A permanent
establishment (PE) and its home offce, other establishments, and their related parties
as well as their PEs are deemed to be related parties.
Unrelated taxpayers entering into a special contractual joint venture agreement known
as an asociacin en participacin are also considered to be related parties for transfer
pricing purposes in Mexico.
The tax authorities are entitled to make an adjustment if a taxpayer fails to comply
with the obligation to report arms-length amounts in the income tax return.
Article 216 of the MITL specifes the following six transfer pricing methods:
1. Comparable uncontrolled price method (CUP);
2. Resale price method (RPM);
3. Cost plus method (CP);
4. Proft split method (PSM);
5. Residual proft split method (RPSM); and
6. Transactional net margin method (TNMM).
In addition to the obligation to pay income tax in accordance with the arms-length
principle, taxpayers have three important transfer pricing-related obligations: to
Mexico
prepare and maintain transfer pricing documentation; to fle an information return on
transactions with non-resident related parties with the timely fling of their income tax
return for the previous fscal year, as Appendix 9 of the multiple information return
(information return); and to meet special reporting requirements for the transfer of
shares and quotas in Mexican companies between related parties.
Both traditional transactional methods (one through three) and proft-based methods
(four through six) as described in the OECD Guidelines are acceptable in Mexico.
In 2007, the preferred method rule was included in the MITL and applies for all
transactions developed between related parties. For this purpose, taxpayers are frst
required to use the CUP method and may apply the other methods only if the CUP
method is not appropriate. This effectively places the burden on the taxpayer to prove
and document the reasons for not applying this method. The law also provides a
second preference to apply the RPM and/or the CP methods, implicitly imposing the
burden of documenting why these methods were not appropriate if a proft-based
method is used. The law also clarifes that the RPM, CP and TNMM methods shall be
considered as being met when it is established that both the revenue and costs are
separately shown to be arms length.
All inter-company transactions (domestic and cross-border) also should be disclosed in
an appendix of the dictamen fscal.
Dictamen fscal
The following taxpayers must fle a dictamen fscal:
1. Companies that obtained gross receipts in excess of MXN34,803,950 during the
prior fscal year (approximately USD2.7 million);
2. Companies or groups of companies whose net worth (calculated pursuant to the
Mexican Assets Tax Act) during the prior fscal year exceeded MXN69,607,924
(approximately USD5.5 million);
3. Companies with at least 300 employees in every month of the prior fscal year (1
January 31 December);
4. PEs that fall in any of the above scenarios described under (1), (2) or (3);
5. Companies involved in or arising from a corporate division or a merger during the
year of the transaction and during the subsequent year;
6. Entities authorised to receive deductible charitable contributions; and
7. Companies in the liquidation period if they had the obligation during the prior
fscal year.
As mentioned, the deadline for fling the dictamen fscal with the TAS according to the
federal tax code is regularly June, with company-specifc dates depending on the frst
letter of the tax ID number, except in the case of holding companies of groups that
consolidate for tax purposes, whose deadline is normally in July. However, in some
years, these deadlines have been extended.
Signifcant additional information is required to be disclosed by the independent
accountant issuing the dictamen fscal. These new provisions are designed to require
the auditor to take on more responsibility toward compliance with transfer pricing
obligations, require taxpayers to specify more details on compliance with transfer
pricing and to help the tax authorities identify potential transfer pricing contingencies.
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Effective fscal year 2008, if there are related party transactions, segmented fnancial
statements must be included in the dictamen fscal. The independent accountant
must indicate whether he/she audited the segmented information or not, and in any
event must explain how the segmented information was prepared. The independent
accountant is required to verify whether the accounting systems of the taxpayer permit
a reasonable segmentation of the information included in the income statement.
This Miscellaneous Rule requires disclosure of the transfer pricing method in the
dictamen fscal, and the independent accountant must state whether the transaction
was refected on an arms-length basis, whether a tax adjustment was made to comply
with the arms-length standard, and a statement as to the tax year in which the
transaction was registered as a cost, expense or income for accounting purposes. The
Miscellaneous Rule now requires disclosure of the tax identifcation numbers of the
persons preparing or advising on transfer pricing report for the applicable year (and
incidentally the tax identifcation numbers of other tax advisers).
These rules require disclosure of information on advance pricing agreements,
favourable resolutions issued by the tax authority on inter-company transactions,
affrmation of the existence or not, of transfer pricing studies for both domestic and
international transactions, and an affrmation of previous fling of informative return
on foreign related party transactions (Appendix 9 of the multiple information return
usually fled together with the annual income tax return). The rule also requires
the independent accountant to affrm compliance with transfer pricing obligations
pursuant to fat tax rules.
Specifc questions must be answered regarding the deduction of pro rata expenses from
abroad, management fees, back-to-back loans, derivative fnancial transactions, thin
capitalisation, Maquiladoras with bonded warehouses, the transfer pricing method
applied for Maquiladoras under Article 216-BIS of the Mexican income tax law and
transfer pricing data relating to the fat tax law for Maquiladoras.
The independent accountant is required to state whether the taxpayer owns or uses
intangible assets and must specify the principal intangible assets it uses, grants or
owns. The independent accountant must state whether all of the inter-company
transactions have been refected in the accounting records.
The independent accountant must also verify whether there has been a transfer pricing
adjustment, specifying where it is recorded in the general ledger and in what part of
the book tax reconciliation it is refected.
Information return
All corporations and individuals engaged in business activities are required to fle an
information return on transactions with non-resident related parties. This information
return is due on the same day of the tax return fling date, within the three-month
period following the end of the calendar year for corporations, and by the end of April
for individuals. Taxpayers that fle a dictamen fscal may fle their tax return along
withit.
The information return must contain the amount of the transaction, the type of
transaction, the gross or operating margin for each transaction, the transfer pricing
method used, the taxpayer ID number of the related party, fscal domicile of the related
party and its country of residence.
Mexico
Unlike the obligation to prepare transfer pricing documentation, all corporate
taxpayers and individuals engaged in business activities must fle this information
return irrespective of the amount of gross receipts. Maquiladora (see Section 5003 The
maquiladora industry) companies with a valid advance pricing agreement (APA) ruling
from TAS and those that comply with Article 216-BIS of the MITL are not obligated to
comply with such fling but only for its maquiladora operations.
Failure to comply with this fling may result in fnes and in the disallowance of the
deduction of all payments made to non-resident related parties. Additionally, failure
to fle the information return must be disclosed in the dictamen fscal. The fnes range
from MXN54,410 to MXN108,830 (approximately USD4,353 to USD8,706), and these
penalties are additional to the ones that could apply in case of a tax defciency.
Because compliance is a requirement for the deduction of payments to non-residents
and payments to resident-related parties are not subject to this requirement, it might
be possible to argue that the disallowance of the deduction is inconsistent with the
nondiscrimination provisions of Mexicos tax treaties (Mexicos tax treaties include a
provision such as that in paragraph 4 of Article 24 of the OECDs Model Tax Convention
on income and on capital). Nevertheless, it should be noted that the obligation to fle
remains in any case.
Both the dictamen fscal and the information return are probably used by the TAS in
scheduling transfer pricing audits.
Transfer of stock
Mexican law imposes income tax on income derived by non-residents from the sale
of stock or quotas in Mexican resident companies. In this case, a special dictamen
fscal prepared by a Mexican independent public accountant must be fled certifying
compliance with tax obligations on the share or quota transfer unless the transaction is
exempt under a tax treaty. This obligation applies even if the transaction qualifes as a
tax-deferred reorganisation under domestic law.
The special dictamen fscal on the alienation of shares must include a report on the
value of the shares, and the CPA must state which valuation methods were taken into
account, and why, for example:
Infation-adjusted capital of the entity;
Present value of future cash fows (income approach); and
The last quote in case of publicly traded stock.
In the frst case, the information must include details on the amount of the historical
capital and the corresponding adjustments. In the second case, the regulations under
MITL require detailed information on the name or names of the methods used for the
discounted value of the cash fows, discount rates, the existence of residual values, the
number of projected time periods and the economic sector of the company whose stock
was alienated. In any case, the CPA is required to explain in the report the reasons
for the selection of one of these three alternatives. Compliance with these provisions
effectively requires a complete appraisal of the company, and it should be noted that
there is not a de minimis rule for small transactions or small companies.
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In general
The statutory rules have not been extensively regulated. Some rules deal with technical
issues such as the documentation that must be attached to an application for an APA.
These requirements are discussed in detail in Section 5014 below.
The regulations under the MITL require the use of the interquartile range for the resale
minus, cost plus and TNMM methods and state that inter-company transactions will
be deemed to be in compliance with the arms-length standard if they are within that
range, but if the taxpayers price, amount of compensation or proft margin is out of the
interquartile range, the median of said range shall be deemed the price or amount of
compensation that would have been used by independent parties.
These regulations require the use of a specifc point within the range if the available
information allows a more specifc determination. According to the regulations,
other statistical methodologies may be used under competent authority or if they are
authorised under general rules issued by the TAS.
The maquiladora industry
Maquiladoras are companies that assemble or manufacture using temporarily imported
raw materials and components on consignment for subsequent export. Typically, a
maquiladora uses machinery and equipment consigned by the non-resident using its
services. The term maquiladora originally referred to a particular customs regime
facilitating temporary imports and reducing costs for such imports such as customs
fees, value added taxes, etc. However, this customs regime was combined with another
similar regime (PITEX) in 2006, and the customs regime applicable to both is now
termed the IMMEX programme.
Prior to 1995, maquiladoras were regarded as cost centres and were not required
to report signifcant profts. However, since 1995 the government has required
maquiladoras either to report arms-length profts or to meet a safe harbour. These
alternatives were regulated by administrative rules subject to annual renewal.
Failure to comply could result in a transfer pricing adjustment and the application of
PE rules to the non-resident company providing detailed instructions to, and exercising
general control of, the maquiladora.
One of the most important aspects of these rules is that they also provided a reduction
on the asset tax liability imposed on non-residents that provide maquiladoras with
inventory and equipment. The reduction was granted by limiting the asset tax base to
the proportion of total production for the domestic market. This reduction in the asset
tax was also available if the maquiladora obtained an APA.
The tax reform for 2003 brought signifcant changes to the special transfer pricing
rules for maquiladoras. Transfer pricing options for maquiladora companies are now
provided under Article 216-BIS of the MITL.
The MITL establishes that foreign companies operating through a maquiladora will not
be deemed as having a PE in Mexico, provided that they are residents of a country that
has a tax treaty in place with Mexico, that all the terms and requirements of the treaty
Mexico
are satisfed and, eventually, that the mutual agreements that Mexico and its applicable
treaty partner may have are observed. This provision applies only if maquiladoras
comply with any of the following options:
1. Prepares and maintains transfer pricing documentation determining an arms-
length level of proftability for the maquiladora, and adding to the result of this
analysis a 1% on the net book value of the machinery and equipment (M&E) owned
by the foreign-related company that is used by the maquiladora in its activities.
2. Reports taxable income of at least, the higher of the following values
(safeharbour):
6.9% of assets used in the maquiladora activity (including the inventories
and fxed assets owned by the foreign related party). Such value must be
determined under the principles of the Asset Tax Act, which requires infation
adjustments and takes into account the statutory depreciation rates. All the
assets used in the maquiladora operation during the fscal year must be taken
into account for the calculation. The only assets that may be excluded from the
calculation are those leased at arms length to the maquiladora by a Mexican
resident or a non-resident related party, except if they were previously owned
by the maquiladora. Property leased at arms length from related parties that
used to be property of the maquiladora may be excluded only if the maquiladora
disposed of the property at an arms-length price. The value of assets used for
maquila and non-maquila operations may be taken into account rateably only
with an authorisation from the TAS; or
6.5% on operating costs and expenses of the maquiladora. The costs must be
determined under Mexicos generally accepted accounting principles except for
the following items:
a. The total amount of purchases is used instead of the cost of goods sold;
b. Tax depreciation is used instead of accounting depreciation;
c. Extraordinary or non-recurring expenses (under Mexicos generally
accepted accounting principles);
d. Infation adjustments; and
e. Financial charges.
Both calculations are subject to a number of exemptions and special rules. The
result of those special rules might differ signifcantly from the numbers in the
books of thecompany.
3. Prepares and maintains transfer pricing documentation considering a return on the
net book value of M&E owned by the foreign-related company that is used by the
maquiladora in its activities. In this case the corresponding return must be adjusted
to recognise that the fnancial activities (and associated risks) for the procurement
of such M&E are not carried out by the maquiladora.
As of 2003, APAs for maquiladoras are elective. The benefts of the special transfer
pricing rules may be secured by following one of the three alternatives described
above, but no APA fling is necessary in any case.
Additionally, on 30 October 2003, a presidential decree was published in the Mexican
Offcial Gazette, by which various benefts for taxpayers are provided. Specifcally,
Articles 10th, 11th and Fourth Transitory, provide important tax benefts applicable for
the maquiladora industry with the main purpose of promoting its competitiveness.
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The decree establishes that maquiladora companies are entitled to apply a partial
income tax exemption. Such exemption will be calculated based on the difference in
income tax resulting from the application of the percentages established in Section II
of Article 216-BIS of the MITL (the higher between the 6.9% on assets and 6.5% on
operating costs and expenses, safe harbour), and a 3% on the corresponding assets
or costs. For purposes of calculating the aforementioned beneft, maquiladora entities
may exclude the value of inventories used in their manufacturing operations. This
beneft would be applicable for all maquiladoras as long as they are in compliance with
the rest of the requirements established under Article 216-BIS.
The new Mexican Flat Tax (referred to as the IETU for its acronym in Spanish),
which was enacted on 1 October 2007, and which became effective on 1 January
2008, has triggered concern in the marketplace due to its anticipated impact on
Mexicanbusiness.
In an effort to address some of these concerns, the Mexican Executive Branch issued
a decree on 5 November, 2007, (effective 1 January 2008). The decree grants relief to
specifc categories of taxpayers, such as those that operate in the maquiladora industry,
those with signifcant inventory on hand, and real estate developers.
The decree provides that the maquiladoras will be entitled to an additional credit
against the IETU which, in principle, should yield an effective tax rate of 17.5% (16.5%
in 2008 and 17% in 2009) on the taxable income as determined under any of the
existing transfer pricing methodologies of the MITL relative to maquiladoras.
Taxpayers desiring to use the cost plus self-assessment option to determine the taxable
income foor for purposes of arriving at the credit would need to adjust the return on
foreign-owned assets to 1.5% in order to compute this credit under this option.
This maquiladora tax credit will be available from 2008 to 2011.
5004. Legal cases
As a result of the frst transfer pricing audits, a few petitions have been fled before
the courts. The Federal Court of Administrative and Fiscal Justice has recently ruled
that the tax examiners outside the Administracin General de Grandes Contribuyentes,
the offce in charge of the largest taxpayers of the country, are now entitled to make
transfer pricing assessments. Please note that more court rulings are expected.
As part of the Ministry of Finance fscal policy, in 2007 the TAS issued a special decree
that involved an amnesty scheme by which those taxpayers with tax credits in place
could obtain important discounts in the penalties and surcharges if they agreed to self-
correct its tax credits.
In case of liabilities for years prior to 2003, the Mexican tax authorities authorised
to disregard 80% of the tax liability and to abate 100% of the related surcharges
and penalties, as long as the agreed-upon amount is paid in one instalment. From
2003 through 2005, the tax liability may not be abated. However, the Mexican tax
authorities are able to abate 100% of any surcharges and penalties for those years, as
long as the agreed-upon amount is paid in one instalment.
Mexico
Through the amnesty scheme, taxpayers in Mexico found interesting settlement
alternatives for important tax audits, especially in corporate restructurings involving
possible exit payments for the migration of intangible assets.
Assuming the taxpayer prepares and submits the transfer pricing study to the tax
authorities upon request, in the case of a transfer pricing audit, taxpayers do not
bear the burden of proof except in the case of transactions with tax havens, which
are discussed below. If the TAS determines an adjustment is in order, it is required
to demonstrate that the taxpayer failed to comply with its obligation to report
arms-length amounts in the income tax return. It should be noted that any notice of
defciency must state the facts on which it is based and the applicable law and must
include an explanation of how the law was applied to the facts. Failure to comply with
these requirements will result in an invalid notice of defciency.
In the context of litigation relating to a transfer pricing assessment when the taxpayer
submitted the transfer pricing study during the tax audit, the tax authorities have the
burden of proving that the taxpayers transfer pricing study was incorrect. On the other
hand, the burden is shifted to the taxpayer when no study is presented. As a general
rule, an assessment not challenged within the 45 working-day period becomes fnal.
Under the competent authority procedure there is an exception to this time limit (see
explanation below).
Any transaction with an entity resident or located in a low-tax jurisdiction will
automatically be presumed to be a transaction with a related party and will also be
considered not to take place at arms length. In these cases, the taxpayer has the
burden of proof, and it will be necessary to demonstrate that the transaction was
entered into with an unrelated party, or that the transaction was entered into with a
related party but took place at an arms-length price.
There is no extensive history on tax audits involving transfer pricing issues because,
for practical purposes, transfer pricing only became relevant as from 1997. Therefore,
transfer pricing may be reviewed as part of a tax audit or a specifc transfer pricing
audit may be performed.
In this regard, it is important to mention that some of the recently initiated
examinations are specifc transfer pricing audits aimed at specifc industries including
pharmaceutical, retail, tourism, automotive, and mining. The issues addressed on
these audits are proft margins, portfolio sales to related parties, intermediate services,
royalty payments, tax-deductibility of guarantee fees and conventional payments, and
government concessions.
The tax audit review begins when the tax authorities summon the companys CPA for
specifc information. If the authorities are satisfed with the information provided,
the procedure stops there and the formal audit procedure is never initiated. But, if the
authorities are not satisfed, they will request the information directly to the company,
and this is the formal beginning of the audit procedure.
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The provision of information and duty of the taxpayer to cooperate with the
taxauthorities:
During an on-site examination, the taxpayer is under obligation to provide all
the information that demonstrates compliance with tax obligations, including
transfer pricing documentation. Failure to comply with a request might trigger the
disallowance of deductions, the imposition of fnes or, in more grave circumstances,
the imprisonment of the representatives of the company. However, it should be noted
that during an on-site examination taxpayers are merely under obligation to allow the
examination to take place and to provide the books and records. Taxpayers are not
required to produce special reports for the tax authorities, or to actively participate in
the proceedings.
A taxpayer opposing a tax audit might be subject to a presumptive assessment of its
income and the value of its assets and activities. The tax authorities are also entitled to
search the companys premises and seize the required information.
Outside the scope of the specifc requests of information and the on-site tax audits,
the tax authorities have a broad power to obtain information from alternative sources,
including as one of the most effective ones, the exchange of information with countries
with whom Mexico has signed tax treaties.
If a taxpayer does not comply with an information request during an audit, the TAS
may impose fnes that range from approximately MXN12,240 (approximately USD980)
to MXN36,720 (approximately USD2,938) and take other measures to secure the
information.
Attorney-client privilege does not exist in Mexico. Although professional service
providers are required by law to maintain confdentiality with respect to client
information, this duty to maintain confdentiality does not apply when the law (under
statutory authority) imposes the obligation to produce a report. In tax audits, the law
states that the tax authorities may request all kinds of documents pertaining to the
audit from the taxpayer or third parties (including lawyers and accountants). In these
situations, the general obligation to maintain confdentiality is overridden by a request
made by the tax authorities.
Documents prepared in anticipation of litigation are not protected, but taxpayers and
their advisers may refuse to provide documents that are not relevant to the tax audit.
In theory, transfer pricing may be reviewed using regular procedures; under this
scenario the tax authorities would initiate the procedure through a summons of the
companys CPA, and if the information provided is not suffcient, they would be able
to apply any verifcation procedure established by the Mexican Fiscal Code, including
specifc requests of information, on-site verifcations, etc. The TAS has a specialised
group (Administracin Central de Fiscalizacin de Precios de Transferencia) that performs
the transfer pricing examinations, and the specifc faculties for this team to review
transfer pricing issues were published on 22 October 2007, in the Mexican Offcial
Gazette. This group is part of the Administracin General de Grandes Contribuyentes,
a division of the TAS that deals with the largest taxpayers.
Mexico
During the examination, the tax authorities may request information and must
be allowed access to the accounting records of the company. All fndings must be
documented in writing, and witnesses are required. In the course of the examination
the taxpayer is not entitled to request information, but the audit cannot be completed
without providing to the taxpayer a written statement of fndings. Upon receipt of this
document, the taxpayer is entitled to furnish proof and reasoning that must be taken
into account for the fnal determination. The document where the taxpayer furnishes
proof and reasoning is known as escrito de inconformidad and is similar to a protest. If
a taxpayer does not provide any information to the TAS in accordance with Supreme
Court rulings, it is still entitled to prove that there is no defciency during litigation.
It is legally possible to obtain and use information from foreign authorities without the
permission of the taxpayer or without giving notice of such actions.
In transfer pricing cases, a three-month period must be allowed between the last partial
written record (ltima acta parcial), which is the frst document of the examination
made available to the taxpayer, and the fnal determination. A two-month extension is
available upon request.
As a general rule, tax examinations must be completed within 12 months. This limit
does not apply to certain audits, including transfer pricing cases, which are under
a two-year rule, but the Supreme Court of Justice has declared this exception to be
unconstitutional. The statute of limitations on assessment is generally fve years for
all federal tax matters, including transfer pricing cases. The running of the period is
suspended during an on-site audit (no suspension applies in the case of other types of
examination) if the taxpayer fles a petition before the federal court of administrative
and fscal justice (Tribunal Federal de Justicia Fiscal y Administrativa).
A transfer pricing adjustment may be appealed before the tax administration (recurso
de revocacin) or a lawsuit may be fled before the Federal Court of Administrative
and Fiscal Justice. It is not necessary to use the appeals procedure within the
administration before going to the Federal Court of Administrative and Fiscal Justice.
In either case, the taxpayer has a 45-working day term to appeal the determination by
the TAS.
In some cases, the administrative appeal is not fled because the TAS usually does
not change its determination. Nevertheless, it is important to mention that as of July
2009 the lawsuit requires the taxpayer to provide a guarantee (bond, deposit, and/or
mortgage) for the amount of the defciency and an estimate of the additions to the tax
of one year. Therefore, if taxpayers appeal a transfer pricing adjustment before TAS
they are not obliged to provide any kind of guarantee until the tax administration has
solved the administrative appeal.
The Federal Court of Administrative and Fiscal Justice is an autonomous administrative
court of original jurisdiction. It is divided into sections that hear cases within its
territory. One of its divisions (Sala Superior) is higher within the hierarchy and is
in charge of important cases, regardless of territorial considerations. In any case,
the Federal Court of Administrative and Fiscal Justice can only decide whether a
determination by the tax authorities was made according to the law; therefore, it
cannot change the amount of the adjustment made by the tax authorities or determine
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that a third alternative must be followed. The Federal Court of Administrative and
Fiscal Justice will only affrm or reverse the assessment made by the tax authorities.
The federal courts may review judgments made by the Federal Court of Administrative
and Fiscal Justice. The federal courts are vested with the authority to review legal and
constitutional issues.
Determinations made by the courts are not binding except for the parties involved
in the litigation. A holding by a court of law may become mandatory precedent only
under limited circumstances (involving a reiterated position of the court) and even in
such cases, it is mandatory only for lower tier courts and not for the TAS. Individual
court determinations may be treated only as persuasive authority to those that were
not involved in the case.
Within the Federal Court of Administrative and Fiscal Justice, there is no subject matter
specialisation and, therefore, in principle, any division of the court may hear a transfer
pricing case. Nevertheless, the Sala Superior may decide to hear any case involving an
amount of at least MXN100 million (approximately USD9.09 million). It also has been
pre-established that the Sala Superior will hear any transfer pricing case where the
statute is construed for the frst time.
Several consequences follow a transfer pricing adjustment. At the outset, an
adjustment is made by making an assessment of the gross receipts and deductions
that would have arisen in uncontrolled transactions. In cases where two or more
comparables are found, a range will be used. The range must be adjusted using
statistical methods, and the adjustment is made to the median of such a range. It
should be noted that an adjustment by the tax authorities is only possible if the prices
used by the taxpayer or the margin in the controlled transaction are outside such
arange.
As a consequence of the assessment, many tax attributes might need to be adjusted. For
instance, if the adjustment turns losses into profts, the amount of net operating losses
will decrease, and if the price of an inter-company transfer of a fxed asset changes, the
depreciable basis in such property will change. Also, the foreign tax credit limitation
may increase if the taxable income increases as a consequence of an adjustment to an
international operation, and the amount of the net after tax earnings account (known
as CUFIN) will increase as a consequence of any increase to the taxable income.
Withholding taxes and estimated payments also might require an adjustment.
In addition to the aforementioned changes, the amount of the adjustment to the
taxable income is itself treated as a constructive dividend.
Constructive dividends may be subject to a corporate level tax triggered in case the
distribution does not arise from the CUFIN account. The tax is calculated by applying
the corporate tax rate to the amount of the transfer pricing adjustment grossed-up by
1.3889 from 2007 to 2009 and 1.4286 from 2010 to 2012.
There are no separate penalties applicable to transfer pricing tax adjustments. Instead,
the regular penalties for failure to pay are imposed. These penalties range from
55%75% of the infation adjusted amount of the assessment. The penalty is 50%
if the payment is made during the audit and prior to the notice of defciency. Where
Mexico
the amount of a loss is reduced, the penalty ranges from 30%40% on the difference
between the reported and the actual loss, to the extent a portion of the misstated loss
is utilised. Besides the penalties and the infation adjustment, late payment interest
(termed surcharges) also is imposed.
A 50% reduction in penalties is applicable if a Mexican taxpayer meets the
documentation requirement. There are no rules designed to determine the degree of
compliance with the documentation requirements.
5010. Resources available to tax authorities
The Mexican government also has implemented important institutional changes aimed
to improve the effciency of law enforcement. A specialised group performs transfer
pricing examinations.
Taxpayers must submit several returns that provide the TAS with useful information
in planning and conducting its examinations. These include the information return on
payments to non-residents, the information return on main suppliers and clients, and
the information return on international transactions between related parties.
Mexico is actively exchanging tax information with its treaty partners, especially with
the US. The exchange of information may be automatic, at specifc request or more
spontaneous in nature.
Comparable information is required to determine arms-length prices and should
be included in the taxpayers transfer pricing documentation. However, there
is little reliable fnancial information publicly available on Mexican companies.
Therefore, reliance often is placed on foreign comparables with a proper evaluation of
marketadjustments.
The tax authorities have the power to use confdential information of third parties. The
taxpayer has limited access to this data through two designated representatives who
must agree to be personally liable to criminal prosecution if the data is disclosed.
Starting in 2007, the International Tax Division and the Transfer Pricing Central
Administration established important audit programmes addressing several main
tax issues: (a) intangible assets migration derived from corporate restructurings, (b)
debt push-down arrangements and (c) pro rata expenses that have been deducted as
management fees.
From an industry standpoint, no substantial basis exists for identifying any particular
industry as being especially at risk.
Double taxation relief is granted by corresponding adjustments under tax treaties.
Mexican law requires approval of the adjustment in order to allow the Mexican
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taxpayer to fle an amended tax return. Should these conditions be met, a tax refund
may be obtained. Under most tax treaties entered into by Mexico, the corresponding
adjustment may be denied in case of fraud, gross negligence or wilful default. Mexico
has not implemented this rule.
The corresponding adjustment for domestic transfer pricing cases is not regulated.
This means that taxpayers may elect to report the adjustment through an amended
tax return for the year in question. However, it should be noted that there are certain
restrictions on the fling of amended tax returns.
The competent authority procedure is available prior to the domestic law remedies,
and it is still available even if there is a fnal judgment against the taxpayer. The
competent procedure is also available if the taxpayer did not meet the 45-working day
term. The only limitation to the use of the competent authority procedure is that it is
not possible to pursue both routes at the same time (competent authority procedure
and domestic law remedies). A competent authority determination subsequent to an
unfavourable ruling by court of law will only affect the tax assessment and not the
ruling itself.
Should the taxpayer elect to appeal before the tax administration, it will be possible
to challenge the fnal decision of such procedure before the Federal Court of
Administrative and Fiscal Justice.
Most tax treaties entered into by Mexico contain time limits for notice of a competent
authority procedure (i.e. four and a half years), and a 10-year period for the
implementation of any agreement is usually included. In all cases it will be important
to take into consideration the specifc time limit included in the applicable tax treaty.
As a fnal step in the dispute resolution process between competent authorities of tax
treaty countries, there is the arbitration procedure. Although is not mandatory for the
countries to enter into, it is a valid resource that should be evaluated.
APAs have been included in the law as a legal possibility since 1997. They are not
agreements between the administration and the taxpayer. They are issued as unilateral
rulings under domestic law or as determinations under the competent authority
procedure. APAs approve a methodology and not a specifc result. Pre-fling meetings
on a no-name basis are possible.
As of 2000, APAs covered up to fve fscal years: the current fscal year, the three
subsequent fscal years and a one-year roll-back.
Bilateral APAs are also possible under the competent authority procedure, and in
these cases tax authorities are entitled to waive late-payment interest. Bilateral APAs
may be issued for more than fve years because they are not subject to the limitations
described above. Unlike rulings on international tax issues, the TAS is not required to
publishAPAs.
The law provides that APAs should be resolved in a maximum of eight months. In
practice, most APAs take longer.
Mexico
The offce in charge of APAs is the Administracin Central de Auditora de Precios
de Transferencia. This is the same offce that performs international examinations;
therefore, the use of roll-back APAs to settle an audit is not practical.
As anticipated above, under general rules issued by the TAS, the information and
documentation requirements for an APA application are substantial:
Power of Attorney of the legal representative;
Name of the company, tax domicile, tax identifcation number and country
of residence of the taxpayer, and the person or persons with equity interest in
thetaxpayer;
Certifed copy of the corporate book of the taxpayer where the shareholders
areregistered;
The names of the related parties in Mexico or elsewhere that have a contractual or
business relationship with the taxpayer;
A description of the principal activities, including the place where the activities
are undertaken, describing the transactions between the taxpayer and its
relatedparties;
Organisational chart of the group; must include shareholding percentages;
Balance and income statement as well as a breakdown of costs and expenses
incurred by the taxpayer for the three prior years to the period to be covered by
the APA; or if taxpayer is under the obligation to fle a dictamen fscal, the audited
fnancial statement with the report issued by the registered CPA;
Tax returns of the taxpayer, including amended returns for the past three years;
Copy in Spanish of all the contracts and agreements between the taxpayer and its
related parties (resident and non-resident related parties);
Beginning and closing date of the fscal years of the related non-resident entities
with which a contractual or business relationship exists, or the indication that they
use a calendar year;
Currency used in the main transactions;
The transactions to be covered by the APA;
Detailed description of activities undertaken by the company and its related parties
with which it has a contractual or business relationship, including a description of
the assets and risks assumed by such person;
The method or methods proposed to determine the price or amount of
consideration in transactions undertaken with related residents and non-residents,
including criteria and other elements for considering that the method applies to the
mentioned transaction or company;
Information on comparable transactions or companies, the adjustments made to
the comparables and the explanation of rejected comparables and adjustments;
Financial and tax information corresponding to the fscal years for which the ruling
is requested, applying the method or methods proposed. (This requirement is
basically a forecast of the fnancial statements and tax returns); and
A disclosure stating whether the non-resident related parties are involved in a
transfer pricing examination elsewhere. (It is also necessary to disclose whether
the taxpayers related parties have fled a legal remedy regarding a transfer pricing
case, or if they have been involved in transfer pricing litigation. In case there is a
fnal determination, the main points of the holding must be explained.)
The fee for an APA is MXN8,040 (approximately USD730). Once the APA is issued,
an annual report must be fled with the TAS. The fee for the APAs annual review is
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MXN1,608 (approximately USD145). Should the critical assumptions change, the APA
may be ended.
Recently, a number of important tax rulings have been conditioned to an APA.
In law
As part of the tax reform undertaken by the Mexican government, in 2007 the Ministry
of Finance created a new tax regime defned as IETU for its acronym in Spanish. The
tax could be considered as a fat tax or alternative minimum tax. The new fat tax law
was effective since 1 January 2008, and replaced the asset tax law. Taxpayers will
continue to be liable for regular income tax based on existing legislation and may
also pay the supplemental fat tax. The fat tax is calculated by applying a 17.5% rate
(please consider a transitional fat tax rate of 16.5%, which applied for FY 2008, 17%
for FY 2009) on cash basis taxable amounts, which consists of the difference between
authorised cash deductions and certain taxable income collected.
Under the fat tax law, entities residing in Mexico and foreign residents with a PE in
Mexico engaged in: (1) the sale or disposition of property, (2) rendering independent
services, and (3) granting of the temporary use of enjoyment of assets, are subject to
that tax.
According to fat tax law, the payments effectively made for, amongst others: (1)
the acquisition of goods, (2) the receipt of independent services should be deductible
for fat tax purposes to the extent they are related to the generating income activity
of the taxpayer. In this regard, taxpayers are required to fulfl the deductibility
requirements established in the income tax law in order to deduct those payments for
fat taxpurposes.
Taken into account the prior considerations we could conclude, from a transfer pricing
perspective, that the Mexican companies that carry out transactions with related
parties resident in Mexico or abroad must comply with the same transfer pricing
regulations established in the current income tax law, including the arms-length
standard and the documentation requirements.
In practice
The TAS has been carrying out transfer pricing investigations outside the maquiladora
industry. Starting in 2007, the International Tax Division and the Transfer Pricing
Central Administration established important audit programmes to address two main
tax issues: (a) intangible assets migration derived from corporate restructures and (b)
tax planning through debt push-down arrangements. These kinds of audit programmes
are likely to increase. Some of the issues that will probably be included in the new
programmes could include fees for technical services, commission payments, royalty
payments, and imputed permanent establishments. Controversial issues probably will
include the use of multiyear averages for the tested party, the use of secret comparables
and the protection of confdential information during court proceedings.
The TAS stated that a consequence of failure to meet the transfer pricing
documentation requirements upon tax audit will result in the non-deductibility of all
payments to non-resident related parties. This position may not have legal weaknesses
and might be against the nondiscrimination provisions in Mexican tax treaties.
Mexico
In regard to the expected effects in Mexico, derived from the recently published
services regulations issued by the Internal Revenue Service in the US, from Mexicos
standpoint, we could conclude that there are no major inconsistencies between
Mexicos transfer pricing regulations and the (new) proposed and temporary
services regulations that will be effective for tax years beginning after 31 December
2006. However, some new, important issues are raised when documenting non-
routine services, particularly the eligibility to employ the proft split method, which
is also provisioned within the Mexican Transfer Pricing Regulations and has not
been modifed. Specifcally, Treas. Reg. Section 1.482-9T(g)(1) now states that the
proft split method is ordinarily used in controlled services transactions involving
a combination of non-routine contributions by multiple controlled taxpayers.
References to high value and highly integrated transactions have been eliminated;
however, the preamble emphasises that routine transactions do not necessarily
signify transactions with a low value.
There is continued uncertainty regarding the determination of an arms-length
return for non-routine services. While the imposition of the proft split has been
deemphasised in certain instances, there appears to be a broad potential for application
of the proft split method. This issue can be mitigated somewhat, however through
carefully developed and adhered-to legal contracts and agreements.
For qualifying services that are charged at cost without a markup, a Mexican entity
can still employ the provisions of Chapter VII of the OECD Guidelines for intragroup
services as the proposed and temporary services regulations feature a new version of
the cost safe harbour. This new version of the cost safe harbour, the services cost
method (SCM) evaluates whether the price for covered services is arms length by
reference to the total costs incurred in providing these services (without a markup).
While there are no major inconsistencies between the proposed and temporary services
regulations and the Mexican transfer pricing regulations, there may be issues in
connection with the application of the IRS positions on high value services and non-
routine contribution for US and Mexican cases by both taxpayers and the TAS. The
proft split method is not intended to be the default method for evaluating high-value
services in the US economic substance (which has to be consistent with the inter-
company agreements in place). It is taking a more important role in the proposed and
temporary services regulations.
The TAS is in charge of the enforcement of both tax and customs law. General tax
examinations undertaken by the TAS include all federal taxes including income tax,
value added tax, assets tax and customs duties. Therefore, values used for the purposes
of payment of customs duties and other customs information are available for tax
purposes. Similarly, any information submitted for tax purposes is also available for
customs purposes. During an on-site audit all aspects of taxation are usually reviewed
by the same team (including customs duties).
5017. OECD issues
Mexico is a member of the OECD and has accepted the revised recommendation of the
council on the determination of transfer pricing between associated enterprises. In
general, the Mexican transfer pricing rules are consistent with OECD Guidelines.
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Under a reservation made on Article 9 of the Model Tax Convention on Income
and Capital, Mexico reserves the right not to insert paragraph two (corresponding
adjustment) in its tax conventions. However, most Mexican tax treaties provide for a
corresponding adjustment if the adjustment made by the other state is arms length.
Under the MITL that became effective from January 2002, the OECD Guidelines are a
mandatory interpretative source of the transfer pricing provisions of the Income Tax
Act to the extent they are consistent with the MITL and tax treaties.
The TAS is vested with the authority to participate in simultaneous tax examinations
with another country under the exchange of information provisions included in
taxtreaties.
As of 1 January 2005, Section XXVI is incorporated to Article 32 of the MITL,
which establishes the procedure to be followed in determining the interest portion
corresponding to loans that shall not be deductible.
In 2007, thin capitalisation rules were modifed. For purposes of determining the
annual average liabilities, all liabilities are now considered. The new rules clarify
that the disallowance applies only to interest on debts with related parties resident
abroad. The defnition of related parties stated in Article 215 of the MITL is applicable.
Moreover, the taxpayer can compare the liabilities multiplied by three, to either the (1)
equity (following Mexican generally accepted accounting principles), or (2) the sum of
the tax basis equity accounts (Account of Contributed Capital or CUCA for its acronym
in Spanish, plus the CUFIN balances).
When the debt of Mexican taxpayers exceeds three times its shareholders equity,
the interest generated by excess debt will not be deductible. In calculating the debt
to equity ratio mentioned above, the amount of the related and unrelated party
loans contracted by the company must be considered, with the exception of certain
mortgages.
The thin capitalisation rules are not applicable to companies belonging to the
fnancial sector, which comply with the capitalisation rules pertaining to their sector.
Furthermore, Mexican entities that have an excessive debt to equity ratio due to loans
with related parties can apply for an APA ruling from the TAS on the arms-length
nature of the loan in order to maintain the excessive ratio. An authorisation is also
possible for excesses attributable to unrelated party loans, if the arms-length nature of
the taxpayers operations with its related parties is also reviewed by the tax authorities.
These formalities to have the non-deductible excess interest waived will require the
certifcation of an independent accountant.
A fve-year transitory rule was enacted to allow taxpayers to reduce their debts
proportionately, in equal parts, in each of those years, until they achieve the reduction
of their debts to meet the 3:1 ratio required. If at the end of the fve-year term, the ratio
of liabilities continues to be higher than the allowed amount, the interest paid as from
Mexico
1 January 2005, arising from debts exceeding three times the book equity will not be
deductible. This transition period ended 31 December 2009.
Although this is a frst step for thin capitalisation legislation, there are some
rules pending for publication together with clarifcation on some issues in the
actualprovisions.
Moldova
51.
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Moldova
5101. Introduction
The arms-length principle has been set forth in Moldovan tax law since 1998. Transfer
pricing regulations, however, are currently at an initial development stage.
Nevertheless, the governments medium-term tax policy provides that formal transfer
pricing documentation requirements shall be introduced in the Moldovan tax law
starting in 2012.
As a general rule, under Moldovan tax provisions, the transactions concluded between
related persons are taken into consideration only if the interdependence of these
persons does not infuence the outcome of the transaction. The arms-length principle
applies to transactions with both resident and non-resident related parties.
With reference to the transactions carried out by Moldovan companies with related
parties, Moldovan tax law provides the following specifc provisions:
No deduction is allowed for losses incurred on the sale or exchange of property,
performance of work or supply of services between related parties, carried out
either directly or through intermediaries (regardless of whether the transaction
price corresponds to the market value); and
No deduction is allowed for expenses incurred in relation to related parties if they
do not correspond to the justifed market price and do not represent necessary and
ordinary business expenses.
Besides transactions with related parties, taxpayers have to follow the market value for
the following operations performed with third parties in non-monetary form:
Alienation of capital assets;
Granting donations;
Non-qualifed reorganisation of the company; and
Distribution of company profts.
In accordance with Moldovan tax law, a company is considered the taxpayers related
party if one of the following conditions exists:
The company controls the taxpayer;
International Transfer Pricing 2011 Moldova 587
Moldova
The company is controlled by the taxpayer; and
Both the company and the taxpayer are under common control of a third party.
From a tax perspective, control is the ownership (either directly or through one or
more related persons) of 50% or more in value of the capital or voting power of one
of the companies. For this purpose, an individual will be treated as owning all equity
interest that is owned directly or indirectly by members of his or her family.
Two individuals are related parties if they are spouses or relatives up to the
fourthdegree.
Moldovan tax law does not list any specifc transfer pricing methods.
5103. Legal cases
To date, no relevant legal action has been brought to challenge the deductibility of
expenses or assess additional incomes if they are not at arms length.
Currently, Moldova has no formal transfer pricing documentation requirements.
Nevertheless, domestic tax law provides that taxpayers have the burden of proof over
the arms-length value of transactions with related parties.
Transfer pricing audits are expected to follow the general procedure applicable to
taxaudits.
Taxpayer liabilities can be subject to a tax inspection only within the statute of
limitation period four years from the last date established for the submission of the
corporate income tax (CIT) return.
However, no tax inspection can be performed on the accuracy of calculation and
payment of CIT liabilities for fscal periods up to 1 January 2007, except for cases
where voluntary requests are made by the taxpayer (e.g. for refund purposes).
Under the Moldovan tax code, the Moldovan tax authorities (MTA) can perform
scheduled inspections a maximum of once a calendar year for the same taxes and
duties which refer to the same fscal periods.
Legal entities must be notifed of the inspection in writing at least three working days
before the scheduled inspection. The duration of a tax inspection cannot exceed two
calendar months. In exceptional cases, MTAs management can decide to extend the
period by no more than three calendar months or to stop the inspection.
The results of the tax inspection are recorded in the minutes of the tax inspection.
Based on these minutes, MTA issues a decision on the specifc case, which can be
appealed according to the procedure described below.
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If the MTA determines that the taxable income declared in the CIT return is
underreported, it may assess additional fnes.
Decisions issued by MTA, as well as actions performed by its offcials, can be appealed
by taxpayers via the submission of a preliminary petition within 30 days.
Preliminary petitions are examined within 30 days of being submitted and decisions
issued thereof can be contested at the Main State Inspectorate of the Ministry of
Finance or appealed in the competent court of law within 30 days. No state duties are
paid for appeals against MTA decisions.
From 1 January 2008, the CIT rate is 0%. Nevertheless, the liability of taxpayers to
calculate the taxable basis for CIT purposes and the requirement to submit CIT returns
are maintained as before.
MTA is entitled to apply a fne of 15% to the amount by which a taxpayer
underreported its taxable income.
Current tax law does not provide for any specifc fnes for the violation of transfer
pricing regulations. However, failure to comply with transfer pricing rules may result
in underreporting of taxable income, which consequently triggers a fne of 15% of the
diminished taxable income.
Besides the implementation of the nil CIT rate, certain non-tax-avoiding measures
were also introduced (i.e. legal entities are to withhold 15% tax from monetary and
non-monetary payments made to non-residents if the related expenses are to be treated
as non-deductible for CIT purposes). This 15% tax cannot be avoided by applying the
provisions of double tax treaties if, under the transactions with related parties, the
arms-length principle was not observed.
Under Moldovan law, the primary source of information on market prices is public and
statistics authorities and bodies regulating price formation.
If information from this source is not available, alternative sources include:
Information on market prices published or made public through the mass-
media;and
Offcial data or data made public on quotations (transactions registered) set at
the stock exchange nearest the sellers (purchasers) headquarters. When no
transactions have been registered at this stock exchange or the sales (purchases)
took place at a different stock exchange, the information on quotations set at this
stock exchange should be used, as well as information on quotations set for state
securities and state bonds.
International Transfer Pricing 2011 Moldova 589
Moldova
In addition, according to the tax law:
Taxpayers also have the right to present data on market prices from other sources to
the MTA; and
The MTA has the right to use such information only if there are reasons to consider
it trustworthy.
Financial statements of Moldovan companies are not available to the public, except in
specifc cases, such as open joint stock companies. Under the accounting law applicable
from 2008, fnancial data should be public. However, this is not yet applied in practice,
which makes carrying out benchmarking studies a rather diffcult exercise due to
unavailability of data to determine the desired proft-level indicators.
No specifc industry or transactions are considered to have a higher level of risk than
any other. Nevertheless, MTA tends to investigate the deductibility of the expenses
related to consultancy services rendered by non-resident related parties. Therefore,
suffcient back-up documentation should be made available to confrm that the services
were actually rendered for the beneft of the local entity.
The avoidance of the double taxation principle is not mentioned under the
Moldovantax law.
Nevertheless, taxpayers might beneft from more favourable tax regimes which are
provided in the double tax treaties (DTTs) concluded by Moldova with other countries.
As of 1 January 2010, Moldova has 42 DTTs in force, which are based on the OECD
Model Tax Convention on Income and on Capital.
The Associated Enterprises article of the DTTs allows MTA to adjust taxpayers
taxable income if the transaction with its related party was not at arms-length value.
Note that the Commentaries to the OECD Model Tax Convention on Income and on
Capital might be used by the MTA and taxpayers as guidance on the interpretation of
DTTs and, correspondingly, also for the purposes of the tax administration.
No APA or binding tax rulings are provided under the current Moldovan tax law.
Anticipated developments in law and practice
Pursuant to the implementation of the nil CIT rate, as well as due to other factors
(e.g. favourable geographical position, relatively low employment costs, qualifed
labour force), Moldova might be viewed by multinational companies as an attractive
jurisdiction for extending their business.
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It is envisaged that formal transfer pricing documentation requirements, along with
a fat 10% CIT rate, shall be introduced in the Moldovan tax law starting from 2012.
The Moldovan Ministry of Finance has developed a draft law which proposes the
introduction in domestic tax law of the transfer pricing methods and principles set out
in the OECD Transfer Pricing Guidelines.
To date, the Moldovan tax and customs authorities do not cooperate jointly on transfer-
pricing-related issues.
The majority of customs value investigations to date were related to the adjustment of
the customs value according to Article 8 of the WTO Customs Valuation Agreement,
as well as to the adjustment of the transaction values according to the reference
prices registered for goods traded under commercial relations between contracting
parties in foreign trade and for identical and/or similar goods, which have been
previouslyvalued.
Adjustments of customs values with royalties, licence fees and transport expenses were
among the most often performed by Moldovan customs authorities, so far.
However, subject to the implementation in Moldova of more rigorous transfer pricing
regulations, we expect that eventual further transfer pricing adjustments could
lead to investigations and adjustments in customs as a result of the exchange of
information between tax and customs authorities or as a result of their refection in the
businesstransactions.
5113. OECD issues
Moldova is currently not an OECD member country and domestic law does not provide
for any reference to the possibility of applying the OECD Transfer Pricing Guidelines.
Based on the information available, no records indicate that MTA has been involved in
joint investigations on transfer pricing issues.
According to Moldovan tax law, there are no thin capitalisation rules (i.e. debt-to-
equity ratios).
Nevertheless, interest expenses incurred by the taxpayer for the beneft of individuals
and legal entities (except fnancial institutions and micro-fnancing organisations)
are deductible within the limit of the base rate established by the National Bank of
Moldova in November of the previous fscal year and applied to short-term monetary
policy transactions.
For 2010, if the interest rate exceeds the 5% threshold (i.e. base rate from November
2009), the exceeding amount of interest expense should be treated as CIT non-
deductible, regardless of whether it is paid to a related party.
The Netherlands
52.
International Transfer Pricing 2011 591 The Netherlands
5201. Introduction
Transfer pricing legislation has existed in the Netherlands since 1 January 2002. In
addition to providing specifc transfer pricing rules, the implementation of transfer
pricing documentation requirements was meant to shift the burden of proof from
the Dutch tax authorities to the taxpayer. This legislation is based largely on the
OECD Guidelines, with some modifcations to refect Dutch business practices. In the
past, transfer pricing disputes have usually been dealt with informally and resolved
by negotiation between the tax authorities and the taxpayer. Consequently, there is
currently little relevant case law. Multinationals are experiencing an increase in the
number of transfer pricing queries, which will force those companies to focus more on
transfer pricing.
Prior to 1 January 2002, Dutch tax legislation did not contain any specifc provisions
on transfer pricing. However, the arms-length principle was recognised through
the application of the general rules of proft determination included in the Personal
Income Tax Act and the Corporate Income Tax Act. The relevant Article of the Personal
Income Tax Act (under the new 2001 Act Article 3.8), which also applies to companies,
implies that income and expenses are eliminated from the taxable proft reported by
the Dutch taxpayer to the extent these arise from transactions that are not at a fair
market price.
Since 1 January 2002, specifc transfer pricing provisions have been included in Article
8b of the Dutch Corporate Income Tax Act. This article is largely drafted in accordance
with Article 9 of the OECDs Model Tax Convention.
The basic features of the transfer pricing legislation are as follows:
Codifcation of the arms-length principle;
A widening of the scope of the transfer pricing legislation through a broader
concept of control between affliated businesses that are directly or indirectly
participating in the capital, management or supervision of another company,
provided that there is suffcient infuence on the prices charged between the
companies involved. The level of control and infuence is not quantifed in the law.
This legislation applies to transactions where one party controls the other or both
parties are under common control; and
A requirement to maintain data in the administration that demonstrates the
arms-length nature of the transfer prices and how these prices have been derived.
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The Netherlands 592 www.pwc.com/internationaltp
A strict interpretation of the documentation requirements implies that taxpayers
should prepare the relevant documentary evidence when the intragroup transactions
take place. Although this is a prudent approach, the tax authorities effectively
allow taxpayers four weeks to respond to any request to provide transfer pricing
documentation, or three months where particularly complex transactions are involved.
Where there is an understatement of the taxable income reported by a Dutch group
company because of non-arms length related party transactions, the tax authorities
make an upward adjustment to the taxable income of that company. Under certain
conditions, the understatement may also be treated as a hidden dividend distribution,
attracting the appropriate withholding tax. Any surplus proft reported by a Dutch
group company because of non-arms length related party transactions may be treated
as an informal capital contribution by the parent company. The Dutch group company
can claim a notional deduction for the amount of the informal capital contribution for
Dutch corporate income tax purposes.
Innovation Box
The Innovation Box is a Dutch corporate tax facility that allows Dutch taxpayers
to beneft from a favourable effective tax rate with respect to income derived from
qualifying intellectual property (IP). Both resident and non-resident taxpayers can
beneft from this facility. The effective tax rate in the Innovation Box is 5%.
For IP to qualify for the Innovation Box, it needs to meet the following
cumulativeconditions:
The IP must be self-developed and must have become a business asset after 31
December 2006;
A patent or an R&D declaration (R&D IP) needs to be obtained for the IP; and
More than 30% of the derived income should be attributable to the patent right or
R&D IP.
Other regulations have been issued to cover certain specifc circumstances. Those that
concern transfer pricing issues are detailed below.
Decrees and resolutions
The decrees and resolutions issued by the Ministry of Finance provide guidance on
the interpretation and application of Dutch tax law in certain specifc situations. They
are intended to ensure a consistent application of the tax laws, and, consequently, the
tax authorities are bound by them. A taxpayer, however, has the right to appeal to the
courts on any provision in the decrees or resolutions.
Details of the relevant decrees, which were issued in 2001 and amended in 2004, as
well as of one resolution are set out below.
Transfer Pricing Decree (IFZ2001/295M)
This decree of 30 March 2001 on Transfer prices, the application of the arms-length
principle and the OECD Guidelines provides guidance on the Dutch tax authorities
interpretation of the OECD Guidelines and clarifes how certain issues should be
approached in practice.
International Transfer Pricing 2011 The Netherlands 593
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The issues dealt with in this decree include the following:
Application of the arms-length principle in practice: The taxpayer should
demonstrate that its transfer prices meet the arms-length standard;
Application of various transfer pricing methods (TPMs): Particular attention is
given to the cost plus method and the practical implications;
Administrative approach for avoiding and resolving disputes regarding transfer
pricing: Insight is given to the policies and procedures applied by the Dutch
government in relation to mutual agreement and arbitration procedures;
Arms-length fee for fnancial services; and
Allocation of proft to headquarters and permanent establishments (PEs):
The arms-length principle is also applicable in determining the tax base of
foreigntaxpayers.
Amendments to the Transfer Pricing Decree (IFZ2004/680M)
This decree of 21 August 2004 is intended as a clarifcation of the 30 March, 2001
decree with respect to the following subjects:
Inter-company services/head offce expenses
Some clarifcation is given on the activities that are considered shareholder activities.
Furthermore, the decree provides guidance on the determination of an arms-length
fee for services. It allows a fee based on cost for support services that meet certain
criteria, thus providing a practical approach for common, low-value-added services.
Contract research and development (R&D)
In the decree of March 2001, the tax authorities explicitly referred to performing
contract R&D from a Dutch tax perspective. In addition, a guideline now defnes the
manner in which these activities should be remunerated. The decree indicates that if
ultimate decision making related to the R&D, the costs and risks of these activities and
the economic ownership of the developed assets lie with the principal, then the cost
plus method is an appropriate method for remunerating the contract R&D activities.
Cost contribution arrangements (CCA)
To terminate further discussions as to whether the cost contribution paragraph in the
March 2001 decree was completely in accordance with the arms-length principle, this
paragraph has been revoked, and it is explicitly stated in the amendments that the
OECD Guidelines apply.
Valuation of intangible assets
According to the Ministry of Finance, there are circumstances under which nonrelated
parties would not agree on a fxed price for a transfer of an intangible asset but
would include a price adjustment clause indicating, for example, that the price of the
intangible asset depends on future income. In the August 2004 decree, it is stated
that an agreement on the transfer of an intangible asset is assumed to include a price
adjustment clause, if such a clause would have been agreed on between independent
parties operating under similar conditions.
Withholding taxes
The decree recognises that some countries levy withholding taxes on service fees, even
if this is not allowed under the tax treaty between that country and the Netherlands.
This is especially true for mixed contracts (i.e. contracts consisting of a service and a
royalty component). For payments under these contracts, withholding tax might be
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levied on the entire fee, even though only withholding tax on the royalty component
is allowed under the tax treaty. The decree states that withholding taxes cannot be
credited against Dutch corporate income tax if these taxes confict with the applicable
treaty clause.
Advance pricing agreement (APA) Decree (IFZ2004/124M)
On 11 August 2004, the Ministry of Finance published a decree (this decree is an
update of the original Decree IFZ2001/292M) titled Procedure for dealing with
requests for upfront certainty on transfer prices to be used in cross-border transactions
(advance pricing agreements). The decree provides guidance on how the OECD
Guidelines on APAs are applied in the Dutch practice.
Details regarding the procedures to be followed and the information to be provided in
an APA request are provided in the separate section 5214 on APAs.
Decrees on fnancing companies (IFZ2004/126M and IFZ2004/127M)
The regime for fnance companies is applicable to back-to-back inter-company loans
and inter-company licensing transactions. Until 1 April 2001, it was possible to obtain a
fnance ruling when certain conditions were met. A fnance company was not allowed
to incur economic risk, or only very limited risk, and it had to report a net taxable
income (spread) on the average borrowed funds. Furthermore, withholding tax could
be credited only on a pro rata basis. This ruling regime was abolished in April 2001
and existing situations were grandfathered until the end of 2005. This means that
currently all companies engaged in these activities need to meet the requirements of
the newregime.
Under this regime, a Dutch fnance or licence company must meet the
followingrequirements:
The company must incur economic risk; and
The company must have suffcient operational substance.
These requirements are further elaborated in two decrees published by the Dutch
Finance Ministry in 2004. The frst decree (IFZ2004/126M) focuses on companies
involved in inter-company fnance activities without economic substance, and
is an update of the original decree of 30 March 2001 (IFZ2001/294 M) on this
subject. The second decree (IFZ2004/127M) contains questions and answers on the
decreesapplication.
The importance of the regime lies in what happens if the requirements are not met. In
such a case, interest and/or royalties paid and received are not included in the Dutch
tax base. In addition, the Dutch Revenue may spontaneously exchange information
with local tax authorities of the countries to which the loan/licence is granted. This
will likely result in an increase of withholding tax on these payments, which can
subsequently not be offset in the Netherlands, as the interest and royalty are not
included in the Dutch tax base.
Although this regime on fnance and licence companies contains more requirements
than the old regime, in practice these requirements are easily met, and they effectively
enhance the benefcial ownership position compared to the situation under the old
regime. Furthermore, it is also fairly straightforward to obtain a unilateral APA in the
Netherlands in which the Dutch tax authorities confrm (1) that the requirements are
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met, and (2) that the remuneration applied (a spread determined on a case-by-case
basis) is at arms length.
Decree on Mutual Agreement Procedures and EU Arbitration Convention
(IFZ 2008/248M)
The decree seeks to provide guidance for taxpayers and improve the effciency of the
process for resolving disputes, and it relates both to MAPs initiated under double tax
treaties and the arbitration convention (AC) for transfer pricing disputes within the EU.
Advance tax rulings (ATRs)
Effective from 1 April 2001, the former Dutch ruling practice was converted into an
APA/ATR practice. Reference is made to the APAs in the 2004 decrees on APAs and
fnance companies.
ATRs typically deal with issues such as the applicability of the participation exemption,
hybrid loans, and the existence of a PE.
5204. Legal cases
There are relatively few court cases on transfer pricing issues since most disputes are
solved through compromise. One reason is the ability to obtain an APA (historically
unilateral advance rulings) from the Dutch tax authorities on the arms-length nature
of certain transfer pricing arrangements. Another factor may be that the burden of
proof in transfer pricing disputes historically lies with the tax authorities, and the
confdence of the tax authorities in this regard may have been a relevant factor.
This is illustrated by a Supreme Court decision of June 2002, which involved a
Japanese parent with a distribution subsidiary in the Netherlands (Supreme Court,
28 June 2002, No. 36 446). The Dutch subsidiary sold a certain product at a loss
for a lengthy period of time while the remaining product range was proftable. The
transfer prices for all products were set by the parent company without clear evidence
of negotiations. The Dutch tax authorities challenged the arms-length nature of the
transfer price for the loss-making product, arguing that a third party would not have
continued selling this product under these conditions. The High Court argued that
the tax inspector wrongfully looked at only the loss-making product. Also, the court
held that the tax inspector had the burden of proof and failed to demonstrate that
third-party distributors would not have agreed to the pricing arrangements for the
transactions under review. The Supreme Court upheld the decision of the High Court
and decided in favour of the taxpayer.
From this Supreme Court decision, one may conclude that the burden of proof rests
with the tax authorities even if a taxpayer reports a proft margin that is relatively low
and differs from the industry average. The Supreme Court also ruled that for the arms-
length test, certain transactions can be aggregated and a particular product may be
unproftable if the overall result for the company represents a fair return on the capital
employed and the business risks incurred.
On 13 September 2002, the State Secretary of Finance issued a decree
(IFZ2002/830M) on the consequences of this Supreme Court decision. In the decree,
it was concluded that the Supreme Court decision results in a heavy burden of proof
for the tax authorities for the years prior to 1 January 2002. Furthermore, the decree
indicates that the Ministry of Finance is considering whether the new transfer pricing
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legislation will lead to an equitable allocation of the burden of proof between the
taxpayer and the tax authorities in transfer pricing disputes.
Furthermore, this decree takes the position that aggregation of transactions is possible
if these transactions have been agreed upon in one contract.
In October 2005, the Supreme Court ruled on a case (Supreme Court, 14 October
2005, No. 41 050) which dealt with the issues of dual residency and the existence of
a permanent establishment. A multinational group with a head offce located in the
Netherlands operated its group fnancing function through a company located and
incorporated in Belgium. The Supreme Court ruled that since a signifcant part of its
core activities were on a day-to-day basis performed by the Belgium employees, the
company should not have had dual residency and was therefore not subject to Dutch
corporate income tax. Moreover, the involvement of the Dutch head offce had not
exceeded a normal level of involvement within a group, and as a result it could not be
concluded that the Belgium group company had a PE in the Netherlands.
In the Netherlands, the tax authorities increasingly not only focus on the arms-length
nature of the conditions of a transaction but also on the arms-length nature of the
transaction itself. An example in relation to the aforementioned is the case ruled by the
Supreme Court in May 2008.
In May 2008, the Supreme Court ruled on a case (Supreme Court, 9 May 2008, No.
43 849) where a loan had been issued by a company to its parent company and where
subsequently the lender was faced with a default on that loan. The court ruled that
if and to the extent a supply of funds occurs on terms and under conditions such that
a third party would not have assumed the debtors risk, it must be concluded that the
supplier of the funds had accepted the debtors risk with the intent to serve the interests
of its shareholder.
Taxpayers have a legal obligation to maintain certain transfer pricing documentation.
To the extent that this requirement is not met, the burden of proof is ultimately
transferred to the taxpayer.
In general, there are no statutory provisions to indicate how the burden of proof is
divided between the taxpayer and the tax authorities. The allocation of the burden of
proof between the parties is at the discretion of the court. However, in practice and as
a result of Dutch case law, if the companys revenue is adjusted upwards because of
transfer pricing issues, the burden of proof usually lies with the tax authorities. On the
other hand, the burden lies with the taxpayer to prove the deductibility of expenses.
In transfer pricing cases, the burden of proof transfers to the taxpayer if the pricing
arrangements are unusual (e.g. if comparable uncontrolled prices (CUP) are available
but not used, or goods or services are provided at cost or below cost). The burden
of proof is also transferred to the taxpayer, and will be more onerous if the taxpayer
refuses to provide information requested by the tax authorities where there is a
legal obligation to do so, or if the requisite tax return is not fled. Finally, the court
sometimes allocates the burden of proof to the party best able to provide the evidence.
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There is no clear criteria as to how companies are selected for a transfer pricing
investigation, but a company bears an increased risk of such an investigation if one of
the following situations occurs:
The company has suffered losses for a number of years;
The company is involved in transactions with related parties in tax havens;
The company shows fuctuating results from year to year;
The company closes;
The companys activities are reorganised;
The results of the company are lower than the average for the industry; and
The company pays substantial royalties or management fees.
The Dutch tax authorities conduct centrally coordinated transfer pricing investigations
for certain industries, such as the pharmaceutical or the automobile industry.
the taxauthorities
In accordance with the General Tax Act, a taxpayer can be compelled by the tax
authorities to provide access to all books and other documentation relevant to the
determination of the facts of the companys tax position. If a taxpayer does not provide
the requested information to the tax authorities, the burden of proof is transferred to
the taxpayer. Furthermore, failure to comply can be considered a criminal offence,
which could ultimately result in penalties or even imprisonment.
Transfer pricing legislation does not give a clear indication as to exactly what the
minimum requirements are in terms of documentation. However, in the explanatory
memorandum on the legislation, reference is made to the OECD Guidelines in this
respect. The decrees of March 2001 and August 2004 also provide some guidance on
the documentation that should be maintained. It is understood that the documentation
should include the following:
A summary of the relevant intragroup transactions;
An industry analysis;
A summary of the TPMs and margins used, including evidence that the methods
have resulted in an arms-length outcome;
Details on the companys strategies, including critical assumptions; and
Intragroup arrangements, including the trading conditions.
These documentation requirements also apply to arrangements entered into by
affliated companies before 1 January 2002 but which are still effective subsequent to
that date.
With respect to requests for information regarding foreign group companies,
which can affect the Dutch companys tax position, the situations set out below can
bedistinguished.
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A Dutch company with a majority shareholding in a foreign company
In this situation, the Dutch tax authorities can require the Dutch company to provide
information on, and give access to, the books and records of the foreign subsidiary.
If the requested information is not provided, the burden of proof transfers to
thetaxpayer.
A Dutch company with a foreign parent company or fellow subsidiary
The Dutch tax authorities can request a Dutch company to provide information on
its foreign parent company or fellow subsidiary. However, a taxpayer is not obligated
to provide this information if the parent company or fellow subsidiary is resident in
either the EU or a country with which the Netherlands has a tax treaty that includes
a provision for the exchange of information. In this case, the information should be
requested directly from the tax authorities. If this process fails, no tax treaty exists
or the treaty does not include an exchange of information article, the Dutch tax
authorities can request access to the books and records of the foreign parent company
or fellow subsidiary. If the requested information is not provided, the burden of proof
transfers to the taxpayer.
Transfer pricing matters usually form an integral part of a general state audit. The
Dutch tax authorities aim to audit every company at least once every fve years and
larger companies once a year. A state audit comprises an onsite examination of the
companys books, which usually covers a number of years, taking into account the fve-
year period within which the tax authorities may statutorily reassess taxes. This period
is extended with the extension period granted for fling the tax return. Historically, the
tax authorities concentrated largely on examining intragroup charges for service fees
and royalties. Recently a lot of attention is focused on the transfer pricing of goods,
the treatment of intangible assets and the allocation of head offce costs by Dutch
multinationals. These may be examined through separate transfer pricing state audits,
as the Dutch tax authorities are more active in this area.
The conduct of the taxpayer during the investigation, particularly with respect to
requests for information from the tax authorities, could have an effect on the outcome
of the dispute and size of the adjustment. Transfer pricing disputes between the Dutch
tax authorities and the taxpayer are usually solved through negotiation rather than
litigation. Note, however, that an additional assessment is the most likely outcome,
since most disputes are solved through compromise.
Furthermore, the Dutch tax authorities tend to enhance the relationship with the
taxpayer through so-called horizontal monitoring, which is to pursue an effective and
effcient method of working based on mutual trust, understanding and transparency.
As a result, the tax audits shift from tax audits performed by the Dutch Tax Authorities
afterwards (reactive) to having upfront assurance from the Dutch Tax Authorities
(proactive) whereby more and more is focused on internal risk and control processes of
the company (Tax Control Framework).
The taxpayer may appeal against the revised assessment and should do so within six
weeks of the date when the additional assessment was raised. The tax authorities
should make a formal decision on the appeal within six weeks. In case the tax
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authorities are not able to give a decision within this term, they may extend the period
for another six weeks at most. The tax authorities cannot just reject the appeal without
frst providing an explanation for this decision.
If the tax authorities reject the initial appeal, the taxpayer can fle an appeal with the
District Court against the decision. This appeal must be fled within six weeks of the
tax authorities formal decision. As of January 2005, the formal appeal procedures
have changed. To speed up the decision process, if there is mutual consent between
the taxpayer and the tax inspector, the appeal to the tax inspector can be bypassed by
sending the appeal directly to the District Court. This is then treated as an appeal with
the District Court.
There is no ultimate time limit within which the District Court must make its decision.
Following its decision, the taxpayer or the tax authorities can fle an appeal with
the Dutch High Court within six weeks. Once the High Court has made a decision,
the taxpayer or the tax authorities may appeal the decision on points of law to the
Supreme Court. Such an appeal must also be fled within six weeks of the High Courts
decision. The Supreme Court is the fnal court; its decision is binding, and no further
appeal is permitted. There is no ultimate time limit within which the High Court and
the Supreme Court must make their decision. To speed up the decision process, and
with mutual consent between the taxpayer and the tax inspector, the appeal to the
High Court can be bypassed by sending the appeal directly to the Supreme Court.
Generally, a taxpayer will want to avoid litigation since it can be a very time consuming
and costlyexercise.
The Dutch legislation does not provide for specifc transfer pricing penalties.
Nevertheless, the existing penalty rules are applicable on any additional tax resulting
from transfer pricing adjustments. The penalties vary from zero to 100% of the
additional tax, depending on the degree of the intent to avoid tax or gross negligence
of the taxpayer. Penalties are not deductible for corporate income tax purposes.
Note that transfer pricing adjustments do not often result in penalties, because the
taxpayers position is usually more or less defensible and therefore is not strictly
considered as tax avoidance. However, an additional tax assessment results in
interestcharges.
Transfer pricing enquiries are conducted by the local tax inspector and the tax auditor,
usually in consultation with specialised accountants from the Transfer Pricing Co-
ordination Group. This group is dedicated to transfer pricing and includes individuals
from the Ministry of Finance and from the tax authorities. Its main task is to prepare
policies for those instances of incorrect application of the arms-length principle.
Furthermore, the group should be consulted by the tax authorities and the Ministry
of Finance on any transfer pricing issues (including allocation of proft between head
offce and PE), and it should guarantee a consistency in dealing with transfer pricing
matters. Transfer pricing cases dealt with by the local tax inspector should also be
reported to this group. This particularly applies to the following scenarios:
Cross-border transactions with related entities established in tax havens;
Proposed transfer pricing audits;
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Cross-border transactions that are, or will be, assessed as part of an industry
examination;
A request by a taxpayer for a corresponding adjustment in the area of transfer
pricing as a result of a (proposed) adjustment at a related entity in another state;
If it is likely that a mutual agreement or arbitration procedure will be started;
A cross-border transfer of intangible assets within a group; and
A request for advance certainty on the extent of the documentation requirements of
Article 8b of the Corporate Income Tax Act.
The group reviews (interim) reports, provides binding advice to the local tax inspector
and also operates as a help desk for staff members of the tax authorities. This binding
advice does not relate to APA requests because the local tax inspectors should involve
the centralised APA/ATR team for these.
Use of information
As indicated above, the principles in the OECD Guidelines have been accepted by
the Netherlands and are generally applied. Since the OECD Guidelines recommend
the use of comparable information, a comparables study is an appropriate means to
justify a transfer pricing policy. Furthermore, the reference to comparables in the
explanatory notes on the transfer pricing legislation make it evident that comparables
information is a crucial element in defending transfer prices in the Netherlands.
The tax authorities have access to their own comparable data, and they also use
commercially available databases (see below). According to the transfer pricing
legislation and their explanatory notes, it is, strictly speaking, not mandatory for a
taxpayer to perform a comparables study (i.e. benchmarking) to support its transfer
pricing policy. On the other hand, in the absence of a comparables study, it is likely that
the Dutch tax authorities will perform such a study themselves. It is therefore advisable
for a taxpayer to perform a comparables study to support the arms-length nature of
its pricing arrangements. In case of an APA, a comparables study is required as part
of the information to be provided to the tax authorities (reference is made to the APA
sectionbelow).
Availability
Dutch companies are required to fle their statutory fnancial statements in full or
abbreviated form (depending on the size of the company) with the local chamber of
commerce. This information is compiled on a publicly accessible database and may be
used by other companies in similar situations to justify or defend a pricing policy.
The tax authorities can also obtain and use all information that is publicly available,
including external databases, to support its position. In addition, the tax authorities
may use information (e.g. gross margins or net operating proft margins) obtained
from corporate income tax returns and state audits. However, such information is
rarely used as evidence before the courts since the tax authorities might be compelled
to disclose the underlying fnancial information and this might put the tax authorities
in breach of their confdentiality obligations.
No transactions or industries are excluded from the scope of the transfer pricing
legislation. Historically, the Dutch tax authorities have primarily focused on intragroup
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charges such as royalties, management fees, commissions, and interest payments, as
well as intragroup transactions with low tax countries and intragroup transactions
involving intangible assets.
More recently, particularly since the introduction of the transfer pricing decrees
and the legislation, there is a tendency for more queries to be raised concerning the
transfer prices and margins of goods, as well as the allocation of head-offce costs and
related service charges by Dutch multinationals. In addition, the Dutch tax authorities
are increasingly becoming sophisticated in the area of inter-company fnancial
transactions, including the arms-length nature of the interest rates applied on group
loans, cash pooling and credit guarantees.
Most tax treaties for the avoidance of double taxation concluded by the Netherlands
include provisions for a mutual agreement procedure (MAP). Moreover, the
Netherlands has concluded a treaty containing an arbitration clause with
approximately 23 countries. In the Netherlands, a request to initiate the MAP should
be fled with the Dutch Ministry of Finance, generally within three years of the date
when the taxpayer becomes aware of the possibility of double taxation. The Dutch
Ministry of Finance has issued a decree on the application of MAP procedure or EU
arbitration procedure (see also Section 5203) to provide guidance for taxpayers and
improve the effciency of the process for resolving disputes. No information is available
on the number of requests made since the Ministry of Finance has not disclosed this
information. The use of the competent authority procedure has increased signifcantly
over the last years. The majority of the cases are solved within a period of two to three
years. Additionally, it is understood that it is part of the Dutch treaty policy to include
an arbitration clause in future tax treaties. It is also worth noting that, together with
other EU member states, the Netherlands has ratifed the protocol to the arbitration
convention applicable as per January 2000.
As indicated previously, there are formal procedures in the Netherlands for setting
pricing policies in advance through a unilateral or bilateral APA. The authority for the
APA procedures lies in the amended APA decree published by the Ministry of Finance
on 11 August 2004, which replaces the 30 March 2001 decree. APAs may include
transfer pricing methodologies covering different types of related party transactions or
specifc transactions, including transfers of tangible or intangible property, fnancing
and licensing activities and the provision of services. APAs may cover all the taxpayers
transfer pricing issues or may be limited to one or more specifc issues.
The number of APAs concluded by the Dutch tax authorities is increasing signifcantly.
An APA request requires a certain amount of detail to be disclosed to the tax
authorities. However, this is not materially different from the documentation that
the taxpayer must maintain under the transfer pricing documentation requirements,
effective 1 January 2002.
The information to be provided to the tax authorities by the taxpayer as part of an APA
request generally includes, among other things, the following:
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Details on transactions, products and agreements relating to the proposal;
Details on the entities and PEs involved;
The relevant jurisdictions;
Details on the worldwide group structure, history, fnancial data, products,
functions, risks and (in)tangible assets involved;
A description of the proposed transfer pricing method, including a
comparablesanalysis;
Details on the critical assumptions applied in the proposal and the implications
of changes therein. This would allow a certain fexibility in the actual application
of the APA, provided that the critical elements (e.g. market share or value chain)
fuctuate within a certain predetermined range;
The accounting years involved; and
General information on the market conditions (i.e. industry analysis).
The APA request needs to be fled with the tax inspector. In all cases, the inspector
is obliged to present the request to the APA/ATR team of the Dutch tax authorities
for binding advice (in cases of new policy after consultation of the Transfer Pricing
Co-ordination Group). In the case of a bilateral APA request, the Dutch Ministry of
Finance initiates the bilateral agreement procedure with the other country involved.
In principle, an APA is applicable for a period of four to fve years unless longer-term
contracts are involved. Under certain conditions an APA can be applied retroactively,
for example as part of a confict resolution during a state audit. The Dutch tax
authorities are eager to make the APA regime work and, therefore, according to the
Dutch State Secretary of Finance, the Dutch tax authorities maintain a professional,
fexible and cooperative international reputation in this area. The APA decree of 11
August 2004 (IFZ2004/124M) entails various measures to further develop the APA
practice and to streamline the fling process. These measures relate to the possibility
of a prefling meeting, the introduction of a case management plan and the possibility
of assistance by the tax authorities in identifying comparable data for small businesses
(i.e. companies with a balance sheet total of less than EUR 5 million and with an
average number of employees of less than 50).
The prefling meeting creates the potential to discuss the APA request with the APA
team before it is actually fled. The beneft to the taxpayer is a clarifcation of the
information that is likely to be required and specifc elements likely to be pertinent to
the formal APA request.
In cooperation with the APA team, a joint case management plan (i.e. a work plan) can
be prepared describing the process and timing between the fling and the completion
of an APA request. The intention of this case management plan is to reduce the
uncertainty for the taxpayer with respect to the handling process of the application.
The case management plan should provide a realistic time frame for the completion of
the request as agreed by both parties.
To decrease the administrative burden for smaller companies, the tax authorities,
to the extent possible, provide comparable fnancial information of independent
enterprises. This assistance should make it easier for relatively small companies to fle
an APA request, as many small companies are reluctant to enter the APA process due
to the administrative burden and related costs. The taxpayer still must provide the
necessary information on the organisation and functional analysis of the company,
as well as the rationale for the proposed transfer pricing method and mechanisms,
forexample.
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With the existence of specifc transfer pricing legislation in the Netherlands and
considering the increased awareness of the Dutch tax authorities with respect to
transfer pricing matters, the most likely development is that, in practice, intragroup
transactions will be reviewed even more closely and challenged even more frequently
than is the case presently. This is also a result of the active approach to transfer pricing
by the authorities of the most important Dutch trade partners, such as Germany
and the US. These developments will force multinationals to review their transfer
pricing policies and carefully document them in order to defend their prices against
futurechallenge.
The exchange of information between the corporate income tax authorities and the
customs authorities takes place as part of the daily routine of the Dutch tax authorities.
The special customs valuation team based in Rotterdam now directly cooperates with
the corporate tax authorities throughout the process of an investigation for customs
purposes. Also, combined customs and corporate income tax teams exist within
other major offces of the Dutch Revenue. Furthermore, the customs authorities
have now implemented a database containing pricing structures and price levels for
differentindustries.
In case of a customs valuation audit, the following information may be requested by
the customs authorities:
General information on the company;
Available information on transfer prices;
Annual accounts;
Legal structure, including contracts and agreements in place;
Specifc information on the goods fow, invoicing structure (including retrospective
price adjustments), special arrangements (e.g. tools, machines, goods or materials
provided to the manufacturer so-called assists), royalties, warranty and
marketing; and
Reports of foreign customs audits.
A copy of the customs valuation report is usually forwarded to the corporate tax
authorities. In principle, any transfer pricing adjustments made for corporate income
tax purposes should be reported to the customs authorities, unless the adjustments
relate to items that are not dutiable for customs purposes. A request for a refund of
customs duties, in the event that the import prices are adjusted downwards, should be
submitted within three years of the date of actual importation. In the event that the
import prices are adjusted upwards, an adjustment should be reported to the customs
authorities. The customs authorities then issue an assessment for the underpaid
customs duties. The customs authorities can impose an additional assessment within
three years of the date of actual importation. In cases where the customs authorities
feel that the underpayment of customs duties was a deliberate action to avoid payment
of customs duties, the period for assessing the duties may be extended to fve years.
Recently, the customs authorities have raised more queries on the intragroup purchase
prices in situations where the group company purchasing the goods has little or no real
economic risk. This may apply to distribution centres with a cost plus remuneration
N
but which are still part of a buy/sell structure, or to low-risk distribution companies.
In these situations, the customs authorities may attempt to argue that the intragroup
purchase price, although in line with the transfer pricing policy, does not qualify as
transaction value according to the customs valuation regulations. This is because
the customs authorities believe the purchase prices do not represent normal market
prices, due to lack of economic risk by the purchasing company. Furthermore, the
customs authorities will verify whether there are additional payments with respect to
the imported products (e.g. for royalties) and if so whether these should be included
in the customs value and thus become subject to customs duties. Therefore, it is
advisable to also consider customs valuation issues when implementing transfer
pricing or corporate income tax arrangements (this is relevant only when the imported
products are subject to an actual duty levy). Furthermore, if the customs authorities
do not accept a transaction value, some questions need to be dealt with from a VAT
perspective (i.e. who may deduct the VAT at import and what is the VAT status of the
service provider in the case of a cost plus arrangement).
5217. OECD issues
The Netherlands is a member of the OECD, and according to the transfer pricing
decrees of 30 March 2001 and 21 August 2004, the OECD Guidelines are directly
applicable in the Netherlands. Also, the explanatory memorandum to the October 2001
proposals on the transfer pricing legislation, effective from January 2002, reconfrms
the adoption of the OECD Guidelines by the Dutch tax authorities.
In principle, the Netherlands could join with another country to undertake a joint
investigation of a multinational group for transfer pricing purposes. In the few
circumstances when a joint investigation has taken place, it was usually initiated by the
foreign tax authorities.
The Netherlands has thin capitalisation rules effective from 1 January 2004. In
summary, interest is not deductible to the extent that interest is payable on group loans
that exceed a three-to-one debt-to-equity ratio (safe harbour). For determination of the
debt position of the company, the net third-party loans and the net group loans payable
should be taken into account. If the debt-to-equity ratio of the Dutch company exceeds
the fxed ratio of three-to-one, the debt-to-equity ratio of the consolidated group to
which the Dutch company belongs, according to its commercial fnancial statements,
may be applied. In that case, the interest payable on group loans is not deductible to
the same extent. For the purpose of this ratio, the gross amount of the liabilities of the
Dutch group and the equity as reported in the commercial accounts should be taken
into account. Special rules exist for the determination of the equity and liabilities of the
Dutch company and for certain specifc situations. Further, for the application of these
rules, a fscal unity for Dutch corporate income tax purposes is considered to be one
single taxpayer.
New Zealand
53.
International Transfer Pricing 2011 605 New Zealand
5301. Introduction
New Zealand enacted new transfer pricing legislation on 12 December 1995, with
effect from the income year ending 31 March 1997. The Inland Revenue Department
(Inland Revenue) issued transfer pricing guidelines in fnal form in October 2000.
5302. Inland Revenues current focus
The Inland Revenue is continuously fne-tuning its targeting approach in terms of
taxpayers and risk areas. We have seen clear evidence of this in our dealings with the
Inland Revenue and commentaries published by the Inland Revenue in the last few
years. The Inland Revenue has expressed its views on the transactions it will monitor,
expectations for New Zealand-based companies when expanding offshore and risk
areas that foreign multinationals should be aware of when restructuring their New
Zealand operations.
Over recent years, the Inland Revenue has lifted its game and sophistication in terms
of transfer pricing enforcement. In this regard, the Inland Revenue has instigated a
number of specifc transfer pricing review programmes. In particular, it maintains a
special focus and conducts comprehensive annual reviews on the top foreign-owned
multinationals (with revenue in excess of NZD 300 million).
In 2009, the Inland Revenue announced that its compliance review programme
for 2009-10 will continue to cover the full range of both inbound and outbound
associated-party transactions with a special emphasis on:
Arrangements to import offshore losses through nonmarket pricing;
Potential gaining of interest rates, taking undue advantage of gyrations
experienced in credit spreads;
Pricing of hybrid fnancial instruments (e.g. mandatory convertible notes);
Advance pricing agreements (APAs); and
Foreign enterprises operating limited-risk structures.
The Inland Revenue continues to focus on companies with low operational
functionality that have incurred losses over a sustained period. The Inland Revenue
has indicated that further audit work is likely to occur where the company fails to lift
its performance following a transfer pricing review by the Inland Revenue. Transfer
pricing adjustments could follow.
N
New Zealand 606 www.pwc.com/internationaltp
The Inland Revenue has identifed several key issues in relation to intragroup
fnancing, including the pricing of interest and guarantee fees, and capital
restructuring that result in a major reduction in New Zealand tax paid (refer to 5320,
Thin capitalisation). In particular, the Inland Revenue will be closely monitoring all
inbound loans over NZD10 million, all outbound loans and the appropriateness of a
non-investment-grade credit rating (Standard & Poors BB or lower).
In addition to its focus areas, Inland Revenue also will continue to monitor business
restructures. The Inland Revenue is aware that multinationals continuously alter their
supply chains in their quest to maximise effciencies in their networks. The Inland
Revenue is looking closely at supply chain restructures, particularly a change from a
standard-risk operation to a low-risk operation. In this type of restructuring, the Inland
Revenue will be focusing on the economic substance underlying the low-risk operation;
for example, structural changes need to be real, not just on paper. In this regard, the
Inland Revenue has issued a commentary outlining 10 key questions that need to be
considered and included in a taxpayers documentation in respect of the restructure.
The Inland Revenue has also shown a great deal of interest and willingness to
entertain APAs. Key areas covered by APAs that have been negotiated recently include
distribution entities with large exposures, business restructures and complicated
royalty structures. Our experience with the Inland Revenue in relation to APAs has
been positive. We believe this is attributable to the agencys informal approach to APAs
and its pragmatic view on commercial realism.
5303. Inland Revenues review mechanism
The main tool that the Inland Revenue uses in assessing taxpayers compliance with the
transfer pricing rules is its transfer pricing questionnaire. There are three versions of
the questionnaire: one for foreign-owned multinationals, one for New Zealand-owned
multinationals and one for New Zealand branches. They vary slightly; however, they
ask the same main questions.
The questionnaire requires taxpayers to provide details of, among other things, their
fnancial performance; the worldwide groups fnancial performance; the type and
amounts of cross-border, associated-party transactions; the method or methods
used to test the transactions; and whether documentation exists to substantiate the
transfer prices. The version pertaining to foreign-owned multinationals also includes
questions designed to assess taxpayers compliance with the thin capitalisation rules.
The questionnaire is a risk assessment tool and does not constitute notice of the
commencement of a transfer pricing audit.
The Inland Revenue frst issued the questionnaires as part of its transfer pricing risk
review project (i.e. bulk rounds of questionnaires sent to multiple taxpayers) and
during general tax audits. The department issued two rounds of questionnaires in 2000
and a further round in December 2003. Since then, questionnaires have remained
central to Inland Revenues compliance programme as a means of scoping risks
effciently and effectively.
Taxpayers with potential transfer pricing issues receive the questionnaire as standard
practice during a tax audit. We also have seen an increasing number of taxpayers
being asked by the Inland Revenue to complete questionnaires during routine tax
investigations. In many cases, a request for transfer pricing documentation has
International Transfer Pricing 2011 New Zealand 607
New Zealand
accompanied the issuance of the questionnaire during a tax audit. Inland Revenue
auditors have received training specifc to transfer pricing, and recent experience
suggests an increasing number of auditors are making transfer pricing queries.
Some taxpayers have also received the questionnaire as a one-off, not as part of a
specifc review project or a tax audit. We suspect that in these incidences, the Inland
Revenue is seeking to obtain an understanding of the transfer pricing issues and risks
associated with a particular industry.
The types of response the Inland Revenue gives a taxpayer following submission of the
questionnaire include no further action required, please provide further information
and please explain. In the second of these responses, the Inland Revenue generally
requests the taxpayer to complete a further questionnaire for a subsequent fnancial
year. The third response usually entails the Inland Revenue requiring the taxpayer to
explain the nature of a particular (and perhaps unusual) transaction or the reasons for
a loss being incurred.
In addition, the Inland Revenue has indicated to some taxpayers that have received
the questionnaire that it is maintaining a watching brief of their transfer pricing
practices. The department monitors the fnancial performance of these taxpayers by
accessing publicly available fnancial statements from the New Zealand Companies
Offcewebsite.
Sections GB 2 and GC 6 to GC 14 of the Income Tax Act 2007
1
(tax act) contain the
current transfer pricing legislation. The transfer pricing legislation closely follows
the current OECD Guidelines and the US Section 482 rules. Other features of the
legislation are as follows:
The basic principle is that of arms length, as defned by the OECD Guidelines,
using fve permitted pricing methods: the comparable uncontrolled price (CUP),
resale price, cost plus, proft split and comparable profts methods;
The amount of arms-length consideration must be determined by applying
whichever method or combination of methods listed above will produce the most
reliable measure that completely independent parties would have agreed on after
real and fully adequate bargaining;
The substitution of an arms-length price applies only so as to increase New
Zealands tax base (GC 7 and GC 8)
2
. The burden of proof as to the arms-length
nature of consideration rests with the commissioner of Inland Revenue (the
commissioner), unless the commissioner can show that the taxpayer has not
cooperated or can demonstrate another amount to be a more reliable arms-length
measure (GC 13(4))
3
;
1
The relevant sections in the Income Tax Act 2004 are GD 13, FB 2 and GC 1. On 1 April 2008, the Income Tax Act 2007
superseded the Income Tax Act 2004. The purpose and intention of the provisions remain the same. The Income Tax Act
2007 applies to tax on income derived in the 2009 income year onwards.
2
Income Tax Act 2004 Sections GD 13(3) and (4).
3
Income Tax Act 2004 Section GD 13(9).
N
There are specifc powers, in addition to those in the double taxation agreements
(DTA), to allow compensating adjustments (GC 9 and GC 10
4
) and corresponding
adjustments (GC 13(11))
5
; and
Section GB 2
6
contains an anti-avoidance provision that includes arrangements
entered into for the purposes of defeating the provisions of GC 6 to GC 14
7
.
In addition to these outlined provisions, Section YD5
8
stipulates the use of the arms-
length basis to apportion income between New Zealand and other countries in the case
of branches and agencies.
5305. Guidance on applying New Zealands transfer pricing
rules
The following additional guidance on the application of the legislation is available
from the Inland Revenue:
A technical information bulletin, which deals with the introduction of the new
legislation and provides an indication of how the Inland Revenue will interpret it;
and
Transfer pricing guidelines.
The Inland Revenue initially released draft guidelines in two parts: part one in October
1997 and part two in January 2000. No subsequent guidelines have been published
since the 2007 rewrite of the Income Tax Act 2004.
The frst part of the draft guidelines covered the arms-length principle, transfer pricing
methodologies, theoretical and practical considerations, principles of comparability,
practical application of the arms-length principle, documentation and the Inland
Revenues approach to administering New Zealands transfer pricing rules. Part two
of the draft guidelines covered the treatment of intragroup services, the treatment of
intangible property and cost contribution arrangements.
The Inland Revenue issued fnal transfer pricing guidelines (the guidelines) in
October 2000. The guidelines consolidate the draft guidelines previously issued,
with no substantive changes. The guidelines specifcally do not apply to permanent
establishments and branches that are covered by Section YD 5
9
of the tax act.
The Inland Revenue states that the guidelines are intended to supplement the OECD
Guidelines rather than supersede them. In fact, the department fully endorses the
comments set out in chapters one to eight of the OECD Guidelines. In its guidelines,
the Inland Revenue indicates that the OECD Guidelines are relevant to DTA issues and
issues not addressed by the guidelines.
Taxpayers are also directed to guidelines issued by the Australian Taxation Offce
and the US 482 regulations, as long as these sources are consistent with the overall
approach of the Inland Revenue. However, on issues concerning the administration of
New Zealands transfer pricing rules, the guidelines are stated as being paramount.
4
5
6
Income Tax Act 2004 Section GC 1.
7
Income Tax Act 2004 Section GD 13.
8
Income Tax Act 2004 Section FB 2.
9
Income Tax Act 2004 Section FB 2.
New Zealand
The comments in the guidelines dealing with the arms-length principle and pricing
methods are broadly consistent with the OECD Guidelines, except there is no explicit
hierarchy for the transfer pricing methods. However, taxpayers must use the most
reliable method.
In relation to the transfer pricing methods prescribed in New Zealands tax act, a
particularly interesting comment is made in the guidelines:
Inland Revenue does not consider that there is any practical difference between
the TNMM [transactional net margin method] espoused by the OECD, the comparable
profts method favoured in the US, and the proft comparison method adopted
by Australia. It was also noted [previously in the guidelines] that the reference to
comparable profts methods in Section GD 13(7)(e) [of the tax act] is wide enough to
encompass all three approaches (the guidelines, paragraph 141)
10
.
With respect to tested parties, the guidelines specifcally allow taxpayers to benchmark
the foreign party in particular circumstances where they believe that that is more
appropriate to determine the most reliable measure of the arms-length price.
However, where a taxpayer does decide to use the foreign party as the tested party,
it should be aware that the Inland Revenue is likely to also test the New Zealand
party and, therefore, it is important there is some analysis in relation to the New
Zealand operations. Specifcally, the Inland Revenue is prepared to accept a foreign
analysis provided that the analysis represents a fair application of the arms-length
principle and results in a return from the New Zealand operations that is, prima facie,
commensurate with the operations economic contribution and risks assumed.
The Inland Revenue recognises that applying the transfer pricing methods can often
result in a range of arms-length outcomes instead of a single arms-length outcome.
Where a range is established, the Inland Revenue considers that, rather than the
entity applying statistical measures to the range, the more important issue is to assess
whether the comparables used to construct the range are reliable.
New Zealands transfer pricing rules do not contain an explicit statutory provision
requiring taxpayers to prepare transfer pricing documentation. However, Sections GC
6 to GC 14
11
of the tax act require taxpayers to determine transfer prices in accordance
with the arms-length principle by applying one (or a combination) of the methods set
out in Section GC 13(2)
12
of the tax act. For an entity to demonstrate compliance with
this requirement, the Inland Revenue considers it necessary to prepare and maintain
documentation to show how transfer prices have been determined.
The Inland Revenue considers there are two reasons for making this assertion for
documentation. The frst is the burden of proof rule in Section GC 13(4)
13
of the tax
act. Under this section, the price determined by the taxpayer will be the arms-length
price, unless the commissioner can demonstrate a more reliable measure or the
taxpayer does not cooperate with the commissioners administration of the transfer
pricing rules. If a taxpayer does not prepare documentation, there are two exposures.
First, it is more likely the Inland Revenue will examine the taxpayers transfer pricing in
10
This reference provided by the guidelines refers to the Income Tax Act 2004. The relevant section in the 2007 rewrite is GC
13(2)(e).
11
Income Tax Act 2004 Section GD 13.
12
13
Income Tax Act 2004 Section GD13(9).
N
detail. Second, if the Inland Revenue substitutes a new transfer price as a result of the
examination, the lack of documentation will make it diffcult for the taxpayer to rebut
that position.
The second consideration sustaining the Inland Revenues view of documentation is
the proposed application of the penalty provisions of the Tax Administration Act 1994
(Tax Administration Act) contained in the guidelines:
In Inland Revenues view, adequate documentation is the best evidence that can be
presented to demonstrate that these rules have been complied with. If a taxpayer
has not prepared any transfer pricing documentation, and Inland Revenue is able to
demonstrate a more reliable measure of the arms-length amount, Inland Revenues
view is likely to be that the taxpayer has, at a minimum, not exercised reasonable care
(carrying a 20% penalty under Section 141C of the Tax Administration Act) or has been
grossly careless (carrying a 40% penalty under Section 141C of the Tax Administration
Act), in its determination of an arms-length amount under Section GD 13 (the
guidelines, paragraph 316)
14
.
The Inland Revenue accepts that the creation and maintenance of documentation
impose costs on taxpayers. In the Inland Revenues opinion, if a taxpayer has reached
the conclusion on the basis of a sensible cost-beneft analysis that it is not prudent
to pursue a full transfer pricing analysis, this would be strongly suggestive that the
taxpayer has taken reasonable care. Of course, the Inland Revenue would expect to
see a document explaining how the conclusion was reached. In respect of the issue of
whether a taxpayer has an acceptable interpretation, the Inland Revenue considers
that the taxpayer must have explicitly considered that its transfer prices are at least
broadly consistent with the arms-length principle. In assessment of the risk of a
potential transfer pricing adjustment, all of the following documentation is suggested
at a minimum:
An identifcation of the cross-border transactions for which the taxpayer has a
transfer pricing exposure;
A broad functional analysis of the taxpayers operations to identify the critical
functions being performed;
An estimate of the business risk of not undertaking and documenting a more
detailed transfer pricing analysis; and
An estimate of the costs of complying with the transfer pricing rules.
It is emphasised that this assessment will not preclude the Inland Revenue from
substituting a more reliable measure of the arms-length price. Where a cost-beneft
analysis indicates the need for a full analysis, the Inland Revenue would expect to see
all of the following documentation:
Some form of functional analysis;
An appraisal of potential comparables;
An explanation of the process used to select and apply the method used to establish
the transfer prices and why the taxpayer considers that it provides a result
consistent with the arms-length principle; and
Details of any special circumstances that have infuenced the price set by
thetaxpayer.
14
This reference from the Guidelines refers to the Income Tax Act 2004. The corresponding references for the Income Tax Act
2007 are GC 6 to GC 14.
New Zealand
It should be noted that these documentation requirements have no legislative authority
and are not, therefore, binding on the taxpayer. Rather, they are an indication of the
Inland Revenues approach to an interpretation of New Zealands transfer pricing rules.
The guidelines also consider cross-border transfers of intangible property, including
any rights to use industrial property (such as patents, trademarks, trade names,
designs or models), any literary or artistic property rights (copyrights, etc.) and any
intellectual property, such as know-how or trade secrets.
The Inland Revenue acknowledges that the application of the arms-length principle to
transfers of intangible property can be problematic because appropriate comparable
transactions can be diffcult, if not impossible, to identify. Despite these diffculties,
the Inland Revenue emphasises that applying the arms-length principle is no different
than for other types of property.
The guidelines also discuss the provision or receipt of intragroup services. Services can
be either specifc beneft or indirect. Specifc beneft services are normally charged to
the recipient entity directly. Indirect services should be charged using a cost allocation
or apportionment approach.
The guidelines depart most signifcantly from the OECD Guidelines relating to both of
the following:
A detailed discussion of the different allocation methods that may be appropriate in
the charging of indirect services; and
The provision of a safe harbour markup on cost of 7.5% in applying the cost plus
method for non-core activity services and for services under a NZD 100,000 de
minimis threshold. A non-core activity is defned as an activity that is not integral to
the proft-earning or economically signifcant activities of the group. This provision
will relieve taxpayers from having to benchmark these services. However, it does
not relieve their obligations to demonstrate the benefts derived from the services
or prepare adequate transfer pricing documentation.
Cost contribution arrangements are also discussed in the guidelines. The guidelines
emphasise that to satisfy the arms-length principle, a participants contribution
must be consistent with what an independent enterprise would have agreed to pay
in comparable circumstances. Cost contribution arrangements remain an evolving
concept from a transfer pricing perspective. Taxpayers should clearly consider
the guidelines on such arrangements if they are participating in or considering
participating in one.
5306. Legal cases
No court cases have arisen in connection with New Zealands current transfer pricing
rules. It should be noted, however, that even under the previous legislation, there were
effectively no transfer pricing court cases in the 20 years prior to its repeal. The two
main reasons for this are:
1. The previous legislation was considered to be defective; and
2. Because most transfer pricing disputes were settled by negotiation, there was no
need to proceed to court.
N
In New Zealand, the burden of proof normally lies with the taxpayer, not the
commissioner. However, Section GC 13(4)
15
places the burden of proof on the
commissioner where the taxpayer has determined its transfer prices in accordance with
Sections GC 13(1) to 13(3)
16
of the tax act.
Where the commissioner substitutes an arms-length price for the actual price, the
commissioner must prove one of the following:
1. This is a more reliable measure; or
2. The taxpayer has not cooperated with the commissioner.
According to the guidelines, non-cooperation constitutes either of the following:
Where the taxpayer does not provide the requested relevant information to the
commissioner; and
If a taxpayer does not prepare adequate documentation and provide it to the Inland
Revenue if requested.
The burden of proof rule is essential in the context of transfer pricing in New Zealand.
Clearly, if taxpayers maintain quality documentation of transfer pricing and produce
it on request to the Inland Revenue, they will substantially reduce the risks of an
intensive transfer pricing audit. And in any event, the burden of proof will fall on the
commissioner to demonstrate that Inland Revenue has a more reliable measure of the
arms-length price.
The Inland Revenue will perform audits or investigations specifcally for transfer
pricing issues. Transfer pricing audits or investigations may also be combined with
normal tax audits and investigations.
Whether a company or group is selected for investigation will depend on a variety of
factors or situations, including:
Previous transfer pricing disputes with the tax authorities, particularly if the
authorities consider that these were unsatisfactorily resolved;
The industry in which the company operates;
Where an application for an advance pricing agreement has been withdrawn or
unsatisfactorily resolved;
Following receipt of information passed to the tax authorities from overseas;
Where there is evidence of transfer pricing disputes with other revenue
authoritiesoverseas;
As a result of desk audits of returns and replies to correspondence
seekinginformation;
15
16
Income Tax Act 2004 Sections GD 13(6) to 13(8).
New Zealand
Inland Revenue risk assessment by reference to all of the following:
Level of proftability;
No evidence of negotiations with parent;
No economic or commercial basis for price;
Poor cooperation; and
Limited transfer pricing documentation.
The Inland Revenue compliance programme focuses its resources on perceived risk
to the New Zealand tax revenue base. A transfer pricing-specifc review ultimately
depends on the extent of tax risk perceived in the taxpayers transfer pricing practices.
The guidelines indicate that the Inland Revenue is likely to inspect transactions
involving an entity resident in a country in which New Zealand does not have a DTA
more closely than transactions involving tax treaty countries.
the tax authorities
Information that tax authorities can request during investigations and the authorities
powers to enforce provision of the information are outlined in Sections 16, 17, 17A, 18,
19 and 21 of the Tax Administration Act. The most important are Sections 16 and 17,
which give the Inland Revenue extensive powers, both to carry out investigations and
to demand information.
The guidelines make it clear that the Inland Revenue expects New Zealand taxpayers
on request to obtain information from overseas associated entities to justify the arms-
length nature of their transfer prices. Section 21 provides the Inland Revenue with
further powers to require information, particularly in respect of information held
offshore. Any information that is not produced in response to a Section 21 request will
not be available to the taxpayer as part of his/her defence in any subsequent court
action relating to such matters.
Effective 22 June 2005, taxpayers can claim a right of non-disclosure for certain tax
advice in documents prepared by tax advisers. However, this right of non-disclosure
can be claimed only in respect of tax advice documents. The Inland Revenue has
issued a standard practice statement (SPS 05/07) to provide guidance to taxpayers on
this matter. The defnition of tax advice documents in the Inland Revenues standard
practice statement excludes transfer pricing reports.
Investigations in New Zealand are conducted by way of visits to the taxpayers premises
and interviews with relevant personnel. In some cases, these visits may be preceded by
requests for the provision of documentation.
Usually in New Zealand, an investigation is decided through negotiation, but it may
proceed to litigation if the issues raised cannot be resolved through negotiation. There
is also a dispute resolution procedure that applies to transfer pricing disputes. This
provides a form of dispute resolution that is primarily aimed at attempting to settle
prior to an assessment. During this procedure, notice of intended assessment is given,
followed by compulsory meetings. At the meetings, full disclosure of all relevant facts
is required to be made, and it should be noted that any information not produced for
these meetings is banned from any future court action.
N
Appeals start with the dispute resolution procedure. After the taxpayer proceeds
completely through the dispute resolution procedure, any further appeal would be
heard by the courts.
New Zealands tax legislation specifes penalties that may be applied to adjustments
arising from transfer pricing issues. Determination of the penalties focuses on
culpability. The shortfall penalties are:
Not taking reasonable care 20% of tax shortfall;
Unacceptable interpretation 20% of tax shortfall;
Gross carelessness 40% of tax shortfall;
Abusive tax avoidance 100% of tax shortfall; and
Evasion 150% of tax shortfall.
These penalties can be adjusted up or down to refect the taxpayers level of
cooperation with the authorities during the investigation and the existence or
otherwise to any disclosures to the tax authorities. Penalties are not tax-deductible.
In addition to the shortfall penalties, an interest charge (deductible) is automatically
applied from the date on which the tax should have been paid to the date on which it is
fnally paid. The rate is adjusted from time to time to refect economic circumstances.
The International Tax Policy Unit of the Inland Revenue has advised that transfer
pricing will not be dealt with by a separate, discrete transfer pricing unit. Rather,
all tax inspectors and auditors will be capable of handling transfer pricing issues.
The inspectors will be supported by the International Tax Policy Unit and will also
receive relevant data and particulars of any APA applications being sought. The Inland
Revenue has economists available as part of its staff resources, and it is clear the
department will not hesitate to contract with outside experts, both economists and
industry experts, to assist with its deliberations.
That a transfer price is at arms length would, in theory, be demonstrated by means
of one or more of the prescribed methods in Section GC 13(2)
17
of New Zealands tax
act. In practice, unless either a CUP or suffcient data to apply a resale price method or
cost plus method is available, justifcation of the pricing used would almost certainly
depend on a comparison of net proft margins. In most cases, unless the taxpayer has
information available regarding its competitors and/or CUPs or internal comparable
transactions, the taxpayer would depend on information available from commercial
databases. This information, likely to be an analysis of published annual accounts,
would almost certainly force any defence to be based on the comparison of net
proftmargins.
17
New Zealand
In some cases, within particular industries, more detailed information is available, but
this is the exception rather than the norm. Because of the small number of independent
companies and large number of controlled entities, New Zealand taxpayers are often
forced to look for comparable entities in foreign jurisdictions (e.g. Australia, the UK or
the US). The Inland Revenue recognises that taxpayers may need to look overseas to
fnd comparable data, which may need to be adjusted to ensure comparability.
Non-publicly available information
The guidelines raise the issue of the Inland Revenues use of non-publicly available
information. The guidelines state the Inland Revenue does not intend as a matter
of course to use non-publicly available information in attempting to substitute an
alternative measure of an arms-length amount. The Inland Revenue concedes there
are diffculties, including the likelihood that such information could not be provided to
taxpayers whose transfer prices are under review because of the secrecy provisions of
the Tax Administration Act.
However, the Inland Revenue does not rule out the possibility that non-publicly
available information will be used in administering the transfer pricing rules because
the New Zealand tax act requires that the most reliable measure of the arms-length
amount must be determined.
Use of hindsight
The guidelines make it clear that the use of hindsight is inconsistent with the arms-
length principle. However, the guidelines state that the use of hindsight may be
valuable in appraising the reliability of comparables used. The guidelines provide an
example of a newly developed intangible being diffcult to value because of uncertainty
as to its future value. Even if time does prove the intangible to be valuable, this is not
grounds for automatically adjusting the transfer price.
Availability
The Inland Revenue could access information on other taxpayers, either during
investigations into those taxpayers or through a direct request for information under
Section 17 of the Tax Administration Act. The latter would enable the Inland Revenue
to obtain precise information. Indeed, a recent comment from the head of the Inland
Revenues International Tax Policy Division indicated that such information might be
used to select companies for audit, although it is uncertain whether, or under what
authority, information obtained in this way could be used as the basis for transfer
pricing adjustments.
As noted previously, the information available to taxpayers is likely to be limited to
analyses of published accounts as found on commercial databases.
The transactions which can be attacked are specifed in Sections GC 6(2) and GC 6(3)
18

of the Income Tax Act 2007. Particular types of payment or receipt that are likely to be
targeted include payments of interest, management fees, royalties and other fees in
relation to intangibles, along with fxed-rate preference shares. Effectively, the only
item that is excluded is share capital other than fxed-rate preference shares.
18
N
The competent authority process in New Zealand operates in the way set out in a
typical DTA, with nominated offcers of the Inland Revenue acting as competent
authorities for particular topics. The head of the International Tax Policy Unit is the
competent authority for transfer pricing matters.
In addition to DTA provisions, specifc provisions in the New Zealand tax act
provide for both corresponding adjustments and compensating adjustments, but
only in consequence of adjustments made in New Zealand, not in consequence of
foreignadjustments.
APAs are available to taxpayers in New Zealand, and the Inland Revenue is keen to see
a greater number of taxpayers seeking APAs. The Inland Revenue has established its
APA programme under a broad framework using informal procedures and has stated
it will not issue formal APA guidelines. The Inland Revenue considers that its fexible
approach to APAs minimises the possibility of the process becoming too bureaucratic
and enhances the effciency of its APA programme. This fexible approach means that
most APAs can be concluded within six months.
The Inland Revenue concluded its frst bilateral APA (with Australia) in 2001. Since
then, the Inland Revenue has concluded several other bilateral APAs. The department
is also party to a multilateral APA. The Inland Revenue has concluded several unilateral
APAs and is currently negotiating a number of others.
The Inland Revenue expects to see a greater number of taxpayers seeking APAs, given
the increase in its auditors inquiries. The department is encouraging taxpayers to seek
unilateral and bilateral APAs, particularly with Australia. The tax authority believes
it is better for taxpayers to obtain APAs than run the risk of potentially costly and
time-consuming transfer pricing audits. Its view is that given the subjective nature of
transfer pricing, APAs are the best way for taxpayers to achieve certainty.
The Inland Revenue will normally obtain information from the customs authorities
and, in fact, is expected to use customs specifcally as a source of transfer pricing
information. Indeed, customs offcers are currently very active in checking the transfer
price of goods, although this is ostensibly for customs duty purposes. However, recently
it has been determined that customs has raised queries specifcally for the purpose of
actively sharing information with the Inland Revenue in relation to the price of goods
being imported into New Zealand.
Although there is no legislation that directly requires transfer pricing adjustments to
be refected in returns made for customs or other indirect taxes, where transfer prices
have been adjusted for income tax purposes, this may require customs to review the
prices for customs duty.
New Zealand
5318. OECD issues
New Zealand is a member of the OECD. It has signed off on the OECD Guidelines and,
as discussed previously, has stated express agreement with them. Further, Inland
Revenue personnel are involved in a number of OECD committees dealing with transfer
pricing issues.
New Zealand would undoubtedly join with another country to undertake a joint
transfer pricing investigation of a multinational group. To this end, there is a formal,
but private, agreement already in existence between the New Zealand and Australian
tax authorities. In the past, the tax authorities have traditionally cooperated informally
with other tax authorities, either in providing information for other transfer pricing
investigations or, in some cases, participating in joint audits or enquiries.
New Zealand introduced a thin capitalisation regime to apply from the beginning of
the 1996-97 income year. The key features are as follows:
The regime is fundamentally designed to deny a deduction for interest if a non-
resident allocates an excessive proportion of its worldwide debt to its New Zealand
operations. An apportionment of deductible interest is required where an entitys
debt ratio (calculated as total debt/total group assets) exceeds both:
a. 75%; and
b. 110% of the worldwide groups debt percentage.
It is important to note that the use of debt-to-asset ratio differs from most thin
capitalisation models, which monitor an entitys debt-to-equity ratio.
The regime potentially applies to:
a. Non-residents who derive New Zealand-sourced income;
b. New Zealand companies controlled by a single non-resident person (together
with persons associated with that person); and
c. Non-qualifying trusts that are 50% or more settled by non-resident persons.
A concession exists for on-lent funds. One effect of this is to minimise the impact of
the regime for fnancial intermediaries.
The thin capitalisation rules were extended in 2009 to include New Zealand companies
that are controlled by New Zealand residents and have interests in controlled foreign
companies (CFC), except where one of the following applies:
The ratio of the New Zealand group assets to the worldwide group assets is at least
90%; and
The New Zealand groups interest deductions are less than NZD 250,000, and the
New Zealand group does not have an interest in a CFC deriving rent from the CFCs
country of residence.
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5321. New Australia-New Zealand DTA
The new DTA between New Zealand and Australia came into force on 19 March 2010.
The revised DTA introduces new dividend, interest and royalty withholding tax rates;
amends the defnitions of permanent establishment and royalties; and introduces a
time bar for making transfer pricing adjustments for trans-tasman transactions.
5322. Revised CFC rules
New Zealands rules affecting the calculation of attributed CFC income were amended
in 2009. The new rules apply from the 2009-10 income year for taxpayers with balance
dates between 30 June and 30 September; for all other taxpayers, the rules apply from
the 2010-11 income year.
The new CFC rules are less comprehensive than the old rules. For example, the new
rules contain a worldwide exemption for CFCs with an active business. Under the new
rules, inadequate pricing policies may no longer result in a zero sum game. Therefore,
the Inland Revenue is more likely to scrutinise transfer prices in transactions involving
CFCs. Inland Revenue recommends that taxpayers ensure they have suffcient
documentation that transfer prices involving CFCs are in accordance with the arms-
length standard.
Norway
54.
International Transfer Pricing 2011 619 Norway
5401. Introduction
In Norway, the arms-length standard for related party transactions is incorporated
into the General Tax Act (GTA) 1999 Section 13-1. New transfer pricing rules became
effective from fscal year 2008. The GTA Section 13-1 (4) makes reference to the OECD
Guidelines; it is stated that the OECD Guidelines shall be taken into account when
addressing transfer pricing issues under Norwegian law.
Until recently, the resources of the Norwegian tax authorities were limited, and
their interest tended to focus on intragroup services and the fnancing of operations.
However, this has changed considerably as transfer pricing has increasingly become
the focus of revenue attention, and the resource issues have been addressed. Through
extensive hiring and knowledge investments, the Norwegian tax authorities are rapidly
becoming more sophisticated on transfer pricing issues. It is fairly common for the
Norwegian tax authorities to pick test cases that are subject to substantial investment.
Such cases may easily end up in court, as settlements are uncommon. During the most
recent years, focus has been inter alia on business restructuring and commissionaire
arrangements.
Norway does not yet have an advance pricing agreement regime. Nevertheless, it is
becoming more common to discuss complex cases with the tax authorities in advance
of implementation or before assessment.
A general arms-length rule is laid down in Section 13-1 of the GTA. The section
provides that, where the income of a Norwegian resident is reduced due to transactions
with a related party, the authorities may estimate the amount of the shortfall in income
or wealth and assess this to Norwegian tax. The following three conditions must be
met for the tax authorities to adjust a taxpayers taxable income or assets in accordance
with the GTA Section 13-1:
The parties involved in the transaction must have a direct or indirect community of
interest;
There must be an income or asset reduction (compared with what the situation had
been had the parties not been related); and
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The income or asset reduction must have occurred as a consequence of the
relationship (the community of interest) between the parties. Where the related
party is resident outside the European Economic Area (EEA), the legislation
assumes that the relationship is the reason for any deviation from arms-length
income or wealth, and puts the onus on the taxpayer to prove otherwise. However,
the Supreme Court made some interesting statements regarding the burden of
proof in the 1999 Baker Hughes case (see Section 5405 below).
In addition to the statutory rules, the substance-over-form principle is a general and
important non-statutory principle in Norwegian tax law:
The starting point in Norwegian tax law is that transactions in accordance with
Norwegian private law are respected. The application of the non-statutory general anti-
avoidance rule (GAAR) is dependent on the tax authorities showing that the relevant
transaction has little value besides the tax effects and that the main purpose behind
the transaction is to reduce Norwegian taxes. Furthermore, the tax benefts gained by
the transaction must be contrary to the legislative intent (i.e. the relevant transaction is
clearly outside the range of situations the tax rule was meant for).
The objective of the GAAR is to fnd the underlying reality, thus substance prevails over
form. (It is important to distinguish between this and so-called pro forma transactions,
which are disregarded for tax purposes.)
Norway has specifc legislation (in the Petroleum Tax Act) to deal with the pricing of
petroleum for tax purposes. Taxation of income from the sale of crude oil produced on
the Norwegian Continental Shelf is based on a so-called norm price of petroleum,
which shall be equivalent to the price at which it could be sold between unrelated
parties in a free market (i.e. an arms-length price). When establishing the norm price,
a number of factors shall be taken into account, including:
the realised and quoted prices for petroleum of the same or a corresponding type with
necessary adjustments for quality variations, transport costs, etc. to the North Sea area
or other possible markets, delivery time, time allowed for payment and other terms.
The price norm is decided individually for each feld by a separate governmental board
(Norm Price Board). The taxpayer will be taxed based on the relevant norm price
irrespective of the actual sales price. The norm price will be used both for internal and
external transactions. So far, the norm price has been set only for crude oil but may
also be set for natural gas.
5404. Court cases
The Supreme Court and the lower courts have made a number of decisions concerning
transfer pricing. Several of the large transfer pricing cases in Norway within the past 10
to 15 years are related to the petroleum activity on the Norwegian Continental Shelf.
International Transfer Pricing 2011 Norway 621
Norway
Bareboat charter rate pricing methods
Trinc and Trag Supreme Court decision 1997
The Trinc and Trag case is primarily an important decision with respect to tax liability
to Norway for a foreign rig-owner. The case also (particularly in the verdicts from the
lower courts) contains interesting elements of transfer pricing.
Two foreign companies, Trinc and Trag, were controlled by the same owners. Trinc was
the ownership company of a drilling rig, and Trag operated the rig under a bareboat
charter. Trag operated the rig on the Norwegian Continental Shelf and was liable to
tax in Norway for that activity. The companies had seemingly not used any specifc
pricing method, while the tax authorities used a cost plus method to set an appropriate
bareboat charter rate. The court stated that no signifcant income reduction was
required in order to adjust the income in accordance with the GTA Section 13-1.
Further, the court stated that the tax authorities were entitled to use the cost plus
method in a situation where it was diffcult to fnd comparable transactions in the
market, and that the discretionary elements used by the tax authorities in the cost
plus calculation were acceptable. The taxpayer argued to no avail that the resale price
method was more appropriate. The historic cost of the rig was used as a basis for the
computation. This part of the case was not appealed to the Supreme Court.
Captive insurance issues
There are basically two issues regarding captive insurance. The frst question is
whether the captive provides real insurance. The second question, if the captive is
accepted as providing real insurance, is to what extent the insurance premiums meet
the arms-length standard.
Amoco Supreme Court Case 2002
The question was to what extent Amocos captive represented real insurance. Through
previous Supreme Court decisions (including Dowell Schlumberger 1995) it has been
concluded that premiums paid to a captive insurance company will, in principle,
be accepted as a deductible for income tax purposes. However, this is subject to
twoconditions:
A formal insurance policy that transfers the risk from the insured to the captive
must be in place; and
The captive must have the fnancial capacity to meet any claims under the
insurance policy (i.e. there must be a real transfer of risk).
Regarding the latter, the tax authorities (in this case, the Oil Taxation Offce) have
focused on the exposure ratio (maximum payout for one accident/the captives equity).
In the Amoco case the exposure ratio was more than 100% (i.e. the captive could not
even meet one maximum loss).
Contrary to the city court and Court of Appeals, the Supreme Court concluded
that Amocos captive insurance arrangement qualifed as real insurance. The main
reason for this was the fact that Amoco Norway had placed its insurance policy in
an independent insurance company (fronting arrangement). The fronting insurance
company had then reinsured all the risk with the Amoco captive company, and Amoco
Corp. had guaranteed coverage from the captive to the fronting insurance company.
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Based on the fact that the fronting company would be in a position to cover any
losses incurred by Amoco Norway, irrespective of the captives fnancial position,
the Supreme Court concluded that the risk effectively had been shifted from Amoco
Norway to the insurer. Therefore, from a Norwegian perspective, this represented a
true and valid insurance.
However, it should be noted that the Supreme Court in principle accepted the
exposure ratio as a key factor in order to test the captives fnancial capability.
Therefore, it was also concluded that the Amoco captive in itself clearly did not qualify
as a true and valid insurance company.
Agip Supreme Court 2001
The Appeal Board for Petroleum Tax did not accept Agips insurance premiums as being
in line with the arms-length standard. In order to fnd the correct arms-length price,
the Appeal Board made use of captive insurance premiums paid by other companies
operating on the same petroleum feld as comparables. The Appeal Board made the
following statement:
Within captive insurance it is diffcult to fnd comparable rates between independent
insurance companies. A comparison with rates paid by other companies on the same or
similar felds will be relevant for the evaluation of whether an arms-length price exists,
even if the comparable insurances are with captives. The key point is to thoroughly
evaluate the comparability of the policies and to make any required adjustments in
order to get a relevant basis for the comparison.
The taxpayer argued that the comparisons and the adjustments made by the Appeal
Board were not representative.
The Supreme Courts conclusion was in line with that of the Appeal Board. The
Supreme Court referred to the OECD Guidelines and concluded that the guidelines
can and should be used as a supplement to the GTA Section 13-1, and that there is no
confict between the two. As the court found that insurance policies differ signifcantly
from feld to feld, it was deemed acceptable to use other captive insurances (i.e.
controlled transactions) on the same petroleum feld as comparables.
With respect to transfer pricing methodology, the court stated that the OECD
Guidelines cover several methods but that none of these methods was directly
applicable in this particular case. The court then stated that in such a situation, the
OECD Guidelines must be adapted to the specifc situation. Thus, the Supreme Court
accepted that the Appeal Board had determined an arms-length insurance premium
using a combination of several methods as well as its own discretionary judgment.
Financing of subsidiaries
During the mid-1990s there were several cases regarding Norwegian parent companies
fnancing of foreign subsidiaries. The key issue was and is to what extent capital
injected formally as a loan into the foreign subsidiaries should generate an interest
income for the Norwegian parent company.
The frst question is whether the capital injection represents loan or equity. Based
on a Ministry of Finance position from 1995 and the result from the court cases, the
taxpayers actual treatment in the statutory accounts will be an important factor even
if it is not entirely decisive.
Norway
If it is established that the capital injection in reality represents a loan, the next
question is whether (and to what extent) the foreign subsidiary would have been able
to borrow money in the market, based on the subsidiarys actual fnancial position
(i.e. whether the subsidiary has borrowing capacity). To the extent the subsidiary has
borrowing capacity, the Norwegian parent company will have to include an interest
income (deemed interest) from the foreign subsidiary in its tax accounts.
Inter-company charges
In 2002, the Court of Appeals made an interesting decision regarding inter-company
charges received by the Norwegian subsidiary of the US-based 3M group. The decision
was appealed, but the Supreme Court dismissed it.
3M had for several years charged its local sales companies, including the Norwegian
sales company, a licence fee for various inter-company services and use of trademarks.
The licence fees ranged from 2% to 5% of actual turnover in each single sales company.
The deduction for the licence fees was disallowed by the Norwegian tax authorities, as
3M Norway AS was deemed not to have provided suffcient documentation for services
received. The tax authorities also charged 3M Norway a penalty tax, as they were of
the opinion that the company had not provided suffcient information.
However, the city court, as well as the appellate court, concluded that the licence fee
was in line with the arms-length principle. The court stated that as long as the OECD
Guidelines accepted the indirect method for inter-company charges, it would also
have to be accepted that detailed documentation could not always be given. In this
particular case the 3M groups accounting system was not designed to give a detailed
breakdown/documentation for the various types of inter-company charges. The court
further concluded that there was no doubt that the Norwegian subsidiary had received
a number of signifcant services, and given the fact that the Norwegian subsidiary had
shown good fnancial results over several years it was assumed that a third party also
would have been willing to pay the same level of licence fee.
It must be pointed out, though, that in recent tax audits, especially following the
introduction of the specifc transfer pricing documentation requirements, the
Norwegian tax authorities tend to demand that a Norwegian service recipient
documents its beneft from inter-company services in quite extensive detail.
Business restructuring transfer of intellectual property
In September 2007, the Court of Appeals issued its verdict in the Cytec case. (Cytecs
appeal to the Supreme Court was dismissed in January 2008). Cytec Norge AS
(Norway) was originally a full-fedged manufacturer but was changed into a toll
manufacturer in 1999. Customer portfolio, technology, trademarks and goodwill were
apparently transferred to the related entity, Cytec Industries Europe (the Netherlands)
free. The appellate court found that Cytec Norge AS held intellectual property rights
of considerable value prior to the 1999 restructuring, and that the Norwegian entity
should have received an arms-length remuneration for the transfer of these rights to
the related Dutch entity. Hence, the court accepted the Norwegian tax authorities
calculation of such remuneration and the according tax increase.
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Commissionaire model permanent establishment
Although not primarily a transfer pricing case as such, the Oslo City Courts December
2009 decision in the so-called Dell case is of considerable interest from a transfer
pricing perspective. The Irish company, Dell Products Ltd., had a commissionaire
agreement with the Norwegian-related company, Dell AS, under which Dell AS sold
and marketed Dell products in the Norwegian market in its own name but for the risk
and account of Dell Products Ltd. Controversially, the city court ruled that Dell AS
was in fact a dependent agent for Dell Products Ltd. The court focused on the fact that
Dell Products Ltd. had no employees in the years in question (the company purchased
extensive services from other Dell Group entities); that Dell AS sold Dell products
almost exclusively and that agreements entered into by Dell AS were never disputed by
Dell Products Ltd. Hence, the city court found that agreements concluded by Dell AS
were actually binding on Dell Products Ltd., and that Dell AS constituted a dependent
agent permanent establishment in Norway for Dell Products Ltd. As a result, 60% of
the overall net proft of the distribution in Norway was allocated to Norwegian tax
rather than merely the commission fee received by Dell AS.
As the Dell Groups structuring of the Norwegian distribution activity is essentially a
typical commissionaire model, the city courts decision in this case basically threatens
the viability of all such models in Norway. The decision is being appealed, and the
appellate court will consider the case in February 2011. It is also important to note
that the French High Courts 31 March 2010, decision in the so-called Zimmer case,
which deemed an almost identical commissionaire model not to entail a permanent
establishment in France for the foreign principal, most likely will carry considerable
weight in the appellate courts handling of the Dell case.
Cash pooling/group account system
The January 2010 appellate court decision in the ConocoPhillips cash pool case
provides an indication as to how far Norwegian Tax Authorities (in this case, the Oil
Taxation Authorities) are prepared to stretch the theory of the arms-length principle
inpractice:
Two Norwegian ConocoPhillips companies (in the following jointly referred to as
ConocoPhillips Norway) were party to a cash pool arrangement. ConocoPhillips
Norway had several accounts in different currencies. The sum of all these accounts
constituted ConocoPhillips Norways net position in the groups cash pool. More than
150 other group companies participated in the cash pool arrangement, and the total
of the net positions of all companies constituted a so-called top account, which was
placed in Bank of America. ConocoPhillips Norway was consistently in a net deposit
position. Although ConocoPhillips Norway was able to document that an alternative
standalone relationship with an external bank would have yielded a lower interest
income on the Norwegian companies deposits, the Court of Appeals ruled that in an
arms-length setup, an independent party in ConocoPhillips Norways (net deposit)
position would have received a larger part of the overall beneft of the cash pool
arrangement. As a result, a higher interest rate was applied to ConocoPhillips Norways
net deposits for tax purposes, increasing the companies taxable interest income to
Norway. A key element in the appellate courts decision is the theoretical maxim that
the arms-length test shall be conducted by comparing the actual transaction to an
otherwise identical transaction in which one imagines that there is no community of
interest. The decision is controversial, especially because as ConocoPhillips Norway
unsuccessfully argued such cash pool arrangements are never entered into by
Norway
independent parties. The validity of the Oil Taxation Authorities (and the Courts)
arms-length test is, therefore, questionable.
The authorities carry the burden of proving that there is due reason to believe that
income charged to tax in Norway has been reduced because of transfer pricing. They
must also demonstrate that such transactions took place with a related party.
Once the authorities have discharged this burden, if the related party is resident
outside the EEA, Section 13-1 of the GTA assumes that the relationship is the
reason for the income reduction and puts the onus of proving otherwise onto the
taxpayer. However, a key Supreme Court case (Baker Hughes 1999) makes the
followingstatement:
Use of the GTA Section 54 (now GTA Section 13-1) will under any circumstances
require that it is more likely than not that the income has been reduced.
In Dowell Schlumberger, a 1995 Supreme Court case, the question of the obligation
placed on taxpayers to
cooperate with the authorities was tested. The case concerned deductions due in
respect of payments to a related (captive) insurance company resident outside Norway.
The authorities argued that they required access to accounts and other information
concerning the offshore company relevant to the question of whether it actually carried
on the business of insurance. As the company had not provided such information
and therefore had not substantiated its tax deductions, the court ruled that no tax
deduction was allowed for insurance premiums paid. The court rejected claims that
the information requested amounted to business secrets and, therefore, ought not to
bedisclosed.
Companies or groups might be selected for transfer pricing audit in several ways, and
there is no specifc guidance on how to select companies for an audit. An audit might
be of a general nature such as an audit of the company as such (i.e. a combination of
various tax issues), or the tax authorities might audit specifc issues/areas.
the taxauthorities
Under the Tax Assessment Act, the tax authorities have extensive powers to collect
information relevant to settling the tax liabilities to Norway as well as to the level of
income subject to Norwegian taxation. The authorities may request any information
they believe to be relevant to the point in question, including information on the
proftability and functions of all parties in a value chain.
There is also a general obligation on taxpayers to substantiate their tax position and
to cooperate with the authorities in the provision of information relevant to deciding
their tax liabilities.
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If the taxpayer does not submit the requested information or does not cooperate in the
provision of information, as in the Supreme Court case of Dowell Schlumberger (see
Section 5405), the tax authorities may base an assessment on the available facts.
Investigations are conducted using correspondence, interviews and site visits, as
appropriate. Once the investigation has been undertaken, the authorities complete a
report that indicates any areas in which they disagree with the taxpayer. They then
make proposals for a revised assessment. The taxpayer responds to this report in
writing, rejecting any arguments or conclusions of the authorities with which she/he
disagrees. Any supporting documentation is included in this response. The authorities
then review the position in the light of the taxpayers response and notify the taxpayer
of their decision.
Audit period
The tax authorities may go back 10 years but usually the audit period is three years.
However, if correct and suffcient information has been provided in the tax return, the
tax authorities may only change the assessment in disfavour of the taxpayer for the two
previous years.
If the taxpayer disagrees with the decision of the tax authorities, she/he may appeal
to the appropriate Tax Appeal Board. For companies taxed by the Oil Taxation
Authorities, there is a special appellate board for petroleum tax.
If the taxpayer disagrees with the appellate boards decision, she/he may take the case
to court. Norway has three levels of courts (city/district court, Court of Appeals, and
Supreme Court) but no specialised tax court.
Norway uses an additional tax (penalty tax), which may be charged administratively
under the Tax Assessment Act. The standard rate is 30% (rates of 45% or 60% may be
used) of any tax not levied as a consequence of errors made by the taxpayer. Penalty
tax is generally not used where the tax issue arises from different interpretations of
laws and regulations. However, in situations where the taxpayer is or should be aware
that the tax situation is uncertain, suffcient information about the transaction should
be fled as a part of the tax return in order to avoid use of penalty tax. Ordinary interest
for late payment of tax also will be charged. Penalty tax is not tax-deductible. Basically,
penalty tax is levied on a strict objective basis.
The Norwegian tax authorities are divided into fve regions (North, East, South, West
and Mid-Norway), which include several local tax offces. In addition, there are three
central tax offces: the Central Tax Offce Foreign Tax Affairs (part of Tax West), the
Central Tax Offce for Larger Enterprises (part of Tax East), and the Oil Taxation Offce.
There is also the Tax Directorate, which is a central tax authority.
Norway
The central tax offces have a high level of competence and resources, and often
pursue aggressive positions in transfer pricing cases. The local tax authorities often
have limited resources and are usually not in a position to handle an extensive transfer
pricing investigation. However, on a regional basis, the resources are considerably
larger, and in addition, the Tax Directorate often investigates transfer pricing issues
and supports/assists the local tax authorities.
It is worth noting that the resources targeted at transfer pricing have increased
considerably and are likely to be increased further over the coming years. It also should
be noted that the tax authorities within the past few years have used a signifcant
amount of resources in developing various IT solutions. As a result, it is easier for the
tax authorities to extract relevant information and also to follow up more closely with
respect to transfer pricing issues.
Use
Where the taxpayer is involved in the offshore oil industry, Norway has specifc
legislation that deals with the pricing of petroleum (Petroleum Tax Act) for tax
purposes, as noted above (see Section 5403).
In respect of all other commodities and services, the brief provisions of Section 13-1 of
the GTA lay down the arms-length principle and its application. There is no legislation
or guidance as to the appropriate methodology for establishing arms-length pricing,
but as Norway is a signatory to the OECD Guidelines, the methodologies laid out
therein generally would be regarded as supporting the (limited) statutory law in the
transfer pricing area. Therefore, to the extent that comparable information may be
used within the terms of the guidelines, it may also be used in Norway.
Availability
Basically, the published annual accounts of companies are the only information
available in Norway about the businesses of third parties. For some business sectors,
statistical data concerning gross profts is also published, but this is not detailed to
the degree of discussing individual companies. Some tax offces also issue a yearly
overview of the tax assessment on an anonymous basis.
A potential problem in this area is the fact that the tax authorities may compare data/
pricing used by other taxpayers, without being able to give any detailed information
regarding the data the taxpayer is compared against (hidden comparables). Thus, in
such situations a taxpayer may fnd it diffcult to prepare an appropriate defence.
Benchmarking
Norwegian tax authorities traditionally have been sceptical towards benchmark studies
in general. Although this attitude is changing in view of the fact that such studies and
the TNMM are widely used globally, Norwegian tax authorities continue to demand
high levels of comparability in order to attribute real signifcance to benchmark
studies. For example, a benchmark study based on database searches (e.g. AMADEUS)
and comparatively high-level analyses the kind of analyses typically provided in
support of a taxpayers transfer prices will not be awarded much signifcance unless
the comparables include Nordic (or at least Northern European) companies, and
a more detailed (manual) study of their actual comparability has been performed
anddocumented.
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The transfer pricing focus in Norway primarily has been on the fnancing of business
operations (thin capitalisation and interest-free loans to foreign-related companies)
and on intragroup service arrangements. This is rapidly changing, however, as
distribution, agency and commission arrangements frequently are being subjected to
the Norwegian tax authorities scrutiny. In addition, it is worth pointing out that the
Norwegian tax authorities auditing of thin capitalisation and classifcation of capital is
becoming more sophisticated: current tax audits and recent court cases show that the
tax authorities will study the capital structure of Norwegian companies in considerable
detail in order to test whether it is arms length.
In two recent cases, the Tandberg case (District Court March 2009) and Dynea case
(Appeal Court June 2009), Norwegian tax authorities aggressively pursued their
claim that inter-company share prices were not arms length, and in a third, the
Telecomputing case (Appeal Court October 2009), they similarly challenged the
calculation of loss on an inter-company receivable. Although the taxpayer prevailed in
all of these cases, the fact that they were tried before the courts is a strong indication
of Norwegian tax authorities general aggressiveness on transfer pricing and their
willingness to go to trial in transfer pricing cases.
For oil companies captive insurance remains a signifcant issue. Several captive
insurance cases are still in the court system, and while some of them have already
been decided by the Supreme Court, others will probably follow. Inter-company and
intragroup leasing arrangements also seem to be a focus area for the Central Tax Offce
Foreign Tax Affairs.
Generally, in order to hinder or limit double taxation, the GTA provides for a tax
credit system for direct and indirect foreign taxes paid by a Norwegian taxpayer or its
subsidiaries. Tax treaties signed post-1992 generally are based on the credit method.
Older tax treaties typically are based on the exemption method.
Double taxation arising due to a transfer pricing issue often will have to be handled
through a competent authority process. The competent authority in Norway is the
Ministry of Finance. The authority for specifc cases is, however, delegated to the
TaxDirectorate.
As of yet, there are no general formal APA procedures enacted in Norwegian
legislation. There is one specifc exception, however: Transactions involving the sale of
gas may be covered by APAs in accordance with the Petroleum Tax Act Section 6 (5).
A general system of binding advance rulings has been introduced, but issues with
respect to transfer pricing will not be handled.
It is, however, possible to obtain an informal statement from the tax authorities
regarding the tax consequences of future transactions, and this procedure has been
used in relation to both domestic and Nordic situations.
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5415. Documentation requirements
After the relatively recent changes in the Tax Assessment Act Section 4-12, with
corresponding regulations, the qualifying taxpayers are obligated to fle a high-level
statement on the type and extent of all inter-company transactions and outstanding
accounts in a standardised form. The form is to be submitted together with the tax
return. Taxpayers who own or control at least 50% of another entity or are at least
50% owned or controlled by another entity are obligated to fle the form unless their
total inter-company transactions amount to less than NOK 10 million and the total
outstanding accounts amount to less than NOK 25 million.
The tax authorities also may request the taxpayer to present transfer pricing
documentation. The documentation shall provide suffcient basis for the tax
authorities assessment of whether the Norwegian taxpayers inter-company
transactions are in accordance with the arms-length principle. The transfer pricing
documentation must be presented to the tax authorities within 45 days after the
request. Taxpayers subject to fle the high-level statement will also be subject to the
transfer pricing documentation requirements, unless on a consolidated basis they have
fewer than 250 employees, and either a turnover of less than NOK400 million or a
total balance of less than NOK350 million (excluding inter-company turnover/balance
items). Taxpayers subject to a special tax under the Petroleum Tax Act or that are
involved in transactions with jurisdictions with which Norway does not have a double
tax treaty will be subject to the documentation requirement regardless of the number
of employees or the consolidated turnover or balance level.
All inter-company transactions shall be addressed in both the high-level statement
and the transfer pricing documentation. It should be noted that transactions between
Norwegian entities are also to be covered by the high-level statement and are subject
to the documentation requirements. In addition, transactions between a Norwegian PE
and its foreign head offce shall be covered, as shall transactions between a Norwegian
head offce and its PE abroad.
If a Norwegian taxpayer fails to submit the high-level statement and/or the more
extensive documentation in accordance with the regulations, then the appropriate tax
may be estimated by the tax authorities. Breach of the regulations covering the high-
level statements and documentation may cause the taxpayer to be cut off from making
an appeal and from presenting additional information during a subsequent court case.
Until relatively recently, the tax and customs authorities have not cooperated closely
in transfer pricing investigations. In the past couple of years, however, this has been
changing, and the exchange of information is now quite common. While transfer
pricing adjustments agreed for corporation tax purposes normally would not be
refected in the returns for customs duty or VAT purposes, there is a high risk that
information exchanged between the different authorities might lead to further
investigation and adjustments.
N
5417. OECD issues
Norway is a member of the OECD and has approved the OECD Guidelines.
Traditionally, Norwegian tax authorities have seemingly had a preference for the cost
plus method in transfer pricing issues. It has, therefore, often proved diffcult to get
full acceptance for other methods such as the proft split or the transaction net margin
method (TNMM). However, the tax authorities currently seem to be developing a more
varied approach, and lately have signalled that they are getting more favourable to
the proft split method. In any case, the imminent changes to the OECD Guidelines as
far as the transfer pricing method preferences are concerned will be of considerable
importance in Norwegian tax law.
After recent changes to the GTA Section 13-1 there is now a formal reference to the
OECD Guidelines. According to the GTA section 13-1 (4) the OECD Guidelines shall be
taken into account when addressing transfer pricing issues under Norwegian law.
It should also be noted that Norwegian tax authorities, despite the negative result in
the Trinc and Trag case as referred above, may try to claim tax liability for a foreign
enterprise on the basis that they have a common business enterprise in Norway with
a subsidiary (joint activity permanent establishment). This may particularly be the
situation when there is a very close connection between the fnancial result of the
foreign company and its Norwegian affliate with respect to the Norwegian operation.
Norway has already been involved in joint transfer pricing investigations with other
Nordic countries, and there is nothing to prevent Norway from undertaking joint
investigations with the authorities of any other country.
Formerly, specifc legislation for companies engaged in the exploitation of petroleum
resources on the Norwegian Continental Shelf provided for a debt to equity ratio of 4:1,
based on the balance sheet in the fnancial statements. This legislation was repealed
effective 1 January 2007.
Hence, Norway currently has no statutory rules on thin capitalisation. Thin
capitalisation issues are decided based on the general arms-length standard in the GTA
Section 13-1. The equity level is subject to a specifc evaluation, and therefore, the 20%
equity level formerly applying to petroleum companies cannot be considered as a safe
harbour. In a relatively recent decision (2004) the court of appeals agreed with the tax
authorities that the Norwegian taxpayer (Scribona) was thinly capitalised. When the
tax authorities computed how much of the interest deduction should be denied, they
based their computation on an equity ratio of 15% of the total capital in the company.
In addition, the court confrmed the general view that a thin capitalisation evaluation
has to be based on several elements and that the crucial question is whether an
independent lender (normally a bank) would have been willing to fnance the taxpayer
under the current circumstances.
Norway
There are several interesting court decisions regarding debt/equity levels for
foreign subsidiaries of a Norwegian parent company, even if this is not a direct
thin capitalisation issue. The debt/equity level will have to be decided based on a
discretionary judgment, where all relevant factors are taken into account (e.g. current
and expected cash fow, type of business, contract situation, level of interest bearing
debt, interest coverage, etc.). It should also be noted that the Norwegian Company Act
has certain requirements regarding the equity level of a company, even if this has no
direct relevance for tax.
Peru
55.
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Peru
5501. Introduction
In January 2001, the Peruvian income tax law (PITL) introduced transfer pricing rules
governing transactions between related parties (domestic and international), as well
as transactions with entities operating in tax havens
1
. These rules are applicable for
transactions with all kinds of goods and services.
The rules governing Peruvian transfer pricing are set forth in Articles 32 and 32(A)
of the PITL as amended in 2003, and Chapter XIX of the regulations, published in
December 2005 and effective as of January 2006. Penalties are established in the
Peruvian Tax Code. Article 32 of the PITL establishes the arms-length principle. In
addition, the PITL sets forth the obligation for qualifying taxpayers, which includes
annually fling an informative return describing transactions carried out with related
parties or parties resident in low-tax jurisdictions (tax havens); preparing a transfer
pricing study; and keeping supporting documentation.
The PITL establishes that all transfers of goods and services must be carried out at fair
market value. According with the PITL, fair market value is the price that is normally
obtained by the same entity when engaging in transactions with nonrelated parties
under the same or similar conditions. If such comparable transactions (internal
comparables) are not available, then the fair market value will be established by
reference to prices agreed upon between two unrelated parties for the same or
similartransactions.
Scope of application
According to the PITL, the transfer pricing rules must be applied when the transfer
price used has led to a lower income tax payment than what would have been
determined if market value were used
2
. In any case, the rules must be applied in the
following cases:
One of the parties is a resident of a foreign jurisdiction;
The company has performed transactions with parties resident in tax havens;
1
The Tax Authority published Inform No. 178-2009-SUNAT/2B0000, which establishes that when a company pays to a
third party through a tax haven (the account is located in the tax haven), even when the third party is not located there, the
situation falls within the scope of numeral 4 Article 32 of the PITL, which states that all inter-company transactions that are
carried with, from, towards and through a tax haven must be analysed.
2
Regulation also claries that tax detrimental occurs, not only when the taxpayer avoids totally or partially the tax, but also
when the taxpayer achieves the deferral of the tax from one period to another.
International Transfer Pricing 2011 Peru 633
Peru
The intervening parties are domestic, and one of them is either an exempt taxpayer
(with the exception of the public sector); is subject to a benefcial tax treatment
such as an exoneration from income tax; is subject to a special income tax regime
(like that for entities in the jungle region); or has in force a contract that guarantees
fscal stability; and
The intervening parties are domestic entities, and at least one of the parties has had
tax losses in one of the past six fscal years.
The transfer pricing rules also must be applied to the value added tax (VAT) and the
selective consumption (excise) taxes, except when the adjustment would determine
an increase in refundable VAT. Transfer pricing rules are not applicable for customs
valuation, where World Trade Organisation regulations apply.
Related parties
Two or more individuals, companies, or entities are considered related if one of them
participates directly or indirectly in the administration, control, or capital of the
other; or if the same person or group of persons participate directly or indirectly in the
administration, control or capital of various person, companies or entities.
In addition, there shall be a relationship if the transaction is carried out using
third-party intermediaries whose sole purpose is to hide a transaction between
relatedparties.
The PITL regulations specify, amongst others, the following forms of
economicrelationship:
A natural person or company owns more than 30% of the capital of another
company directly or indirectly through a third person;
More than 30% of the capital of two or more companies belongs to the same
natural person or company, directly or through a third person;
Companies that have one or more directors or managers in common with decision-
making power;
When a person, company, or other entity domiciled in the country performs in the
fscal year previous to the one under analysis, 80% of its sales of goods or provision
of services to a person or company for whom those sales in turn represent 30% of
their purchases during the same period
3
;
When a person or a company has or exercises dominant infuence over the
management decisions of one or more companies or entities; and
When companies consolidate fnancial information.
Article 32A of the PITL states six transfer pricing methods. Regulations will establish
the criteria to determine the most appropriate transfer pricing method for each case.
The following methods are acceptable:
Cost plus (CP) method;
3
This fact has to be veried in the average of a three-year period.
Peru 634 www.pwc.com/internationaltp
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Residual proft split method (RPSM); and
In general terms, the application of the above-mentioned methods is governed by
doctrine and by the OECD Guidelines, which now have explicit legislative recognition
as source of interpretation in the body of the PITL. Regarding comparability, the PITL
4

establishes two general guidelines:
1. Two transactions are comparable as long as none of the differences existing
between the transactions compared or between the characteristics of the entities
involved may materially affect the price or free market margin.
2. Two transactions may be comparable even if (1) above is not met (i.e. the
conditions of the transactions compared are not similar or the same), as long as
adjustments can be made (and are made) to offset the effects of such differences.
Informative return
Beginning fscal year 2006, taxpayers are required to render a TP Informative Return
Form if they have carried out transactions with related parties for a value of at least
PEN 200,000
5
(approximately USD70,200). By value the law means the sum of the
income accrued during the fscal year and to the acquisition of goods and/or services
made during the fscal year without distinction or netting between positive and
negative values, as long as these derive from transactions with related parties. The
return has to be fled also by a taxpayer if it has performed a transaction with parties
resident in tax havens without exception. The TP Informative Return Form must be
fled every year on a date set each year by the tax authority (TA) through the issue of a
resolution. Since 2006, the date has fuctuated from July to December.
Transfer pricing study
Early in 2001, transfer pricing regulations were passed under the PITL. The regulations
established the obligation for taxpayers to keep documentation and information
regarding the methods used to determine their transfer prices with related entities. The
documentation must emphasise the criteria used to establish transfer prices and any
other objective elements relevant to a transaction. A similar obligation was established
for taxpayers in connection with their transactions with entities resident in tax havens.
In addition to the TP Informative Return, beginning fscal year 2006 the taxpayer is
obliged to have a transfer pricing study if it has performed transactions with parties
resident in tax havens
6
or if it has transactions with foreign and local related parties for
a value greater than PEN1 million (approximately USD350,900
7
) and if the revenue
accrued from the taxpayer exceeds PEN6 million (approximately USD2.110 million).
However, in cases where a transfer pricing study is not required, the taxpayer must
have information and documentation that prove that transactions with local related
parties were conducted at an arms-length value.
4
Notice that there is a sort of order of preference for method selection that establishes in the rst place the comparison of
prices, followed by the comparison of gross margins and nally the comparison of operating margins.
5
When calculating, all inter-company loans that accrued an interest rate of zero must not be taken into consideration.
However, if all other inter-company transactions exceed the amount set by the TA, the inter-company loans must be
informed and documented.
6
The taxpayer must take into consideration that all expenses accrued with a tax haven that are not recognised in the cost
of goods sold must be included in the taxable income. Even though its contradictory, all expenses must be informed and
analysed for transfer pricing matters.
7
For the determination of the value, transactions with related parties domiciled in the country must NOT be taken
into account.
Peru
According to the PITL, the transfer pricing regulations are applicable for the income
tax, VAT, and special consumption selective taxes, and they will not be applicable to
custom duties.
Regulations state that the administration may adjust the price of goods and services
transferred if those prices, for VAT purposes, are not considered reliable. The word
reliable price has been defned by regulations as the usual market value for the
transfer of other similar goods or services in similar conditions.
The PITL makes expressed reference to the possibility of entering into advance pricing
agreements. Chapter XIX of the PITL regulations sets forth APA procedures and
characteristics. According with the aforementioned regulations, the APA objectives
are: to set price, amount of compensation, proft margin, and the transfer pricing
methodology supporting the values the taxpayer will use in future operations with
related parties or with entities operating in tax havens. The APAs cannot be modifed
or unilaterally terminated, except when any of the related parties involved in the APA
has been condemned by court for tax or customs crimes or if the terms of the APAs are
notmet.
Under the procedure, the taxpayer proposes the transfer pricing method (TPM), the
comparable transactions or enterprises, and the supporting data, including years
analysed, adjustments made to the selected comparables, the exact price or range
of prices, amount of compensation or proft margin; also the hypothesis used for
theproposal.
After reviewing the proposal, the administration may approve it, approve an
alternative version, or reject it. The administration will have a 12-month period to
review the proposal. If after this period it has not issued a response, the proposal is
automatically considered rejected.
The APAs will be applicable to the fscal year during which it was approved and the
three subsequent years.
The burden of proof lies with the taxpayer. However, a challenge by the TA would
require some supporting evidence to be accepted by the tax courts (TC). It is expected
that regulations to the recently passed legislation will shift the burden of proof to the
authorities if it has an APA and if proper transfer pricing documentation exists.
If a company has been selected for audit, the TA grants several days notice of the
impending audit to the company, requesting that all information be ready for its
review. During the audit the taxpayer may informally clarify issues, produce evidence
to support facts and discuss tax issues with the auditors. After the audit, the TA may
or may not issue an assessment. If it does, the taxpayer may fle an appeal if it does not
P
agree with the assessment. If transfer pricing documentation was requested during
the audit and was not provided, the documentation may not be presented during an
appeal, unless the full amount of taxes assessed is either paid in advance or the debt is
bonded. The attitude of the Peruvian TA generally is considered aggressive, although,
so far, it is only beginning to focus on transfer pricing issues. No settlements are
possible in the course of the audit or later. As of 2009, there have been audits specifc
to transfer pricing, but we are not familiar with the outcome of the procedures.
It must be taken into consideration that the TA has used information submitted to
customs related to the prices of the goods in order to calculate differences in the
taxable income.
Additional tax and penalties
Each transfer pricing violation is penalised, based on the Tributary Tax Unit,
called Unidad Impositiva Tributaria (UIT). For 2010, one UIT is PEN3,600
(approximately USD1,270). The following constitute violations of the related transfer
pricingobligation:
Not keeping the documentation and information, reports, and analysis related to
the operations that could create tax obligations during the period of time of the
obligation will result in a penalty of 0.3% of the net income; it may not be less than
10% of a UIT or greater than 12 UITs;
Not providing the TP informative return according with the deadline set by the law
will result in a penalty of 0.6% of the net income; it may not be less than 10% of a
UIT or greater than 25 UITs;
Not exhibiting or presenting the documentation and information that supports the
calculation of transfer prices according to law will result in a penalty of 0.6% of the
net income; it may not be less than 10% of a UIT or greater than 25 UITs;
Not counting with the documentation and information that supports the
calculation of transfer prices according to law will result in a penalty of 0.5% of the
net income. (When the penalty is calculated over the annual net income it may not
be less than 10% of a UIT or greater than 25 UITs.); and
Any adjustments to transfer prices as a result of information omitted in tax returns
will automatically trigger a penalty equivalent to 50% of the taxes imposed on
theadjustment.
In case a company has several transactions with a related party, the TA must take into
account all the transactions made between the companies and not limit its analysis to
only transactions made beneath market value.
8
5507. Legal cases
Through the end of 2009 there were no court cases dealing specifcally with the
new transfer pricing provisions. However, in several cases the TA has challenged
the price used between related and unrelated parties in their transactions based on
thislegislation.
The following are some of the most important TC rulings regarding the prices
fortransactions:
8
According to Inform No. 208.2007-SUNAT/2B0000, published by the TA.
Peru
In the case of Lamitemp SA (a company specialising in the sale of glass), the TA
considered there was an undervaluation of sales in two of the companys business lines
due to the fact that the cost of sales for some months was above the sales value and
because there were discounts of 40% granted to a single client. The TC decided that
market value does not necessarily have to be above the cost, a situation that can derive
from technological factors, higher fnancial costs in comparison with other companies,
and access to market of raw materials, amongst others. Thus, what should have been
done is to prove that market value was above that considered by the company. Finally,
in order to deny the discounts granted, the TC stated that the TA should have verifed
that these were not granted to other clients, that it was not a usual practice or that they
did not correspond to the volume of items bought or payment conditions. Therefore, it
cannot be argued that the discounts do not comply with current legislation.
In a case against Aceros Arequipa SA (a company dedicated to the smelting and
commercialisation of steel), the TC confrmed the adjustment made to discounts
granted to clients for achieving certain volume goals. The TC stated that for such
discounts to be valid, they must be offered to clients complying with certain criteria
(general principle) and should be granted uniformly. However, the company did not
grant the discounts to certain clients that did meet their criteria but did grant them to
other clients that did not. Thus, the deduction of all discounts was denied.
The Peruvian TA, based on a valuation report found during the audit process,
pointed out that the company Hotel Macchu Picchu SA had undervalued the sales
price agreed for the transfer of the right to use the hotel unit, which included assets
and/or furniture. The company argued that the transfer value used corresponded
to the valuation report with a minimum reduction of 1.1564%. The TC considered
that the company should have used the value set forth in the valuation report with
noadjustments.
In a case against a company dedicated to the renting of helicopters, the TA challenged
the comparables selected in the transfer pricing study. The TC is still evaluating
thecase.
Finally, the TA considered that a trader of commodities should take as market value, for
its transaction with related entities, an average value for a period of time and not the
value for a specifc date. The TC is also still evaluating the case.
5508. Resources available to the TA
There are special units being trained within the Peruvian TA in order to deal
specifcally with transfer pricing issues. At present, transfer pricing issues are being
dealt with by the Peruvian tax inspectors mainly during the course of a general tax
audit and at a smaller and more incipient level by the transfer pricing unit. At the
beginning of fscal year 2010, the transfer pricing unit sent out several information
requests to a substantial number of companies.
Neither the law nor the regulations have established criteria as to which are the
acceptable sources for comparable information. According to the Tax Code, the TA
could use third-party confdential information; however, the Peruvian Tax Court in its
P
resolution N02649-5-2006 indicated that in case a company has internal comparables
the TA should consider them as a source of information.
If the TA uses third-party information, the taxpayer has limited access to this data
through only two nominated representatives. Nevertheless, it is understood that the
authorities should only use publicly available information; otherwise, constitutional
rights to due procedure and defence could be violated. Due to the limited amount of
local public information on comparable transactions, the use of foreign comparable
transactions is acceptable; in this case, necessary adjustments should be made. Article
32 of the PITL explicitly establishes that in order to determine comparable transactions
and, in the event that there is no locally available information, taxpayers are allowed to
use foreign companies information, provided that the necessary adjustments are made
to refect market differences. Said provision puts an end to the problem of having very
little information available in countries where the fnancial market is underdeveloped,
and, therefore, the access to public fnancial information of companies is very limited.
Furthermore, specifc information on local industries can be obtained from a
number of industry associations, such as the Sociedad Nacional de Industrias for
the manufacturing industry, Sociedad Nacional de Minera, Petrleo y Energa for
the energy, mining and oil industry, Asociacin de Exportadores for the exports
trade, the Superintendencia Nacional de Bancos y Seguros for the banking industry,
Asociacin Nacional de Laboratorios Farmacuticos for the pharmaceutical
industry, Cmara Peruana de la Construccin for the construction industry, and the
Confederacin Nacional de Comerciantes for the trade industry, amongst others.
Membership of these organisations might be required to obtain information. A second
possibility for obtaining local comparable information is through the Comisin
Nacional de Supervisora de Empresas y Valores, the agency of National Supervisory
Commission for Business and Securities where publicly traded companies fle their
fnancialstatements.
There are no transactions or industries excluded from the transfer pricing regulations
as set out above.
5511. OECD issues
Even though Peru is not a member of the OECD, the OECD Guidelines are used to
interpret transfer pricing regulations.
There is no evidence of any joint investigations having taken place in Peru. However,
the Peruvian TA may exchange information with other countries for transfer pricing
purposes. For example, Peru has a treaty with the US, which provides for the exchange
of information.
Philippines
56.
International Transfer Pricing 2011 639 Philippines
5601. Introduction
The Philippines statutory transfer pricing rule is patterned after what is now Section
482 of the US Tax Code. It was codifed in 1939 and has remained unchanged
since. Court decisions have also confrmed that the US Section 482 transfer pricing
regulations can be used for guidance when applying the Philippine transfer pricing
rules; in practice, the Philippine Bureau of Internal Revenue (BIR) also relies heavily
on the OECD Guidelines.
Since 2005, the BIR has begun challenging the transfer pricing arrangements of some
taxpayers. These challenges arise mostly from ad hoc examinations during a regular
tax audit. BIR auditors are gaining sophistication in this area, and have, in fact, made
signifcant transfer pricing tax assessments, although this could also be based on a
misappreciation of issues. Because of these developments and the imminent issuance
of more comprehensive transfer pricing revenue regulations, companies are advised
to pay close attention to transfer pricing arrangements when doing business in
thePhilippines.
The statutory rule on transfer pricing is found in Section 50 of the National Internal
Revenue Code (NIRC). The rule has remained essentially unchanged since 1939,
when it was patterned after the transfer pricing rule in the US Revenue Act of 1934.
Section 50 allows the BIR to allocate income and deductions between related parties
as a means to prevent tax evasion or clearly refect the amount of income earned by
eachparty.
The only formal regulations for transfer pricing are found in Section 179 of Revenue
Regulations No. 2, issued in 1940. These regulations were drawn directly from
Article 45 of US Regulation 86, issued in 1935, and detailed the scope and purpose
of the transfer pricing rule to place a controlled taxpayer on a tax parity with an
uncontrolled taxpayer by determining, according to the standard of an uncontrolled
taxpayer, the true net income from the property and business of a controlled taxpayer.
More recently, the BIR has issued Revenue Audit Memorandum Order (RAMO) No.
1-98 and Revenue Memorandum Order (RMO) No. 63-99. The former, issued in
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Philippines 640 www.pwc.com/internationaltp
1998, provides audit guidelines and procedures for examining interrelated groups of
companies and endorses the use of the OECD Guidelines. The latter, issued in 1999,
deals with intragroup loans and broadly follows the US Section 482 regulations. Both
documents are less authoritative than regulations, but they do reinforce the general
theme that Philippine transfer pricing rules should be applied in accordance with the
arms-length principle as it is applied internationally.
The government plans to issue more detailed transfer pricing regulations soon. In fact,
the BIR has fnalised its draft of proposed new regulations, which are awaiting fnal
approval of the Secretary of Finance to become effective. In the meantime, the BIR
issued in March 2008 Revenue Memorandum Circular (RMC) No. 026-08, wherein
it formally adopted the OECD Guidelines in resolving transfer pricing issues and
concerns, pending issuance of the transfer pricing regulations.
5604. Legal cases
The broad doctrine followed in the Philippines is that when Philippine law has
been sourced from an equivalent provision in the US Tax Code, the decisions of
American courts construing the US Tax Code are entitled to signifcant weight in the
interpretation of Philippine tax laws.
In two Philippine cases relating to transfer pricing, the Court of Tax Appeals (CTA)
has taken the doctrine further and allowed the Section 482 regulations to have
persuasiveeffect.
In Cyanamid (1995, affrmed by the Court of Appeals (CA) in 1999), the CTA held that
the BIR had acted in an arbitrary, unreasonable and capricious manner when it made
no apparent attempt to verify the comparability of pharmaceutical products being
compared under a comparable uncontrolled price (CUP) method analysis.
In Filinvest (2002), the CTA upheld the imputation of interest by the BIR on an
interest-free loan. The CTA also required the BIR to allow correlative relief by way of an
interest deduction, based on Section 1.482-(1)(g) of the US regulations. Upon appeal,
the CA reversed this decision, however, citing that the imputation of interest rule does
not apply to alleged indebtedness which was in fact a contribution of capital; the CA
appreciated the loan/advances made in the case to be capital contributions.
The same issue on imputation of interest was presented in the Belle Corporation case
(2005) where the CTA ruled in favour of the petitioner company, deciding that RMO
63-99 was inapplicable on the facts of the case.
Two other cases decided by the CTA in early 2005, Avon Products and ING Barings
Securities, validated the notion that the initial burden to prove that the inter-company
pricing complies with the arms-length principle lies with the taxpayer. However,
once the initial burden is complied with, the onus shifts, and the revenue authority
is supposed to prove that its basis for questioning the taxpayers policy has suffcient
support. Accordingly, in these two cases, the courts ruled in favour of the taxpayers
after the BIR failed to produce evidence to refute oral explanations by the taxpayers
during the trial proceedings.
International Transfer Pricing 2011 Philippines 641
Philippines
The BIR has fnalised a comprehensive Transfer Pricing Revenue Regulations (TPRR)
that seeks to consolidate and expand the existing RAMO 1-98 and RMO 63-99. The
provisions in the draft TPRR were heavily lifted from the US TP regulations and
OECDGuidelines.
The draft TPRR includes a reiteration of the BIR Commissioners authority to look
at transfer pricing, as well as the bureaus adoption of the arms-length standard in
determining the true taxable income of a controlled taxpayer.
The draft TPRR also provides for fve methodologies in determining the arms-
length price. The fve methods are all accepted internationally. In broad terms,
these methods can be grouped into two categories: one is the traditional transaction
method consisting of (1) the comparable uncontrolled price (CUP) method, (2) the
resale price method, and (3) the cost plus method; and the second category is the
transactional proft methods involving (4) proft split method and (5) transactional net
marginmethod.
The application of each method depends on the transaction and the circumstances
involved; the draft TPRR contains illustrations to show the interplay of the different
methods. No hierarchy of methods is provided in the draft regulations, but they do
indicate that the method requiring the fewest adjustments and providing the most
reliable measure of the arms-length result is the preferred method.
The regulations also provide more details on the general rules that apply with respect
to specifc situations, such as loans or advances, performance of service for another,
use and sale of tangible property, and transfer or use of intangible property. In all these
cases, the concept of comparability, determination of the appropriate transfer pricing
method, and the arms-length principle apply.
The draft regulations provide guidelines for the preparation of documentation to
support the transfer price adopted. The BIR requires fairly extensive documentation,
including functional and economic analyses of the taxpayers business and results, as
well as benchmarking. When the BIR requests transfer pricing documents, the taxpayer
must submit them within 45 days of the request.
Although the TPRR still needs to be signed by the Secretary of Finance to become
effective, the BIR has already started challenging taxpayers using the provisions of the
TPRR. Assessments made to date run into hundreds of millions of pesos, and there is
reason to believe that this BIR challenge will continue. Also, indications show that the
BIR is conducting structured training for its personnel.
The BIR, in July 2009 and in March 2010, issued RMO No. 23-2009 and RMC No.
36-2010, respectively, wherein it specifcally mandated the audit and investigation
of certain taxpayers, including companies that are interrelated or that form part of a
conglomerate. In this regard, special audit teams under the Large Taxpayers Services
and Enforcement Division of the BIR will be created and assigned to conduct a
simultaneous, joint and coordinated audit and examination of the books of accounts of
the identifed taxpayers to ensure that these taxpayers are clearly refecting income and
expenses attributable to inter-company transactions.
P
As a general rule, taxpayers should be prepared to justify their transactions to the BIR.
The NIRC affords the commissioner fairly strong assessment and collection powers.
However, the burden of proof shifts to the BIR once the taxpayer is able to demonstrate
that its pricing complies with the arms-length principle, as the 2005 cases of Avon
Products and ING Barings Securities demonstrate.
To date, transfer pricing has been raised as an issue only in the context of regular
audits by the BIR. A framework does exist, however, for issue-oriented audits to
beundertaken.
Based on the informal indications that the BIR is training its people the executives
and offcers have been confrmed to have received training from abroad and internally
and the likelihood that regulations will be issued, it seems reasonable to expect
transfer-pricing-specifc audits to occur in the future.
5608. The audit procedures
The tax examination process starts with the issuance of a Letter of Authority (LOA) by
the BIR. This authorises a named revenue examiner to gather documents and fnancial
information from the taxpayer, such as books of accounts and other accounting
records, for the purpose of determining whether the taxpayer is liable for a defciency
tax assessment.
Upon discovery of defciency tax, the revenue examiner is required to prepare a
report stating whether the taxpayer agrees with the fndings. If the taxpayer does not
agree with the examiners fndings, the BIR communicates the examiners fndings
to the taxpayer in writing and offers the taxpayer the opportunity to respond in an
informalconference.
If the taxpayer fails to respond within 15 days from receiving the notice from the BIR,
or engages in the informal conference but is unable to dissuade the revenue examiner
from the examination fndings, the case is referred to the Assessment Division of the
Revenue Regional Offce (ADRRO) or to the commissioner or the duly authorised
representative for appropriate review and issuance of a defciency assessment, if
warranted. If the ADRRO determines that suffcient basis exists to assess the taxpayer
for defciency tax, it issues a Preliminary Assessment Notice (PAN) which the taxpayer
must contest within 15 days from receipt. If the taxpayer does not contest the PAN, a
formal letter of demand and assessment notice is issued.
5609. Appeals procedures
Within 30 days from receipt of a formal demand and assessment notice, a taxpayer
must fle an administrative protest with the BIR in the form and manner prescribed
under regulations. Failure to fle the protest in the prescribed period renders the
assessment fnal, executory and demandable.
International Transfer Pricing 2011 Philippines 643
Philippines
The taxpayer then has 60 days from date of fling of the letter of protest to submit
all the required documents supporting the protest. Failure to do so results in the
assessment becoming fnal, executory and demandable.
If the protest is denied by the BIR, the taxpayer has 30 days from receiving advice
from the BIR to appeal the decision to the Court of Tax Appeals (CTA). Alternatively,
if the BIR fails to act on the taxpayers protest within 180 days from submission of
the documents supporting its protest, the taxpayer has the right to appeal to the
CTA within 30 days from the end of that 180-day period to expedite resolution of
theprotest.
An adverse decision by a CTA division may be appealed to the CTA en banc, and from
there to the Supreme Court.
The Philippines does not have specifc transfer pricing penalties, hence transfer pricing
adjustments are governed under the general penalty rules. A 25% surtax is generally
imposed on tax defciencies. Interest is imposed on the defciency tax (but not on the
surtax) at 20% per annum. A compromise penalty of up to PHP 50,000 is also imposed.
The BIR recently issued Revenue MC No. 10-2010 which outlines the agencys Strategy
Map for the year 2010. In its Assessment Enforcement Programme for the year,
benchmarking and profling and transfer pricing are considered signifcant areas or
projects in the bureaus strategies.
In addition, the BIRs computerisation programme is now producing positive results
in terms of catching tax evaders. The effciency of its system has, to date, generated
a signifcant amount of tax collections, and there are indications that the BIR will
leverage the system for its other revenue-generating efforts. However, whether it will
be used as an aid to challenge taxpayers transfer pricing policies and arrangements
remains to be seen.
5612. Risk transactions
The BIR has increased its challenges on the transfer pricing arrangements of
multinationals, and the areas of concern are varied. For example, whereas previously
the BIR would be content with brief explanations on payments for management
services, they now require further proof on the validity of these charges, sometimes
asking for additional documentation such as passport details of visiting foreign
employees and basis of the charges.
Arrangements that grant fnancing to an entity that does not provide for payment of
interest (or low rate of interest) are now attracting attention. Specifcally, inbound
fnancing is a concern. Many multinationals are benefting from tax incentives in the
Philippines, such as income tax holidays or a 5% tax regime. Because the tax rate
on any interest income imputed to a foreign entity exceeds the tax rate of Philippine
entities entitled to incentives, adjustments to low or no interest loans enable the BIR to
collect additional revenues.
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The provision of outbound services is now also attracting the BIRs attention.
Previously, a 5%10% markup on cost could be safe harbour. However, it is diffcult
nowadays to say that even a 10% markup is defensible, especially if the services
involved high-value-adding activities such as R&D, technical design, or knowledge
processing outsourcing services. Benchmarking therefore is key. What apparently
alerts the BIR is when they notice a sharp decline in proftability in certain companies
operations once they fnish their tax holiday, which is generally available for these
sunshine industries. Certainly, this is an area that the BIR will be looking into more
closely in the future.
The Philippines does not have statutory rules dealing with thin capitalisation, although
this does not prevent the tax authorities from attempting to recharacterise interest as
dividends. The TPRR also contains provisions on thin capitalisation, indicating that an
interest payment or accrued interest attributable to the excess debt shall be treated as
dividends and shall be taxed accordingly. If an entity is thinly capitalised, the interest
may probably be non-deductible.
The proposed rules in the TPRR provide for a threshold of three-to-one (3:1) ratio,
unless a different debt-to-equity ratio is prescribed by special laws or special provisions
of existing law. This 3:1 ratio does not apply to banks, fnancing companies and
nonbank fnancial intermediary performing quasi-banking functions.
The TPRR recognises that an APA could be useful in avoiding or resolving transfer
pricing disputes. APAs look to the future, in that the agreement involves setting an
appropriate set of criteria (e.g. methods, comparables and adjustments, and critical
assumptions) for the determination of the transfer pricing for the covered transactions
over a fxed period of time. The result is a stable transfer pricing environment for
the parties involved, so much so that a taxpayer can rest assured that its transfer
pricing arrangements will not be challenged by the BIR as long as it complies with the
parameters set.
APAs may also involve the agreement of more than one revenue authority and
taxpayer. The draft regulations provide details on how APAs may be initiated,
monitored and concluded.
No public evidence suggests that the BIR has been or is prepared to be involved in joint
investigations with the authorities of other jurisdictions, although a framework exists
under existing BIR issuances.
5616. OECD issues
The Philippines is not a member of the OECD. However, the BIR relies heavily on the
OECD Guidelines and treaty models with regard to international tax issues. In RMC
No. 026-2008, the BIR stated that as a matter of policy it subscribes to the OECD
Guidelines. Taxpayers, therefore, should feel confdent that they will be in better
standing if they follow the OECD Guidelines.
Poland
57.
International Transfer Pricing 2011 645 Poland
5701. Introduction
Poland has well-established transfer pricing regulations that apply to cross-border as
well as domestic transactions. These regulations draw heavily on the OECD Guidelines
(Poland has been a member of the OECD since 1996). The statutory thresholds for
the documentation requirements (introduced in 2001) are relatively low, and the
requirements apply to a wide range of transactions. Since 2007, legislation also
requires taxpayers to document the allocation of profts to permanent establishments.
On 1 May 2004, Poland joined the European Union. Poland, therefore, accepts the
EU Transfer Pricing Code of Conduct. Nonetheless, based on local regulations, the tax
authorities accept only documentation that is written in Polish and covers all items
required under local law.
In January 2006, Poland introduced APA legislation which, from 1 January 2007, also
applies to the allocation of profts to permanent establishments.
5702. Statutory rules, other guidelines
Methods for determination of the arms-length price
From 1 January 1997, Article 11 of the Corporate Income Tax (CIT) Law and Article
25 of the Personal Income Tax (PIT) Law, have presented the methodology for
determining arms-length prices by use of:
Comparable uncontrolled price (CUP);
Resale price; and
Reasonable margin (cost plus).
Where these methods cannot be applied, transactional-proft methods may be used.
However, the tax authorities prefer traditional transaction-based transfer pricing
methods when estimating income from given transactions.
In October 1997, the Ministry of Finance issued a regulatory decree on the methods
and procedures for determining taxable income by estimation of prices applied in
transactions between taxpayers. The decree was replaced in October 2009 by two
decrees on (1) the methods and procedures for determining taxable income by
estimation and (2) the methods and procedures of eliminating double taxation in case
of a transfer pricing adjustment (TP decrees). One decree concerns PIT law, while the
other concerns CIT law. However, for all intents and purposes, both decrees contain the
same rules and regulations.
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Poland 646 www.pwc.com/internationaltp
The new decrees introduced more detailed regulations with regard to comparability
and new provisions concerning the procedure of eliminating double taxation in case of
transfer pricing adjustments. The decrees also present in more detail the application of
the fve pricing methods in a manner similar to that outlined in the OECD Guidelines.
The decrees oblige the tax authorities to verify transfer prices using these methods.
Polish transfer pricing regulations apply to domestic and cross-border relationships.
However, the defnitions of these relationships differ.
A Polish and a foreign company are considered related if one of the following three
conditions is met:
A Polish taxpayer participates directly or indirectly in the management or control of
a company located abroad or holds a share in its capital;
A foreign resident participates directly or indirectly in the management or control
of a Polish taxpayer or holds a share in its capital; and
The same legal or natural person, at the same time, participates directly or
indirectly in the management or control of a Polish and a foreign entity or holds
shares in their capital.
Polish companies are considered related when one of the following conditions is met:
A domestic entity participates directly or indirectly in the management or control of
another domestic entity or holds a share in its capital;
The same legal or natural person participates, at the same time, directly or
indirectly, in the management or control of two domestic entities or holds a share in
their capital;
Relationships of a family nature, resulting from employment contracts or common
property, exist between (1) two domestic entities or (2) persons involved in their
management, control or supervision; and
The same person combines managerial, supervisory or controlling duties in
bothentities.
From 1 January 2001, the CIT law imposes compulsory documentation requirements
on taxpayers concluding transactions with related parties and for transactions
resulting in payments to entities located in tax havens. Entities are obliged to prepare
documentation comprising:
The determination of costs, including the form and terms of payment;
The method and manner of calculating the proft and determination of the
priceapplied;
The business strategy adopted;
Other factors if they infuenced the transaction; and
In the case of contracts relating to intangible products and services, determination
of the benefts.
The reporting thresholds are EUR 20,000 for transactions with entities located in tax
havens and EUR 30,000 EUR 100,000 (depending on the companys share capital and
the nature of the transaction) for transactions with related parties.
International Transfer Pricing 2011 Poland 647
Poland
From 1 January 2007, the same requirements apply to the allocation of proft to a
permanent establishment.
A company is obliged to submit the required documentation within seven days of a tax
inspectors request. If the tax inspector makes an assessment of the taxable income/
tax-deductible costs and there is no documentation in place for the transactions subject
to the assessment, the difference between the proft established by the tax authority
and that declared by the taxpayer will suffer a 50% CIT rate (in comparison with the
19% CIT rate applicable for 2009).
When fling its annual tax return, the company is required to state whether it was
required to prepare transfer pricing documentation according to the requirements.
Reporting requirements
Information on agreements concluded with related entities (ORD-U form)
A taxpayer is obliged to submit information on agreements concluded with related
entities. Taxpayers are required to report related party transactions concluded with one
of the following:
Non-residents where they exceed EUR300,000 in a given year with the same entity;
A non-resident owning a company, permanent establishment or representative
offce in Poland where the amount of receivables or payables resulting from a single
transaction exceeds EUR5,000; and
Both foreign and domestic related parties on the specifc request of the
taxauthority.
The taxpayer is obliged to submit the information on a designated form (ORD-U). The
information should be submitted to the tax offce together with the annual tax return
(i.e. by the end of the third month after the fscal year-end). Failure to submit the
notifcation is subject to a fne of up to 120 daily rates (the level of daily rate is decided
by the court for each case), while submission of false information is subject to a fne of
up to 240 daily rates.
Information on fees paid to specialist services providers (ORD-W1 form)
Polish entities must collect, draw up and submit information on fees paid for services
provided by natural persons who are not Polish tax residents. The information should
be presented on a special form (ORD-W1) by the end of the month following the
month in which the non-resident started providing the services. This obligation arises
only when:
The fee is paid to a non-resident natural person by a foreign entity;
The foreign entity is related to the Polish entity; and
The amounts paid have an impact on the tax obligation of the natural person
performing the services (the taxpayer is obliged to submit the information under
the same conditions as for the ORD-U report).
Information on the obligation of maintaining transfer pricing documentation
Taxpayers are liable to tick a specifc box in the annual tax return to confrm that they
are required to develop the transfer pricing documentation for the transactions they
concluded with their related parties in a given year.
Tax havens
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Taxpayers concluding transactions that result in payments to companies located in
tax havens, regardless of whether they are related, are required to prepare suitable
documentation. A decree of the Minister of Finance lists countries applying harmful
tax competition (tax havens). From 1 January 2007, if the transactions concluded
by Polish taxpayers with companies located in tax havens are not arms length, the
tax authorities may assess taxable income on the same grounds as income from
intragrouptransactions.
5703. Legal cases
In the period 2008-09, the Polish fscal control offce conducted more than 600 tax
audits concerning related party transactions. This fgure does not include proceedings
initiated by tax offces independent from the fscal control offce. Furthermore, in
the same period, administrative courts issued approximately 50 verdicts relating to
transfer pricing cases. Most of them related to fnancial transactions. The courts ruled
against the taxpayers in the majority of these cases.
Taxpayers are required to maintain specifc documentation describing the conditions
applied in related party transactions. However, the burden of proof that non-arms-
length prices or other conditions are applied falls on the tax authorities.
When examining transfer prices, the tax authorities must determine the arms-
length value of a transfer using the method(s) previously applied by the taxpayer,
providedthat:
The taxpayer established the transfer price using a traditional transaction-based
transfer pricing method;
The taxpayer submits documentation supporting the choice of a particular
method, based on which the price calculation is performed and transfer pricing
documentation required by the CIT law;
The objectiveness and reliability of the documentation submitted, based on which a
transfer price was calculated, cannot be reasonably questioned; and
Another method would not have been self-evidently more appropriate.
Transfer pricing is examined as part of a normal corporate tax audit.
Foreign-owned companies that have been loss-making for more than three years
are likely to be targeted. The tax authorities can request any information deemed
necessary for the investigation and have full search powers. Noncompliance with
information requests can result in severe penalties.
A particular characteristic of the audit procedure is the short time frame that taxpayers
have to respond to transfer pricing assessments:
Upon completion of a tax audit, the tax inspector issues a written protocol setting
out his/her preliminary fndings;
The taxpayer has 14 (calendar) days to respond to this protocol in writing,
presenting his/her explanations and objections;
Poland
Within 14 days, the tax inspector issues a document of formal information on the
method of dealing with the taxpayers response;
Subsequently, before issuing the tax decision, the tax authorities inform the
taxpayer about the intended decision. The taxpayer has seven days to review the
data collected during the tax audit and to present his/her opinion;
The taxpayer can expect a tax decision or formal closing of the proceeding if the
audit fnds the taxpayers reconciliation to be correct;
The taxpayer may appeal in writing to the higher authority (the tax chamber)
within 14 days;
The verdict of the tax chamber may be further appealed to the administrative court
within 30 days; and
The taxpayer has the right to appeal against the courts verdict to the Supreme
Administrative Court within 30 days.
Tax investigations may examine related party transactions which are not time barred.
Transactions are subject to the statute of limitations after fve years from the end of
the year in which tax returns concerning those transactions were fled (i.e. effectively
six years). Penalty interest may be charged on underpaid tax, and the standard rate is
currently (as of March 2010) 10% per annum. Penalty interest is not tax-deductible.
Special tax offces for large entities
Special tax offces exist for large entities (i.e. taxpayers that exceed an annual revenue
threshold of EUR 5 million). Additionally, all entities with a foreign shareholding
exceeding 5% of voting rights and Polish holding companies are recognised as
largeentities.
5706. Comparable information
Where possible during a tax audit, the Polish tax authorities try to use internal
comparables (sometimes without carrying out all necessary adjustments). They also
use external comparables drawing on data gathered through controls of comparable
taxpayers. Here, however, due to commercial and fscal secrecy, the taxpayer may have
diffculty obtaining access to such data.
The tax authorities have access to databases to establish comparable information.
However, it is rarely evident that they use such comparables during tax audits.
The tax authorities take a relatively sceptical view of foreign comparable data. In
practice, while preparing benchmarking studies, domestic comparables should be
examined frst. If there is not suffcient information concerning domestic comparables,
the search could be extended to comparables within the CEE region. If there is still not
suffcient comparable data, a Pan-European benchmarking study may be conducted.
For taxpayers undertaking comparable analysis, the source of Polish company
fnancial results is the government journal, Monitor Polski B. However, as fnes for not
submitting fnancial information are low, many companies do not present their results
at all or disclose them late.
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5707. Competent authority proceedings and advance pricing
agreements
Rulings
Amended regulations relating to interpretations of the tax law by the tax authorities
and the Minister of Finance were introduced on 1 July 2007. Currently, two types of
rulings are issued by Polish tax authorities:
General rulings Issued by the Minister of Finance where there are differences
in the interpretation of tax regulations by the tax authorities and apply to all
taxpayers; and
Individual rulings Issued by tax chambers appointed by the Minister of Finance
and apply only to the case of the requesting taxpayer.
The request for an individual ruling is fled on a special form, ORD-IN, and
shouldinclude:
The background to the case;
The applicants standpoint with respect to the interpretation of the tax law; and
A declaration that the case subject to interpretation is not subject to a tax
proceeding, tax control or earlier tax decision. If this condition is not met, the
ruling is not binding and the person applying may be fned under the Penal
FiscalCode.
An individual ruling may not be harmful for the taxpayer (i.e. if the taxpayer follows
the ruling, no penalty interest or sanctions under the Fiscal Penal Code may be
imposed). If the ruling is issued before the transaction starts, no tax other than that
resulting from the interpretation may be imposed on the taxpayer with respect to the
transaction. This does not apply if the ruling is issued after the transaction started.
An individual ruling may be amended by the Minister of Finance at any time. If the
amendment is less favourable for the taxpayer, the taxpayer is entitled to apply the
earlier ruling until the end of the current accounting period.
The tax authorities must issue individual rulings within three months (this may
be extended in complicated cases). The fee for an individual ruling is PLN 40
(approximately EUR 10) per question in the request.
Individual rulings cannot be used to confrm the correctness of the transfer
pricingmethod.
Advance pricing agreements (APA)
From 1 January 2006, a taxpayer may conclude an APA with the Minister of Finance to
confrm the appropriateness of the taxpayers transfer pricing policy. The purpose of an
APA is to agree in advance the arms-length character of the terms of the transactions
between related parties. From 1 January 2007, APAs also cover the attribution of proft
to permanent establishments. As a result, the local tax authorities will not be able to
question the arms-length character of these transactions.
Poland
The tax law allows for the following types of APAs:
Unilateral APA For transactions between domestic entities or a domestic entity
and a foreign entity; and
Bilateral/multilateral APA Issued by the Minister of Finance after obtaining
foreign tax authorities consent.
The administrative fee for the APA is approximately 1% of the transaction value.
However, depending on the type of APA, the fee may not be lower than approximately
EUR1,250 or higher than approximately EUR50,000 (exchange rate EUR 1 = PLN 4).
The APA decision will include:
Determination of the entities covered by the agreement;
Determination of the type, subject and the value of the transaction covered by the
agreement, as well as the period concerned;
Determination of the transfer pricing method, method of calculation of the transfer
price and rules of application of this method, including all crucial assumptions; and
Period during which the decision remains in force.
Starting from 1 January 2007, an APA will be concluded for a maximum period of fve
years, with the possibility of extending the period by another fve years.
Corresponding adjustments
Poland ratifed the convention on the elimination of double taxation in connection
with the adjustment of proft of associated enterprises of 23 July 1990. The convention
came into force on 26 August 2006.
The new decrees introduced regulations regarding the procedure for elimination of
double taxation. They are applicable to a price adjustment in cross-border transactions
between related parties or in cross-border settlements between a head offce and its
permanent establishment. The procedure is based on the Arbitration Convention and
double tax treaties.
According to the new regulations, local taxpayers are entitled to fle an application to
the Minister of Finance to initiate a mutual agreement procedure (MAP) in order to
avoid double taxation. In principle, the application should be submitted within three
years from receipt of a decision or protocol that leads or may lead to double taxation. If
the Minister of Finance believes the application is justifed but cannot be settled under
domestic proceedings, the Minister should initiate a MAP.
5708. Liaison with customs and other tax authorities
In 2002, the customs authorities (GUC) merged with the Ministry of Finance. As a
result, the fow of information between the two tax authorities improved. The tax
authorities are now working on the digitisation of the tax system. Once fnished, the
information gathered by various tax departments is likely to be made available to the
tax police.
The tax authorities cooperate with the tax authorities of other countries in conducting
multijurisdictional international investigations. Poland also applies the procedure of
mutual communication.
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The tax authorities are active in information exchange procedures.
Thin capitalisation rules came into force on 1 January 1999. These rules generally
apply to loans from a direct shareholder or a lending company which has the same
shareholder as the tested entity. The debt-to-equity ratio is 3:1. For the purposes of
these rules, equity is defned narrowly as paid-up share capital.
For thin capitalisation purposes, the word loan includes bonds and deposits.
Fees paid by Polish companies for consulting, accounting, market research, marketing,
management, data processing, recruitment, guarantees and warranties, and other
similar services are subject to 20% withholding tax, unless a relevant double tax treaty
states otherwise. However, to apply the treaty withholding tax rate, the taxpayer needs
a valid certifcate of fscal residence.
Portugal
58.
International Transfer Pricing 2011 653 Portugal
5801. Introduction
Although the arms-length principle has been included in Portuguese tax law for
many years, it generally has not been enforced, due to a lack of clarity and supporting
regulations. However, this changed in December 2000, when new Portuguese transfer
pricing legislation was enacted.
Law number 30-G/2000 of 29 December 2000, which entered into force on 1 January
2001, by amending Article 57 of the Portuguese Corporate Income Tax (CIT) Code,
introduced detailed transfer pricing rules. This article was subsequently changed
into Article 58 by Decree-Law number 198/2001, dated 3 July 2001 (Decree-Law
198/2001) and changed again into Article 63 by Decree-Law number 159/2009, dated
13 July 2009 (Decree-Law 159/2009). The new transfer pricing documentation rules
are applicable to tax years starting on or after 1 January 2002.
Article 63, number 13 of the CIT code states that a decree from the minister of fnance
will regulate, amongst others, the application of the transfer pricing methods, the
type, nature and contents of the documentation and the procedures applicable
to (corresponding) adjustments. This decree, number 1446-C/2001, dated 21
December 2001 (Decree 1446/C-2001), was published in the National Gazette on 14
January2002.
Article 63 CIT Code
The key elements of the transfer pricing rules are as follows:
The concept of special relations between entities is broadly defned, including
situations ranging from statutory to economic dependency, and also certain
familyrelations;
A set of defned methodologies for evaluating transfer prices and the comparability
factors that should be taken into account when assessing their arms-length nature;
The best method or most appropriate method for every transaction or series of
transactions should be considered;
Extensive requirements regarding how taxpayers justify and document their
transfer pricing arrangements; and
A shift in the burden of proof from the tax authorities to the taxpayer (self-
assessment procedure) in the case of controlled transactions with non-resident
associated enterprises.
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Portugal 654 www.pwc.com/internationaltp
Any commercial transactions, including transactions or a series of transactions
related to goods, rights, services or fnancial arrangements between a taxpayer and
another entity with which it has special relations must be conducted as if they were
independent entities carrying out comparable transactions.
The transfer pricing methodology adopted must ensure the best level of comparability
between the tested transactions and the comparable data used to provide the
benchmark. Factors affecting comparability include characteristics of the goods, rights
or services, economic and fnancial environment, activities and functions performed,
assets employed and risks borne.
The transfer pricing regulations also apply in cases of transactions between a non-
resident entity and a permanent establishment (PE) in Portugal or between a PE of
a non-resident entity with other PEs outside the Portuguese territory. The rules also
apply to entities that are simultaneously exercising activities that are subject to CIT and
activities that are exempt from CIT, such as entities based in the Madeira International
Business Centre (MIBC).
Associated enterprises
Special relations between two entities exist in case one entity has or may have, directly
or indirectly, a signifcant infuence in the management of the other entity. The law
stipulates that a special relationship exists in the case of:
An entity and its shareholders, or its relatives, that have directly or indirectly a
participation greater than or equal to 10% of the capital or the voting rights;
Entities in which the same shareholders, or its relatives, have, directly or indirectly,
an interest greater than or equal to 10% of the capital or the voting rights;
An entity and the members, and their relatives, of its corporate bodies;
Entities in which the majority of the members of its corporate bodies, or of any
other administrative body, board of directors or supervision or control, are
the same persons or being different persons are connected with each other by
marriage, other (legal) forms of joint households or by direct parental relation;
Entities connected by a contract of subordination or other with equivalent effect;
Entities that are required to prepare consolidated fnancial statements;
Entities where one of the following relationships exist:
1. The activities of one entity substantially depend on industrial or intellectual
property rights or know-how owned and granted by the other entity;
2. The sourcing of raw materials or the access to sales channels of products,
merchandise or services for one entity substantially depends on the
otherentity;
3. A substantial part of the activity of one entity can be performed only with the
other or depends on decisions taken by the other entity;
4. The prices for goods or services rendered or acquired by one entity is, by
provision set in juridical act, determined by the other entity; and
5. Terms and conditions of commercial or juridical relations between the parties
have the effect that one entity can infuence the management decisions of the
other entity in a way other than between two commercial parties acting at
armslength.
An entity resident in Portugal or a non-resident with a PE in Portugal and an entity
resident in a territory considered by Portuguese law as a territory with a clearly
more favourable tax regime.
International Transfer Pricing 2011 Portugal 655
Portugal
These territories (83) are listed in the Decree number 150/2004 dated 13 February
2004 (Decree 150/2004).
The methods to be used are:
The comparable uncontrolled price method;
The resale price method;
The cost plus method;
The proft split method;
The transactional net margin method; and
Other methods when the methods mentioned above cannot be applied or if these
methods do not give a reliable measure of the terms that independent parties
would apply.
Tax information and documentation
Every taxpayer shall indicate, in the annual declaration of accounting and tax
information (IES/Declarao Annual), an integral part of the annual CIT flings, the
existence of transactions with entities with which it has special relations (associated
enterprises) in that period. The requested information includes the associated
enterprises, the amount of the controlled transactions with each of the associated
enterprises and an indication as to whether supporting documentation for transfer
prices existed at the time of the transactions (and is still available).
Taxpayers with turnover of EUR3 million or more also should comply with the
documentation requirements below, which are further regulated by the Decree 1446-
C/2001 (see Section 5806).
Corresponding adjustments
Where the transfer pricing provisions apply to transactions between two parties that
are both liable to Portuguese CIT, any adjustment to the taxable income of one should
be refected by a corresponding adjustment to the taxable income of the other. If a tax
treaty is applicable, then the Portuguese tax authorities may also make corresponding
adjustments through the competent authority procedure.
Article 23 of the Portuguese CIT Code considers that costs are deductible only if
indispensable for generating profts or gains or for the maintenance of the production
factors. Costs that are not (or not properly) documented are not deductible for CIT
purposes. Furthermore, such costs are subject to an autonomous tax rate of 50 %, even
in the case of tax losses.
The Decree 1446-C/2001 deals in more detail with the following issues:
General rules on the arms-length principle;
Scope of application of transfer pricing rules;
Adjustments to taxable income and corresponding adjustments;
Transfer pricing methods and the best or most appropriate method;
Factors determining comparability;
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Cost contribution and intragroup service arrangements;
Relevant information and supporting documentation; and
Special provisions.
5804. Legal cases
There have been few court cases on transfer pricing issues under the previous
legislation. The older case law is mainly related to cost contribution arrangements
(CCA). The lack of legal provisions and administrative guidelines regarding transfer
pricing has given rise to discretionary and contradictory court decisions, some of
which do not seem to be in accordance with the OECD Guidelines. More recent case
law shows the importance of a well-prepared factual and functional analysis to support
arms-length dealings with associated enterprises.
According to the general tax law (Lei Geral Tributria), the burden of proof lies with
the tax authorities. However, under the recent transfer pricing rules, it is not clear
whether this rule is applicable. It can be argued that the burden of proof regarding
transfer pricing has effectively shifted to the taxpayer, irrespective of the fact that the
tax authorities must justify any (transfer pricing) adjustments made to the taxable
income of the taxpayer.
In fact, the taxpayer must support the transfer pricing policy adopted with proper
information and supporting documentation. In the case of controlled transactions
with non-resident associated enterprises, the taxpayer must apply any necessary
corrections in its corporate income tax return in order to refect arms-length pricing
(self-assessment).
5806. Documentation
Tax documentation fle
Based on Decree 1446-C/2001, taxpayers are required to keep a transfer pricing
documentation fle, which is expected to include the following information:
The terms and conditions agreed, accepted and observed in the open market in
relation to the controlled transactions; and
The selection and application of the method or methods most appropriate for
benchmarking transfer prices through the use of arms-length comparables.
The transfer pricing documentation fle should include the following information
anddocumentation:
A description of any special relations that exist with any entities with which
commercial, fnancial or other transactions are carried out;
A record of the corporate relationship by which the special relationship arose,
including any documents that demonstrate a subordination or dependency
relationship as mentioned above;
A description of the activities carried out during the controlled transactions, a
detailed list of amounts recorded by the taxpayer over the past three years and,
where appropriate, the fnancial statements of the associated enterprises;
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A detailed description of the goods, rights or services involved in controlled
transactions and of the terms and conditions agreed if such information is not
disclosed in the respective agreements;
A description of the activities performed, the assets used and the risks
assumed, both by the taxpayer and the associated enterprises involved in the
controlledtransactions;
Technical studies on essential areas of the business, namely investment, fnancing,
research and development, marketing, restructuring and reorganisation of
activities, as well as forecasts and budgets connected with the global business and
business by division or product;
Guidelines regarding the transfer pricing policy of the frm, containing instructions
on the methods to be applied, procedures for gathering information (particularly
on internal and external comparables), analysis of the comparability of
transactions, cost accounting policies and proft margins obtained;
Contracts and other legal instruments concluded with both associated enterprises
and third parties, together with any other document that may govern or explain the
terms, conditions and prices under those transactions;
An explanation of the method or methods applied to determine arms-length prices
for each controlled transaction and the rationale for the selection;
Information regarding comparable data used (The grounds for selection, research
records and sensitivity and statistical analyses should all be documented);
An overview of business strategies and policies, particularly regarding commercial
and operational risks that might have a bearing on the determination of transfer
prices or the allocation of profts or losses for the transactions; and
Any other information, data or documents considered relevant for determining an
arms-length price, the comparability of transactions or the adjustments made.
The taxpayer is expected to maintain the documentation for a period of 10 years after
the fling of the tax return and to deliver the documentation to the tax authorities
upon request. The documentation should help to verify the arms-length nature of the
transfer prices without the need for the taxpayer to incur excessive compliance costs.
The tax authorities have four years to raise additional CIT assessments. If tax losses
were offset against tax profts within the above-mentioned period, the tax authorities
may also audit the accounts of the years in which the tax losses were incurred.
Taxpayers are expected to update the prior-year documentation for transactions where
the relevant facts and circumstances have changed to the extent that there is a material
impact in the determination of the arms-length price.
Cost contribution arrangements (CCAs)
With respect to CCAs, the taxpayer must maintain documentation supporting the
following information:
Description of the participants and other associated enterprises involved in the
activity covered by the agreement or that are expected to exploit or use the results
of that activity;
The nature and type of activities carried out within the scope of the agreement;
The method by which each participants proportionate share in the expected
advantages or benefts are determined;
The accounting procedures and methods applied to allocate costs, including the
calculations made to determine each participants contribution;
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The assumptions that underlie forecasts of expected benefts, frequency of review
and forecasts of any adjustments arising from changes in the agreement or in
otherfacts;
Expected duration of the agreement;
Anticipated allocation of responsibilities and tasks under the agreement;
Procedures for a participant entering or withdrawing from the agreement and
conditions for the termination of the agreement; and
Penalty clauses.
Intragroup services
Regarding intragroup services agreements, the supporting documentation must
include the following data:
A copy of the agreement;
A description of the services covered by the agreement;
A description of the recipient of the services; and
A description of the costs of the services and the criteria applied for their allocation.
The audit procedure can be either internal or external. During an internal audit, the
taxpayer is requested to send documentation to the tax authorities for analysis; in an
external audit, investigations are carried out at the taxpayers premises. In the last
case, documentation also may be requested from the taxpayer in order to be analysed
at the tax authorities premises.
Furthermore, the audit procedure can be either global or partial. A global tax audit
reviews the entire tax status of the taxpayer, while a partial tax audit will focus on only
one or more (but not all) of the taxpayers tax duties. An audit may address more than
one taxable period. The tax audit procedure is continual and must be concluded within
six months. However, under certain circumstances, this period may be extended.
The audit procedure begins with a notifcation sent by the tax authorities to the
selected taxpayer. This sets out the nature and scope of the audit, as well as the rights
and obligations of the taxpayer during the audit process.
Audits are completed when the tax auditor considers that all the necessary information
has been obtained to draw up a proposed tax audit report. This proposal is sent to the
taxpayer, who has the opportunity to oppose, in all or in part, against the conclusions
of the proposal. After the objections have been heard, the tax auditor will issue a fnal
audit report, which may give rise to an additional tax assessment.
Following a tax audit, the taxpayer is allowed to challenge an additional tax assessment
made by the tax authorities, either by means of an administrative claim submitted
to the tax authorities, or via a judicial appeal to the tax courts. An appeal against an
additional tax assessment does not prevent the collection of additional tax. Therefore,
the taxpayer should either pay the tax due or provide a guarantee for its payment.
There are no specifc regulations in respect of appeals connected with additional
assessments based on the transfer pricing arrangements adopted by the taxpayer.
Portugal
5809. Additional tax assessment and penalties
In general terms, additional assessments usually carry penalties and fnes. Currently
there are no specifc penalties in force for transfer pricing issues. However, a transfer
pricing penalty regime may be introduced in the future (see Section 5815).
In the notifcations that the tax authorities have issued to taxpayers to deliver the
transfer pricing tax fle, it is mentioned that a penalty from EUR200 to EUR2,500 may
be applied if the transfer pricing fle is not delivered or if it is delivered late. We note
that if a taxpayer refuses to deliver the transfer pricing fle, this may result in a penalty
that may range from EUR500 to EUR100,000.
Penalties for the nonpayment of taxes range between 20% and 100% of the amount
of tax due, capped at EUR30,000. In case of intention, penalties range between 100%
and 200% of the amount of tax due capped at EUR110,000. The taxpayers may request
a reduction of the penalty (under certain circumstances) and may appeal against the
penalties imposed by the tax authorities.
Late assessment interest (4% per year) is also charged. Neither penalties nor late
assessment interest is deductible for tax purposes. In case of the late payment of an
additional assessment made by the tax authorities, interest for late payment will be
applied (the interest rate is determined annually, in December, using the monthly
average of the Euribor at 12 months in the preceding 12 months, adding 5%
regarding 2010 the interest rate should be fxed at 6.6% per year).
Practice
It is believed that the tax authorities have developed suffcient experience to deal
with transfer pricing issues. Various transfer pricing audits have been performed, and
recently the tax authorities have started to make transfer pricing adjustments to the
taxable proft of taxpayers.
Use
The taxpayer should select the transfer pricing method that assures the best grade of
comparability between its transaction or series of transactions and the uncontrolled
benchmarking data. Where possible, the comparable uncontrolled price (CUP) method
should be used to establish an arms-length price, making use of available comparable
price information.
Availability
There are commercial databases available that contain (fnancial) information about
Portuguese companies. Nevertheless, third-party fnancial data for Portuguese
companies remains relatively sparse. This may represent an obstacle for taxpayers
wishing to support their transfer pricing policies and methods with comparable data.
The tax authorities have been using information available from their own sources
(i.e. information that is not publicly available but obtained from CIT returns and
governmental tax audits). Recently, the tax authorities acquired AMADEUS,
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a fnancial database, to assess the compliance of controlled transactions with the
In January 1999, the tax authorities published a list of ratios determined by dividing
taxable income by turnover for the various sectors recognised for commercial register
purposes. The ratios are based on taxpayer information for the years 1994, 1995 and
1996. Entities that in 1998 have a ratio that is inferior to the one determined for the
relevant sector would, in principle, be subject to a tax inspection. We are not aware of
such a study being repeated in later years. Furthermore, it is uncertain whether the
tax authorities may use such data to support proposed adjustments to taxable income
because the underlying data may be considered confdential (secret comparables).
Transfer pricing is becoming an area of increasing focus for Portuguese tax authorities.
They are notifying more and more companies to deliver the transfer pricing
documentation of the recent years. In our understanding, such companies are in
different types of industries, and it does not follow that the tax authorities transfer
pricing audits are focusing on certain industries or specifc types of transaction.
Therefore, as a general rule, all controlled transactions should be duly supported and
documented in accordance with the arms-length principle.
More recently, tax authorities have started to question the economic analyses
presented in the transfer pricing documentation, among others by questioning
the chosen proft level indicators and the criteria used in the benchmark searches.
Moreover, we have experience that tax authorities are asking for detailed information
and documentation underlying intragroup services such as management fees.
In principle, transfer pricing adjustments should be implemented so as to avoid double
taxation. When the adjustment affects transactions between a Portuguese company
and a non-resident, the mechanisms laid down in the relevant double taxation treaty
should be applied. Where the non-resident is within the EU, the provisions of the
Arbitration Convention relating to the elimination of double taxation (EC Directive
90/436) may also be applied.
The procedures regarding corresponding adjustments are laid down in Decree
1446-C/2001.
The Decree 1446-C/2001 stipulated that after relevant experience would have been
gained regarding the application of the new transfer pricing rules, the Portuguese tax
system would be in a position to adopt the OECDs recommendations in the area of
advance pricing agreements (APAs). The state budget for 2008 introduced APA rules by
means of adding article 128-A to the CIT Code. This article was subsequently changed
into Article 138 by Decree-Law number 159/2009.
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Article 138, Number 9 of the CIT code stated that a decree from the minister of fnance
would regulate the requirements and conditions for preparing and fling a request, as
well as what procedures, information and documentation are to be applied in the APAs.
Detailed APA rules were introduced by the Decree 620-A/2008, which entered into
force on 16 July 2008.
This decree establishes specifc regulations regarding the implementation (procedures
and obligations) of the APA regime in Portugal, namely:
The APA request or proposal should be sent to the Portuguese Tax Authorities
(PTA) up to 180 days prior to the beginning of the frst fscal year covered by
theagreement;
The maximum duration of an APA (duration from APA application to fnal
conclusion) is 300 days for unilateral APAs and 480 days for bilateral APAs;
The conclusion of an advance agreement is subject to the payment of charges,
which are determined under the terms and limits foreseen in Decree 923/99, dated
20 October 1999;
The APA is valid for a maximum of three years with the possibility for renewal; and
Rollbacks are not available.
Due to the fact that Portugal only recently enacted legislation concerning APAs, it is
possible to obtain an APA only for the tax years starting on or after 1 January 2010.
It is expected that existing transfer pricing regulations will be extended by the
publication of specifc legislation on penalties for noncompliance with the obligations
as set out in Decree 1446-C/2001, especially in respect of noncompliance with
documentation requirements. In addition, a decree on the requirements and conditions
of an APA procedure is expected in the short term (see Section 5814).
In practice, there is little communication and exchange of information between the tax
authorities and the customs authorities.
5817. OECD issues
Portugal is a member of the OECD. The new transfer pricing rules refect the approach
set out by the OECD Guidelines. Decree 1446-C/2001 indicates that in more complex
cases, it may be advisable to consult the OECD Guidelines for further clarifcation.
Under a reservation made in Article 9 of the Model Tax Convention on Income
and Capital, Portugal reserves the right not to insert paragraph two (regarding
corresponding adjustments) in its tax treaties. The older tax treaties, most of them
with EU countries, do not contain a corresponding adjustment provision. However, the
more recent treaties include a corresponding tax adjustment provision equivalent to
the above-mentioned paragraph of the Model Tax Convention on Income and Capital.
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Portuguese law does not prevent Portuguese tax authorities from joining the
equivalent body of another state to set up a joint investigation into a multinational
company or group.
Portuguese taxation rules for thin capitalisation were introduced in January 1996.
Where the indebtedness of a Portuguese taxpayer to a non-resident entity in Portugal
or in an EU country with whom special relations exist is deemed excessive, the interest
paid in relation to the part of the debt considered excessive will not be deductible for
the purposes of assessing taxable income.
In determining whether special relations exist, reference is made to Article 63 of the
CIT code regarding transfer pricing (i.e. special relations exist if the non-resident
entity has or can have substantial infuence, directly or indirectly, in the management
decisions of the resident entity).
Excessive indebtedness occurs where the value of the debts in relation to each
of the entities is more than twice the value of the corresponding shareholding in
the taxpayers equity. Any disallowed interest is not requalifed as a dividend for
withholding tax purposes. This means that withholding tax should be levied on the
full amount of the interest, including the interest related to the part of the loan that
exceeds the 2:1 debt-to-equity ratio.
To determine the qualifying debt, all forms of credit will be considered, whether in cash
or in kind, including credit resulting from commercial transactions that are overdue
for six months or more. In order to determine qualifying equity, paid in share capital
includes all equity capital except for unrealised capital gains or losses, including those
arising from revaluation not authorised by the tax legislation, and amounts resulting
from the equity method of accounting.
In cases where the 2:1 ratio is exceeded, the taxpayer may be able to avoid adjustments
under the thin capitalisation rules where it can be shown that the same level of
indebtedness could have been obtained with similar conditions from an independent
party. Such evidence must be kept in the annual tax fle of the company for 10 years.
This option is not applicable where the indebtedness is towards a resident entity in a
territory considered by Portuguese law as a territory with a clearly more favourable
taxregime.
Romania
59.
International Transfer Pricing 2011 663 Romania
5901. Introduction
The Romanian transfer pricing legislation follows the OECD Guidelines and requires
that transactions between related parties be carried out at market value. In case
transfer prices are not set at arms length, the Romanian tax authorities have the right
to adjust the taxpayers revenue and expenses so as to refect the market value. Proft
adjustments on transactions between related parties can be performed within the
domestic statute of limitation period (i.e. fve years).
The trend in transfer pricing developments in Romania reveals a growing interest of
the Romanian tax authorities towards transfer pricing, which is one of the main areas
of tax investigation. Under these circumstances, multinational companies are advised
to pay close attention to the arms length of their related party transactions and their
documentation so as to be prepared in case of any transfer pricing disputes with the
taxauthorities.
The arms-length principle was introduced in domestic tax law in 1994. An important
milestone in the development of the transfer pricing legislative framework occurred in
2004, upon the introduction of the fscal code, which set out in a systematic manner
the defnition of related parties, the statement of the arms-length principle and the
methods for setting transfer prices at arms length.
The fscal code norms detail the scope and the application of transfer pricing rules.
Although Romania is not a member of the OECD, these norms expressly stipulate
that in the application of transfer pricing rules, the Romanian tax authorities also will
consider the OECD Guidelines.
The arms-length principle
The arms length principle is applicable to all related party transactions, including
those between a foreign legal entity and its Romanian permanent establishment.
Nevertheless, related party transactions carried out between two Romanian legal
entities are currently excluded from the scope of transfer pricing investigations.
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Romania 664 www.pwc.com/internationaltp
Two legal entities are related parties provided that:
One entity holds directly or indirectly (through the shareholding of related entities)
a minimum of 25% of the number/value of shares or voting rights in the other
entity or it effectively controls the other entity; and
One entity holds directly or indirectly (through the shareholding of related
entities) a minimum of 25% of the number/value of shares or voting rights in the
twoentities.
An individual is a related party with a legal entity provided that he/she holds directly
or indirectly, including the shareholding of related entities, a minimum of 25% of the
number/value of shares or voting rights in the legal entity or it effectively controls
the legal entity (unfortunately the legislation is silent on the meaning of effective
control). Two individuals are related parties provided that they are spouses or
relatives up to the third degree.
Local legislation provides that taxpayers may use traditional transfer pricing methods
(comparable uncontrolled price, cost plus and resale price), as well as any other
method that is in line with the OECD Guidelines (transactional net margin and proft
split). If the comparable uncontrolled price or a traditional transfer pricing method is
not used, as it is the case, the taxpayer should set out in the documentation the reasons
for not doing so.
Taxpayers should consider the following main criteria when selecting the most
adequate transfer pricing method:
Activities carried out by the related parties;
Availability of data and justifying documents;
Accuracy of adjustments to meet comparability criteria; and
Circumstances of the specifc case (e.g. characteristics of the tangible goods
transferred, stage within the supply chain, payment conditions, guarantees,
discounts, etc.).
For specifc types of transactions, guidance is provided on the application of
transfer pricing methods and the comparability factors that should be considered by
thetaxpayer.
Provision of services the arms-length transfer price should be set using the
comparable uncontrolled price method, by considering the usual fees for each
type of activity or the standard rates in certain felds. In the absence of comparable
transactions, the cost plus method should be used; and
Inter-company loans the arms-length transfer price is represented by the
interest that would have been agreed upon between third parties in comparable
circumstances, including the commission for handling the loan. Comparability
factors that should be considered in assessing the arms-length interest rate
include: amount and duration of the loan, nature and purpose of the loan, currency
and foreign exchange risk, existence of guarantees, costs of hedging the foreign
exchange risk, etc.
International Transfer Pricing 2011 Romania 665
Romania
In line with the fscal procedure code, taxpayers engaged in related party transactions
are required to prepare a transfer pricing documentation fle that needs to be presented
upon request of the tax authorities during a tax audit. The deadline is to be set at
maximum three months from the date of receiving the formal written request, with the
possibility of a single extension with a period equal to the term initially established.
In February 2008, detailed regulations regarding the content of the local transfer
pricing documentation fle were published. The content of this fle is in line with the
Code of Conduct on Transfer Pricing Documentation for Associated Enterprises in the
European Union (EU TPD).
There is currently no minimum threshold for documenting controlled transactions
or any simplifed documentation rules and, therefore, irrespective of materiality,
Romanian tax authorities can scrutinise the arms length nature of any
controlledtransaction.
Advance pricing agreements
In Romania, taxpayers engaged in related party transactions have the possibility
to apply for advance pricing agreements (APAs). Details regarding the application
procedure and the documentation that needs to be prepared by a taxpayer intending to
request an APA are provided in a government decision issued in June 2007.
The APA is defned as an administrative act issued by the National Agency for Tax
Administration in the view of addressing a taxpayers request in relation to establishing
the conditions and methodology to set transfer prices in related party transactions for a
fxed period of time.
The procedure is initiated by the taxpayer through submission of a request for an
APA that can be preceded, if desired by the taxpayer, by a prefling meeting. The
documentation that needs to be provided upon request for an APA is similar to the
transfer pricing documentation fle and needs to suggest upfront the content of
theAPA.
The APA can be issued for a period of up to fve years and is generally valid starting
from the fscal year subsequent to the fling of the request. By exception, its validity
may be longer in case of long-term agreements. The APA is opposable and binding
on the tax authorities as long as its terms and conditions are observed. In this view,
taxpayers need to submit an annual report on these terms and conditions by the
deadline for submitting the statutory fnancial statements.
If the taxpayer does not agree with the APA, a notifcation may be sent to the issuing
tax authority within 15 days from the communication date, and the APA no longer
produces legal effects.
The deadline for issuing APAs is 12 months in case of unilateral and 18 months in case
of bilateral or multilateral APAs. In case of large taxpayers and for transactions with an
annual value exceeding EUR4 million, the fee for issuing an APA is EUR20,000, and the
fee for amending it is EUR15,000. For the rest of the taxpayers, the fee for issuing an
APA is EUR10,000, and the fee for amending it is EUR6,000.
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Taxpayers are classifed as large taxpayers, provided that their annual turnover exceeds
EUR16.5 million; if they are banks, insurance companies or other fnancial institutions;
or if they voluntarily make a formal commitment upon their set-up to perform
investments of at least EUR400 million.
5903. Risk transactions or industries and legal cases
Having regard to the legislative changes and developments in the transfer pricing
feld, the transfer pricing audit activity has signifcantly increased, and requests for
presenting the transfer pricing documentation fle have started to become common
practice. Currently, the Romanian tax authorities focus on cross-border related
partytransactions.
In recent cases, the Romanian tax authorities adjusted the taxable result of taxpayers
in accordance with the applicable regulations. The adjustments are carried out so that
the proftability of the taxpayer reaches the median value of the arms-length interval
derived through a local benchmarking study. Most challenges and disputes generally
arise in relation to the economic analysis.
Taxpayers should address with careful consideration the documentation of their
related party transactions. Having appropriate transfer pricing documentation in place
is, in all circumstances, a safeguard against noncompliance penalties and adverse tax
consequences, which can result from transfer pricing adjustments.
5904. Burden of proof and tax audit procedures
In Romania, the burden of proof lies with the taxpayer that should prepare transfer
pricing documentation in order to defend the arms length of its transfer prices. In
the case of litigation, the burden of proof may shift to the tax authorities in order to
demonstrate that the transfer prices set by the taxpayer are not at arms length.
The Romanian tax authorities should frst assess the arms length character of the
controlled transaction by using the method applied by the taxpayer. However, in case
the tax audit reveals that the arms-length principle is not observed, the Romanian tax
authorities may apply the most appropriate method from the ones listed above.
5905. Comparable information
The detailed regulations regarding the content of the local transfer pricing
documentation fle include specifc provisions on the procedure to conduct
benchmarking studies. These should include local comparables. European or
international benchmarking studies are accepted, provided that there are no local
comparables or if the set of local comparables is too limited.
Another particularity of the way to carry out the benchmarking study is that the
comparability range is narrowed to the interquartile interval. If the taxpayers transfer
prices fall outside the arms-length range, the adjustment shall be carried out to
themedian.
International Transfer Pricing 2011 Romania 667
Romania
In Romania, information on the performance of companies is available only in the
form of published annual fnancial statements. These statements contain information
that can enable computation of various proft level indicators. However, in some cases,
segregation of transactions and identifcation of the cost base may prove to be diffcult
due to the particularities of the Romanian accounting system.
5906. Additional taxes and penalties
Failure to present the transfer pricing documentation fle may result in fnes ranging
from RON12,000 to RON14,000 (i.e. approx EUR2,800 to EUR3,300 at the current
foreign exchange rate) and estimation of transfer prices by the tax authorities based
on generally available information on similar transactions, as the arithmetic mean of
prices on three similar transactions.
The additional taxable profts resulting from this estimation or any transfer pricing
adjustments are subject to the general 16% proft tax rate and related late payment
interest of 0.1% per day of delay. Under Romanian legislation, late payment interest is
non-deductible.
5907. Inter-company loans
Under the Romanian Fiscal Code, interest expenses incurred in relation to inter-
company loans having a maturity that exceeds one year are subject to the following
twolimitations:
Safe harbour rules
Interest expenses on these inter-company loans are deductible within the limit of:
In the case of loans denominated in hard currency (any other currency than the
local currency), a ceiling established annually through government decision (i.e.
6%); and
In case of loans denominated in local currency, the reference interest rate of the
National Bank of Romania.
The particularity of these safe harbour rules is that taxpayers are not exonerated
from their documentation obligations.
Interest expenses exceeding these limits are non-deductible and cannot be carried
forward to subsequent years. This limitation is applied separately to each inter-
company loan before considering the thin capitalisation rules detailed below.
Thin capitalisation rules
Interest expenses on inter-company loans are deductible, provided that the debt to
equity ratio is lower than or equal to three. In case the debt to equity ratio is negative or
higher than three, interest expenses are non-deductible in the current year and can be
carried forward to subsequent years.
The debt to equity ratio is determined as a ratio between the companys related party
liabilities with a maturity exceeding one year (including liabilities whose maturity
was extended so that it exceeds one year) and the owners equity, by considering the
average of the book values recorded at the beginning and at the end of the year.
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In particular, expenses with foreign exchange differences also need to be considered.
Therefore, in case expenses with foreign exchange differences exceed revenue from
foreign exchange differences, the difference is treated as interest expense and is subject
to the limitation mentioned above. The expenses with foreign exchange differences
subject to this limitation are those related to the liabilities considered for determining
the debt to equity ratio.
This limitation is not applicable to banks, Romanian legal entities or branches of
foreign banks, leasing companies for their leasing operations, real estate mortgage
companies, credit institutions and non-banking fnancial institutions.
Other considerations
In case of related party fnancing, the following should also be analysed:
Whether the loan granted serves the business interest of the benefciary and has
been used for that purpose; and
Whether there has been a proft distribution scheme.
Requalifcation of an inter-company loan into a proft distribution scheme occurs if, at
the moment of granting the loan, a reimbursement is not expected and the agreement
includes unfavourable conditions for the borrower. Under these circumstances, the
loan can be reclassifed as share capital; the deductibility of interest expenses and
any foreign exchange differences can be challenged, and they can be assimilated to
dividend payments.
The tax and customs authorities in Romania do not usually cooperate when it comes
to transfer pricing issues. The majority of customs value investigations to date have
been related to the adjustment of the customs value according to Article 8 of the WTO
Customs Valuation Agreement. Issues including the adjustment of customs value
for royalties, licence fees, assists (e.g. packaging design, tools), and the inclusion of
transport expenses were among the favourites of the customs inspectors.
However, we expect that transfer pricing adjustments, although not automatically
notifed to the customs authorities, will lead to further investigations and adjustments
in customs as a result of the exchange of information between tax and customs
authorities or as a result of their refection in the business transactions.
Russia
60.
International Transfer Pricing 2011 669 Russia
6001. Introduction
Russian transfer pricing provisions have been in force since 1 January 1999. Under the
headings Principles of Determining the Price of Goods, Work or Services for Purposes
of Taxation (Article 40 of the tax code) and Interdependent Parties (Article 20 of the
tax code), the rules provide a basis for the tax authorities in certain circumstances
to challenge transfer pricing arrangements. The provisions also set out the basic
rules for determining market prices against which the prices used by taxpayers are to
becompared.
As initially drafted, the new Russian transfer pricing rules were rather vague and the
terms employed were often subjective or undefned. As a case in point, the new rules
were modifed within six months of being introduced. However, they still present the
basis for future transfer pricing legislation rather than detailed guidelines for dealing
with transfer pricing arrangements. The general rules for determining prices for tax
purposes were expanded by the Profts Tax chapter of Part II of the tax code, which
came into force as of 1 January 2002 and contained some elements of transfer pricing
to deal specifcally with individual situations.
Reform in current Russian transfer pricing rules is imminent. On 19 February 2010, the
draft law on new Russian transfer pricing rules (the draft law) was passed on its frst
reading by the lower chamber of the Russian Parliament, the State Duma. Although
during consideration of the draft law by the State Duma it came under a great deal of
criticism from the business community, the draft law will likely be revised and fnally
approved by the State Duma in 2010. The draft law is due to come into effect on 1
January 2011. For the purposes of this chapter, we refer to the version of the draft law
which passed the frst reading in the State Duma.
The draft law aims to make Russian transfer pricing rules work in practice and bring
them closer into line with OECD Guidelines. The proposed amendments will also
give the tax authorities more information about the transfer prices applied and the
methods used in intragroup transactions (by introducing transfer pricing reporting and
documentation requirements).
The following briefy summarises the overall differences between current Russian
transfer pricing rules (Articles 20 and 40) and the proposed draft law.
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Controlled transactions
Under Article 40, the tax authorities may challenge the pricing arrangements between
taxpayers only in the following cases:
Transactions between interdependent (related) parties domestic as well as
cross-border;
Foreign trade transactions; and
Transactions where the prices within a short period of time deviate by more than
20% either way from the prices set by the taxpayer for identical or similar goods
(work, services).
The term short period of time, while extremely important, is still undefned in the
taxcode.
The draft law reduces the list of transactions where pricing can be controlled by the
Russian tax authorities for tax purposes. The new rules will cover the following types of
controlled transactions:
Domestic transactions between related parties (see below) if they meet one of the
following criteria:
1. The transaction amount exceeds RUB 1 billion (approx. USD 33 million) per
calendar year. Transactions between Russian companies forming a consolidated
taxpayer group will not come under the pricing control. It is expected that
both the draft law on new Russian transfer pricing rules and the draft law on a
consolidated taxpayer regime will be adopted simultaneously;
2. One of the parties to a transaction is subject to mineral extraction tax (MRET)
calculated as a percentage of the value of minerals extracted; and
3. One of the parties to a transaction is subject to taxation under the unifed tax on
imputed income or unifed agricultural tax.
Cross-border transactions between related parties;
Cross-border transactions with certain types of commodities, including: (1) oil
and oil products, (2) ferrous and nonferrous metals, and (3) precious metals and
stones. The list of commodities is to be established by the Russian Ministry of
Economic Development; and
Transactions between Russian entities (permanent establishments of foreign
entities in Russia, Russian tax resident individuals) on one side and entities located
(or individuals residing) in certain foreign jurisdictions and territories on the other
side. The list of such territories is approved by the Russian Ministry of Finance for
the purposes of applying a participation exemption on dividends. The list includes
such jurisdictions as the British Virgin Islands, Cyprus, Hong Kong, Gibraltar,
Liechtenstein and certain other territories. In addition, the Russian tax authorities
will be able to control transactions with a foreign entity whose benefcial owners
are located in one of the jurisdictions and territories included in the list.
According to the draft law, if prices are regulated by the Russian authorities or
established in accordance with Russian anti-monopoly law, the Russian tax authorities
will accept such prices for tax purposes.
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Russia
With such a reduced list of controlled transactions, the new Russian transfer
pricing rules become, to a certain extent, aligned with those of the OECD, whose
pricing controls focus solely on transactions between related parties. Nevertheless,
by proposing the control of cross-border transactions involving certain types of
commodities and transactions with residents of low-tax jurisdictions, the tax
authorities have in effect incorporated certain elements of anti-avoidance rules in the
new Russian transfer pricing rules.
Interdependent parties
Currently, the defnition of interdependent parties is found in Article 20 of
Part I of the tax code and describes three situations where one of the following
conditionsexists:
One party has a greater than 20% direct or indirect equity participation in the
other. The participatory share of indirect participation of one party in another
through a sequence of other parties is determined in the form of multiplying
the participatory shares of direct participation of parties of this sequence one
toanother;
One individual is subordinate to the other in terms of offcial position; and
Individuals have a marital, kinship, affnity, adoptive or adopted, trustee or
wardrelationship.
Although the list of interdependent parties in the tax code appears to be exhaustive,
it does not encompass more complicated cases where parties not meeting the above
formal criteria, may, nevertheless, be found to be truly interdependent in nature. It is
worth noting that, unlike the tax authorities, which may undertake transfer pricing
adjustments only with respect to controlled transactions meeting the tax codes
defnition of interdependent parties, courts are not subject to this restriction. Courts
can declare persons to be interdependent for reasons other than those defned in the
tax code if the relationship between the parties could affect the transactions outcome.
The draft law expands the list of situations in which parties will be treated as
being related for Russian tax purposes. Among others, the following parties will be
recognised as being related under the tax code:
Entities where one party (the party and its related parties) has more than a 20%
direct or indirect participation in these entities;
An entity and a member of its board of directors/supervisory board, another
collegial management body or its member, or an individual acting as its sole
executive body;
Entities, where the same individual/entity acts as the sole executive body; and
Settlers, trustees and benefciaries of the trust interdependent (only under certain
circumstances when declared by the courts).
Basis for transfer pricing adjustment
The tax authorities may make a justifed decision to levy additional tax and interest
(for outstanding tax liability, if any) if the result of the controlled transaction was
calculated based on the market price of identical or similar goods (work, services)
when the price used in the controlled transaction differs from the market price by
more than 20%. However, the draft law proposes to abolish the current safe harbour
provision the allowable 20% fuctuation either way of prices from market prices.
The draft law introduces the concept of a market price (proftability) range. The
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tax authorities will be able to adjust prices for tax purposes if the price applied in a
controlled transaction is not within the determined range of prices (proftability).
The current tax code provisions do not appear to allow the tax authorities to reduce the
tax base accordingly. The absence of a correlative adjustment provision in Article 40 is
likely to lead to double taxation after a transfer pricing adjustment. Some Russian tax
treaties provide for correlative adjustment provisions. However, in practice we have
not come across such incidents where the Russian tax authorities have applied transfer
pricing treaty protection for transfer pricing cases.
The draft law will introduce a correlative adjustment mechanism for taxpayers in order
to avoid double taxation in Russia. Provided that the tax authorities adjust the tax base
of a Russian taxpayer, the other party to the controlled transaction will be entitled to
claim a corresponding adjustment to its tax base. The wording contained in the draft
law refers to correlative adjustments relating to Russian domestic transactions only.
In addition to the three existing pricing methods under the current Russian
transfer pricing rules (1-3) mentioned below, the draft law introduces three new
methods(4-6):
1. Comparable uncontrolled price (CUP);
2. Resale price;
3. Cost plus;
4. Sale of processed product (secondary product) (we anticipate that this method
will be excluded from the draft law, since it represents a modifcation of
othermethods);
5. Transactional net margin (comparable profts method); and
6. Proft split.
The strict hierarchy of applying the transfer pricing methods will be replaced by the
best-method rule, coupled with a certain hierarchy in the methods application. The
CUP method will remain the primary transfer pricing method to be used over all other
methods. If this method is not applicable, the taxpayer is free to choose between the
remaining fve, although the proft split method should be used as the method of the
last resort. The choice of a particular transfer pricing method should be supported
with due consideration of the functions performed, the commercial (economic) risks
assumed and the assets employed in a controlled transaction.
The Russian Ministry of Finance will develop methodological recommendations on
the application of transfer pricing rules. The methodological recommendations will be
binding for tax authorities but not for taxpayers.
Note that the current wording of the tax code presumes that only one market price
exists rather than a range of market prices. It is unclear how the tax authorities will
select the market price in cases where several market prices exist for certain goods
(work or services). However, in practice some courts admit the existence of a range of
market prices, although they have not clarifed which price out of the range should be
used for comparing with the actual price applied by a taxpayer.
The new draft law seems to address this problem by introducing a market price
(proftability) interval concept. However, the formula suggested by the draft law is
Russia
different from the interquartile range formula traditionally applied by OECD member
countries to determine market prices. Moreover, when determining the market
proftability range on the basis of the fnancial data of comparable independent
companies, the draft law establishes a number of criteria to be followed for selecting
such comparable companies.
Safe harbours
In determining the market price, the tax authorities are required to take into account
usual discounts from or markups to prices. For example, such discounts or markups can
be caused by the following:
Seasonal or other fuctuations in the consumer demand of goods (work, services);
Loss of goods quality from luxury goods and other consumer properties;
Expiration (approaching the expiry date) of the goods shelf-life or
realisationperiod;
Marketing policy, including new product promotion and new market
penetration;and
Test models and sample goods sales for the purpose of consumer familiarisation.
The tax code incorporates the commonly used principle that, for the purpose of
determining the market price, only transactions carried out under comparable
conditions should be taken into account. In particular, the following factors should
beevaluated:
Quantity (volume) of supply;
Period within which any liabilities should be fulflled;
Terms of payment; and
Other reasonable circumstances which may infuence the market price.
The draft law extends the list of comparability factors to be considered during the
transfer pricing analysis; in particular, the companys functional and risk profle and
business strategy will be introduced as comparability factors.
Securities and derivatives
The Profts Tax chapter of Part II of the tax code came into force on 1 January 2002
and introduced special transfer pricing rules for securities and derivatives. At the end
of 2009, the Russian Parliament passed Federal Law No. 281-FZ of 25 November 2009,
which introduced a number of important changes to the tax treatment of securities and
derivatives. The rules establish the conditions that should be met so that the actual
price of a transaction is deemed to be the market price and therefore may be used as
a basis for the calculation of taxes by the tax authorities. At the same time, aligning
the draft laws provisions with the Profts Tax chapter remains an area for further
legislative development.
The current Russian transfer pricing rules, as codifed by the tax code, are vague and it
is diffcult to apply them in practice. To date, there have been no offcial guidelines or
recommendations on the application of the tax codes transfer pricing provisions, other
than offcial explanations to courts of general jurisdiction and arbitration courts. These
explanations were issued by the Plenum of the Russian Federation Supreme Court
and the Plenum of the Russian Federation Supreme Arbitration Court (Resolution of
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the Plenum of the Russian Federation Supreme Court and the Plenum of the Russian
Federation Supreme Arbitration Court No. 41/9 of 11 June 1999), on Certain Issues
Related to the Enactment of Part 1 of the Russian Federation Tax Code. In general, the
joint resolution simply reiterates the tax code provisions and fails to address a number
of very controversial issues, thus providing evidence of the lack of relevant experience
and ability of the courts to resolve transfer pricing disputes.
At the same time, certain unoffcial clarifcations on the application of transfer pricing
rules are occasionally issued by the Russian Ministry of Finance (e.g. a letter on the
non-application of transfer pricing rules to the interest on loans was published in
April 2007, and a letter on expected margins was released in July 2007 and updated
in2008).
6004. Legal cases
Although case law does not exist in Russia, the vagueness of tax laws and the
inconsistency that exists between the laws and their broad interpretation by the tax
authorities means that the courts play a vital role in developing tax law interpretations
in Russia. That is, in particular cases the law is construed by the decisions of various
courts. However, for the reasons discussed, these decisions often serve only as a
general guide in disputes between the tax authorities and taxpayers, where situations
are similar.
The main factor explaining why taxpayers have won the majority of court cases is that
the burden of proof in transfer pricing cases rests with the tax authorities, who often
fail to show that transfer prices were set incorrectly or try to do so using unoffcial
sources of information.
For example, an analysis of current Russian arbitration court practice in relation to
transfer pricing cases shows that:
When applying the resale minus or cost plus methods, the tax authorities
often fail to prove that the CUP method is impossible to apply in the particular
circumstances;
The court will recognise companies interdependence on grounds other than
the formal grounds listed in the tax code only if the tax authorities prove that
this interdependence had an impact on the results of sales transactions between
them;and
However, the recent trend is that tax authorities are gaining more experience in
transfer pricing according to our analysis, the percentage of court cases won
by them in 2009 increased as compared to 2008. Hot topics inter alia include
challenging the economic justifcation of the procurement of goods through a chain
of intermediary companies and royalty deduction.
The burden of proof rests with the tax authorities, who are required to demonstrate
that the price charged by the taxpayer deviates by more than 20% either way from
the market price. Unless proven otherwise, prices set by taxpayers are deemed to be
marketprices.
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In the draft law, the burden of proof that the prices of controlled transactions do
not correspond to market prices will formally rest with the Russian tax authorities.
However, during a tax audit the tax authorities will be more equipped, since formal
reporting and transfer pricing documentations requirements will be introduced (please
see below).
Reporting requirements
The draft law introduces reporting requirements for taxpayers, who will be required
to submit information on controlled transactions no later than 20 May of the
calendar year following the year when a controlled transaction was performed. Such
information is to include:
A list of controlled transactions (specifying the type and subject of each
transaction) concluded during the corresponding tax period;
A list of parties with which controlled transactions were concluded;
Prices applied/proftability received;
Transfer prices methods applied; and
Such reporting requirements apply, provided the income and expenses from
controlled transactions concluded with the same entity exceed the threshold of
RUB 100 million (approx. USD 3.3 million) per calendar year. It is intended that
the above threshold will gradually decrease to RUB 10 million (approx. USD 0.33
million) by 2016. By decreasing the threshold, the authorities anticipate covering
a wider range of transactions in terms of reporting requirements. At the same
time, as the RUB 10 million threshold appears rather low, we anticipate that tax
authorities may decide to raise it.
Currently, Russia has no formal transfer pricing documentation requirements.
However, in practice, during a feld tax audit the tax authorities may request
supporting documentation confrming the calculation of transfer prices. Therefore, it is
always recommended to document inter-company transactions in advance, rather than
waiting for a request from the tax authorities to provide it.
The draft law formally introduces transfer pricing documentation requirements and
provides that the tax authorities may request transfer pricing documentation during a
tax audit, but not earlier than 1 April of the calendar year following the year in which
a controlled transaction was performed (e.g. transfer pricing documentation for 2011
would be required not earlier than 1 April 2012). Taxpayers will be required to present
transfer pricing documentation within 10 working days of receiving a tax authoritys
request. Documentation can be prepared in a free format (provided there is no
legislative requirement for a specifc format) and contain the following information:
Business overview, including organisational structure, formal intragroup
agreements, other background information;
Industry overview;
Nature and terms of the controlled transaction;
Functional analysis: Assets employed, functions performed, risks assumed by each
party to the controlled transaction;
Transfer pricing methods used;
Description of comparables: Sources of information and other data used and
calculating the range of the arms-length prices/proftability; and
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Financial analysis: Calculations showing how the method has resulted in arms
length terms, calculation of income (proft) to be received, and the economic
beneft obtained in the controlled transaction.
For the purpose of applying transfer pricing documentation requirements, the
threshold on income and expenses from controlled transactions is the same as for
reporting requirements.
In cases where taxpayers have complied with the above procedure in a timely manner,
the tax authorities will release taxpayers from penalty in the event of a tax adjustment.
In these circumstances, taxpayers will have to pay tax calculated in addition to what
they have already paid, plus late payment interest.
Currently, Russian tax code contains no specifc procedures to guide tax authorities in
conducting separate transfer pricing audits. The control of prices is made in the course
of ordinary desk or feld tax audits. A signifcant number of assessments under transfer
pricing rules have already been made, including a few assessments targeting large
integrated oil and energy companies. Although in the current version of Part I of the
tax code the burden of proof of incorrect prices rest with the tax authorities, companies
are advised to take Russian transfer pricing issues seriously and develop and maintain
properly documented and defensible transfer pricing policies.
The most widely used interpretation of the tax code is that the general penalties for
underpayment of taxes may not be imposed on a taxpayer in cases where the taxes
were additionally accrued due to a price adjustment. Furthermore, no special transfer
pricing penalties are provided under the tax code. Technically, the current version of
Article 40 provides that only additional tax and late payment interest on underpaid
tax may be charged by the tax authorities (i.e. on the face of it, no penalties currently
apply to transfer pricing adjustments). Interest should be charged in accordance with
the general rules at a rate of 1/300 of the Central Bank of Russia refnancing rate (set
as 8.25% per year from April 2010).
The draft law will introduce penalties of up to 40% of the transfer pricing adjustment
for underpayment of tax liability as a result of applying prices which do not comply
with the arms-length principle in the event of the non-submission or submission of
incomplete, untimely or inaccurate transfer pricing documentation.
The untimely submission of transfer pricing reporting forms, or their inaccurate
completion, may result in a penalty of RUB 5,000 (approximately USD 167). In the
event of noncompliance with advance price agreement provisions, the tax authorities
will be able to terminate the advance price agreement and impose penalties of up to
RUB 1.5 million (approx. USD 50,000).
The tax authorities may collect underpaid tax, late payment interest, and tax penalties
without a special court order. However, in cases where the underpayment of tax occurs
due to the reclassifcation of the legal treatment of a transaction or the legal status of
a taxpayer by the tax authorities, the underpaid tax may only be collected through a
court. (We interpret this provision as applying to situations where the transfer pricing
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assessment is made by the tax authorities by treating the parties to a transaction as
interdependent on grounds other than the formal grounds provided in Article 20 of the
tax code.)
To date, the tax authorities have not publicly indicated that a dedicated unit will be
established to handle transfer pricing audits. Transfer prices are examined in the
course of a general tax audit. However, it is expected that in the near future selected
tax inspectors will be allocated to specialise in transfer pricing audits and concluding
advance pricing agreements (APAs).
The tax code provides that comparables for determining market prices are to be taken
only from offcial information sources of market prices and exchange quotes. The tax
code does not defne what is meant by offcial information sources. In practice, most
courts have treated only information provided by the Russian statistics authorities as
information from offcial sources. Also, several court cases can be cited as examples of
where commodity exchange information was used.
It appears that the draft law, if introduced in its current form, will provide some clarity
to taxpayers in this area by introducing an open list of information sources that can be
used to establish the market price range. These sources include international exchange
quotations, statistical data of Russian customs authorities and pricing information
available from authorised state government bodies or publicly available information
systems. However, the draft law is silent regarding the feasibility of using fnancial
information on foreign companies to determine the market proftability interval;
thus, we believe there is a risk that the Russian tax authorities may reject using
foreign comparables. Practice will show how this provision will be interpreted by the
taxauthorities.
Russia is a party to more than 60 double tax agreements, most of which have been
concluded on the basis of the OECD model (although often with signifcant deviations)
and therefore contain the Associated Enterprises (or Adjustment of Profts) article.
This article provides for correlative adjustments in the majority of the agreements
(although primarily those concluded recently). In the older treaties, this article
provided for a one-way adjustment that increases the proft of a treaty resident due to
the use of nonmarket prices.
Very little information is available on the practice and procedure for invoking
competent authority assistance (as no such information is published). Moreover,
we are not aware of any cases where relief in cross-border transfer pricing disputes
was obtained through the mutual agreement procedure. However, the opportunity
might exist, as according to informal interviews with Russian Ministry of Finance
representatives, there are some cases when the mutual agreement procedure has been
initiated (e.g. cases related to withholding tax application).
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Currently, there is no legal procedure for obtaining an APA in Russia.
The draft law introduces an APA procedure that will become effective not earlier than
2012. Under the current draft law, only a selected group of taxpayers (the largest
taxpayers) will be given an opportunity to conclude an APA. As such a provision
discriminates towards other taxpayers, we are monitoring whether it stays in the fnal
version of the draft law. An APA will represent an agreement between a taxpayer
and the federal executive body responsible for control and supervision in the area of
taxation. The term of the APA would not exceed three years, with the right being given
to the taxpayer to apply for an extension of up to two years, provided that all of the
APAs terms and conditions are being complied with by the taxpayer. Breach of the
APAs conditions will lead to its premature termination and result in a penalty of RUB
1.5 million (approximately USD 0.5 million).
As noted above, the Russian tax authorities may cooperate with the customs authorities
in determining comparables. The customs authorities possess certain databases for
comparable prices and have certain techniques for evaluating the customs value of
goods which may be used by the tax authorities when challenging prices in a controlled
transaction. Moreover, the tax authorities will work in close cooperation with the
customs authorities on auditing prices in foreign trade transactions. However, it is to
some extent unclear whether information provided by the customs authorities would
satisfy comparability requirements for tax purposes.
Note that taxes payable on the import of goods to Russia (import VAT and customs
duties) are calculated on the basis of the customs value determined by applying special
rules contained in customs legislation (the Law On Customs Tariffs of 21 May 1993
of the RF, with subsequent amendments) as opposed to the general transfer pricing
rules contained in the tax code. The customs pricing rules provide for six methods of
determining customs values and contain a much wider defnition of interdependent
parties than that which is given in the tax code.
6013. OECD issues
Russia is not a member of the OECD but is infuenced by OECD Guidelines and models.
In December 2007, the Ministry of Finance initiated discussions with OECD offcials
regarding the possibility of Russia becoming an OECD member country.
The Profts Tax chapter of Part II of the tax code, which entered into force on 1 January
2002, introduced thin capitalisation rules on debts between interdependent parties.
These rules apply when the loans due to a foreign entity by a Russian entity that is
more than 20% owned by this foreign entity or its affliated parties exceeds by more
than three times (or 12.5 times in the case of banks/credit institutions or enterprises
engaged in leasing) the own capital of the Russian entity. From 1 January 2006, these
rules also apply to loans received from third parties if such loans are guaranteed by the
above foreign company or its Russian affliates. Such loans are determined in the tax
legislation as controlled debts.
Russia
If the above conditions are met, the maximum deductible interest would be determined
by the ratio of the interest accrued on the controlled debt to a capitalisation
coeffcient (a ratio of the controlled debt multiplied by a percentage of the direct or
indirect shareholding to the Russian entitys own capital multiplied by three (or 12.5
in the case of banks/credit institutions or enterprises engaged in leasing)). Interest
in excess of the maximum interest is treated as dividends that are non-deductible for
profts tax purposes and are subject to withholding tax.
In addition to restrictions imposed by thin capitalisation rules (if any), the general
requirements on the deductibility of interest should be observed. Generally,
interest incurred by an entity should be deductible for Russian profts tax purposes,
provided such interest expenses meet the general deductibility criteria (i.e. they are
economically justifed, documentarily supported and relate to the taxpayers proft-
generating activity).
At the same time, Russian tax legislation establishes certain limitations in respect of
the level of interest deductible for tax purposes.
For interest expense to be deductible, the interest rate should not deviate by more
than 20% either way from the average interest rate on comparable loans obtained
in the same calendar quarter (whereby comparable loans mean loans in the
same currency for a comparable amount and against similar collateral), or at the
taxpayers choice; and
A fxed deduction threshold equal to the Bank of Russias refnancing rate (e.g.
8.25% on 1 April 2010) multiplied by 1.1 for RUB loans, and 15% for foreign
currency loans should be used.
Be aware that, based on the current wording of the Russian Tax Code, it is unclear
whether current Russian transfer pricing legislation applies to loan interest. However,
in accordance with the Ministry of Finances latest clarifcations, the current rules
should not apply to loan interest until the respective amendments are introduced to
the legislation. Irrespective of the above, we cannot rule out the possibility that the
Russian tax authorities may in practice attempt to apply such transfer pricing rules.
Moreover, once the draft law becomes effective, its provisions will apply to loan
interest. Therefore, for intragroup loans, it is recommended to establish an interest rate
at an arms-length level.
Singapore
61.
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Singapore
6101. Introduction
Although Singapores income tax rates are traditionally lower than the income tax rates
of the majority of Singapores primary trading partners, the Inland Revenue Authority
of Singapore (IRAS) is increasing its focus on transfer pricing issues.
The Singapore Income Tax Act (SITA) contains provisions that may be used in a
transfer pricing context to effectively allow IRAS to challenge and revise inter-company
transactions. Further, the IRAS recently issued transfer pricing guidelines to provide
greater clarity on transfer pricing matters and procedures in Singapore.
Anti-avoidance
Section 33 of the SITA contains general anti-avoidance rules that allow IRAS to
disregard or revise any arrangement in order to counteract a tax advantage obtained
under an existing arrangement. The rules are applicable to any scheme, agreement
or transaction as a whole, as well as the component steps by which the arrangement
was carried into effect. The anti-avoidance rules do not apply if the arrangement is
conducted for bona fde commercial reasons and the reduction or avoidance of tax is
not one of its main purposes.
Related-party transactions
Section 34D has been enacted recently in the SITA to legislatively endorse the arms-
length principle.
Section 53(2A) of the SITA applies where a resident and a non-resident are closely
connected and conduct business in such a way that produces profts to the resident that
are less than the ordinary profts that might be expected to arise in such transactions.
In such a case, IRAS may assess and charge the non-resident tax in the name of the
resident, as if the resident were an agent of the non-resident. Where the true amount
of the proft is not readily ascertainable, IRAS has the power to assess tax on a fair and
reasonable percentage of the turnover of the business done between the resident and
the non-resident.
Tax authorities powers
As a fnal measure, IRAS has the power to simply refuse to accept a tax return as
fled and assess tax based on taxable income determined according to the best of
itsjudgment.
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Singapore
Singapore transfer pricing guidelines
Background
The Singapore transfer pricing guidelines (the guidelines) were issued by the IRAS
in February 2006. These guidelines provide guidance to Singapore taxpayers on
application of the arms-length principle and on documentation matters.
The said guidelines also provide the procedures for applying for the mutual agreement
procedure (MAP) and advance pricing arrangement (APA) facilities, which are used to
avoid or eliminate double taxation.
Scope
The guidance on application of the arms-length principle is applicable to all related
party transactions of goods, services and intangible properties. The guidance on MAPs
and APAs are applicable only to related party transactions involving at least one party
resident in Singapore or a jurisdiction with which Singapore has a comprehensive
Double Taxation Avoidance Agreement. Further, the guidelines are applicable where at
least one related party is subject to tax in Singapore.
Defnition of related party
The guidelines defne a related party for Singapore transfer pricing purposes as:
The related party, in relation to any entity, means any other entity who directly or
indirectly controls that entity or is controlled, directly or indirectly, by that entity, or where
both entities, directly or indirectly, are under the common control of a common entity.
The arms-length principle
The arms-length principle described in the guidelines and legislated in the SITA is in
line with the arms-length principle in the OECD Model Tax Convention on Income and
Capital and in the OECD Transfer Pricing Guidelines (i.e. the arms-length principle
requires the transaction with a related party to be made under comparable conditions
and circumstances as a transaction with an independent entity).
The guidelines, however, recognise that establishing and demonstrating compliance
with the arms-length principle requires exercise of judgment and recommends that
taxpayers adopt a pragmatic approach to ascertaining arms-length pricing for related
party transactions.
The guidelines seek to provide guidance and recommendations on the application of
the arms-length principle with the following three-step approach:
1. Step 1 Conduct a comparability analysis.
A comparability analysis is conducted to analyse whether the uncontrolled price/
margins being compared to the controlled price/margins have all economically
relevant characteristics similar, such that one of the following conditions exists:
a. None of the differences of the situations being compared can materially affect
the prices or margins being compared; and
b. Reasonably accurate adjustments can be made to eliminate the effect of any
such differences.
The guidelines also suggest that a comparability analysis should examine the
comparability of the transactions in the following three aspects:
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a. Characteristics of goods, services and intangible properties;
b. Analysis of functions, assets and risks; and
c. Commercial and economic circumstances.
The ultimate aim of the comparability analysis is a comprehensive assessment and
identifcation of the areas and extent of signifcant similarities and differences
(such as product characteristics or functions performed) between the transactions/
entities in question and those to be benchmarked against.
2. Step 2 Identify the appropriate transfer pricing method and tested party.
The guidelines indicate that, in theory, the traditional transaction methods provide
for a more direct comparison with independent-party transactions and hence
would be superior to the transactional proft methods. However, the guidelines do
recognise that, in practice, the reliability of the results produced by any method
would be crucially affected by the availability and quality of data as well as the
accuracy with which adjustments can be made to achieve comparability. Hence,
the guidelines do not have a specifc preference for any one method. The guidelines
recommend the adoption of the method that produces the most reliable results,
taking into account the quality of available data and the degree of accuracy
ofadjustments.
The guidelines allow the Singapore taxpayer to select any one of the following
methods for its transfer pricing purposes:
a. Comparable uncontrolled price (CUP) method;
b. Resale price method;
c. Cost plus method;
d. Proft split method; and
e. Transactional net margin method.
The guidelines also allow the taxpayer to use a modifed version of one of these
methods to comply with the arms-length principle, as long as the taxpayer
maintains and is prepared to provide suffcient documentation to demonstrate that
its transfer prices are established in accordance with the arms-length principle.
3. Step 3 Determine the arms-length results.
Once the appropriate transfer pricing method has been identifed, the method is
applied on the data of independent-party transactions to arrive at the
arms-lengthresult.
Documentation
The guidelines provide guidance on the type of documentation that taxpayers should
keep to demonstrate that reasonable efforts have been taken to comply with the arms-
length principle.
The guidelines indicate that the following information (not exhaustive) would be
useful in substantiating that the taxpayers transfer pricing analyses are in accordance
with the arms-length principle and that the taxpayer has made reasonable efforts to
determine arms-length transfer prices, margins or allocations:
General information on the group;
Information on each related party in Singapore (Singapore entity);
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Details of transactions between Singapore entity and all related parties; and
Transfer pricing analysis.
However, the guidelines recognise that keeping robust documentation may result
in compliance and administrative costs for taxpayers. In this respect, the guidelines
indicate the following principles with regard to documentation:
Taxpayers are only required to prepare or obtain documents necessary to allow
a reasonable assessment of whether they have complied with the arms-length
principle;
Singapore currently does not impose a penalty specifcally for the lack or
insuffciency of documentation. However, if the taxpayer violates the recordkeeping
requirements under Sections 65, 65A and 65B of the SITA, the IRAS would not in
any way be precluded from enforcing these relevant provisions; and
The IRAS does not require documentation to be submitted when the tax returns are
fled. Taxpayers should keep the documentation and submit it to IRAS only when
requested to do so.
Guidelines in connection with MAP
The guidelines also provide the IRAS position on the MAP process as well as provide
guidance on the manner in which taxpayers may apply for the MAP with respect to
transfer pricing adjustments.
The MAP aims to provide an amicable way by which competent authorities may
eliminate double taxation. Although IRAS would endeavour to eliminate or reduce
the double taxation that the taxpayer may encounter, it is possible only if there is
concurrence by all competent authorities involved in the process and full cooperation
by the taxpayer.
The guidelines indicate that the IRAS generally accepts a taxpayers request for MAP if:
The taxpayer has complied with the time limit specifed in the applicable DTA for
presenting the MAP request;
Double taxation is almost certain and not just a possibility; and
The taxpayer is willing and able to render full cooperation.
Further, the guidelines also provide the procedural aspects involved in making a MAP
request to IRAS. The procedure involves:
1. Step 1 Submit notifcation of intention to make MAP request.
The notifcation to IRAS should be made in writing and should describe briefy
the circumstances and provide basic information concerning the cause of
doubletaxation.
2. Step 2 Hold preliminary meetings.
In the preliminary meetings, the IRAS evaluates the taxpayers situation and
grounds for making the request as well as the quality and adequacy of the
taxpayers documentation.
3. Step 3 Submit formal request.
Unless the IRAS or other competent relevant authorities object to the taxpayers
MAP request, the taxpayer should formally submit a MAP request to the IRAS.
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4. Step 4 Review and resolve double taxation.
IRAS commences the process of MAP and tries to resolve the double taxation issue
with the other relevant competent authorities.
5. Step 5 Hold post-agreement meeting and implement agreement.
Upon reaching agreement with the other competent authority, the IRAS meets
with the taxpayer to discuss the details of the agreement and to implement
theagreement.
Guidelines in connection with APA
An APA determines, in advance, an appropriate set of criteria to ascertain the transfer
prices of specifed related party transactions over a specifed period of time. The treaty
provisions and the domestic tax provisions enable Singapore competent authorities to
accede to requests from taxpayers for APAs and enter into such agreements. Singapore
allows for unilateral as well as bilateral APAs.
IRAS has issued additional guidance for taxpayers seeking to enter into unilateral,
bilateral or multilateral APAs. This supplementary administrative guidance on
APAs sets out various important time lines to observe during preliminary meetings,
the formal APA submission and review, and when (and the period for which) roll-
back may apply to bilateral or multilateral APAs. The guidance also spells out the
circumstances under which the IRAS will discontinue an APA discussion. Broadly, the
processinvolves:
1. Step 1 Hold preliminary meetings.
Generally, at preliminary meetings, the taxpayer is expected to present the salient
information such as the companys business model and industry information,
transactions to be covered, the period of APA, etc. The frst preliminary meeting
with the IRAS should take place at least three months before the date the taxpayer
intends to submit an APA application to the IRAS and/or another competent
authority. The IRAS discourages anonymous requests to discuss potential APAs.
If the IRAS is willing to accept the APA, it advises the taxpayer on the appropriate
follow-up action.
2. Step 2 Submit formal APA.
Unless the IRAS or relevant foreign competent authorities disagree, the taxpayer
should formally submit an APA request at least six months before the frst day of the
proposed APA covered period.
3. Step 3 Review and negotiate APA.
Within one month of receipt of the formal application, the IRAS informs the
taxpayer of whether the APA application has been accepted or rejected. The
taxpayer should note that the IRAS reserves the right to propose alternative
methodologies or to request a restriction or expansion of the scope of the proposed
APA subsequent to the formal submission of the APA application. If the IRAS
accepts the APA application, it begins the process of seeking an APA with relevant
foreign competent authorities (in case it is a bilateral APA).
4. Step 4 Hold post-agreement meeting and implement APA.
Upon reaching agreement, the IRAS meets with the taxpayer to discuss the details
of the agreement and to implement the agreement.
Singapore
The IRAS releases interpretation and practice notes as well as administrative
statements to provide guidance to taxpayers on a variety of issues. These publications
do not have the force of law and are not binding. However, they do provide the IRAS
view on the law and its administrative practices in its application of the law.
6104. Legal cases
To date, no specifc cases relating to transfer pricing issues have been brought before
a Singapore court. However, case law from other common law jurisdictions may be
applicable on a case-by-case basis.
It is common for the IRAS to query the basis of inter-company charges or transactions
by requesting that a taxpayer provide evidence that such transactions are at arms
length. The burden of proof lies with the taxpayer.
Pursuant to the transfer pricing consultation circular issued by IRAS in July 2008, a
questionnaire requesting information on related party transactions is sent to selected
taxpayers. The objective of the transfer pricing consultation is to assess the level of
compliance with the Singapore transfer pricing guidelines by reviewing the taxpayers
transfer pricing documentation. This questionnaire is, in effect, a declaration that the
taxpayer must sign. Based on the response to the questionnaire, taxpayers may be
selected for an in-depth feld visit and further examination by the IRAS if their transfer
pricing practices are found to be inappropriate.
Additionally, to determine the accuracy of a tax return, the IRAS may require
any taxpayer to provide their books, documents, accounts, returns and any other
information that would allow the IRAS to obtain full information in respect of
the taxpayers income. Business records are required to be maintained for at least
fveyears.
If the IRAS does not agree with a taxpayers tax return, it may, within six years after
the year of assessment (for year of assessment 2007 and earlier) and four years after
the year of assessment (for year of assessment 2008 and thereafter), issue a notice
of assessment based on its best judgment. A taxpayer that disagrees with a notice
of assessment must object in writing within 30 days from the date of the notice. As
the taxpayer is required to provide detailed grounds for objection, documentation to
support its inter-company pricing should be available at this time. The IRAS considers
the grounds for the objection, including any documentation received, and may issue an
amended assessment. If the IRAS and the taxpayer are unable to reach an agreement, a
Notice of Refusal to Amend is issued.
Taxpayers have the right to appeal to the Board of Review if they are dissatisfed with
the IRAS decision. Based on the decision of the Board of Review, the taxpayer or the
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IRAS may choose to appeal to the High Court. Subsequently, application may be made
to the Court of Appeal if either party is dissatisfed with the High Courts decision.
However, the Court of Appeal does not hear appeals on a question of fact.
The legislation and the transfer pricing guidelines do not provide penalties specifcally
directed at transfer pricing offences. However, the general provisions relating to
offences and penalties are applicable where the IRAS has a dispute with a taxpayer in
relation to its inter-company transactions.
A taxpayer that omits or understates any income may be subject to a penalty equal to
the amount of tax that has been or would have been undercharged. Where a taxpayer
is found to be negligent in omitting or understating income, the penalty is double the
amount of tax that has been undercharged plus a fne not to exceed SGD5,000, or
imprisonment for a term not to exceed three years, or both. A taxpayer who is found
to have wilfully understated their income with intent to evade tax is subject to more
severe penalties.
Further, IRAS can invoke penalty provisions under Sections 65, 65A and 65B of the
SITA for violation of record- or information-keeping requirements; can impose a fne
not to exceed SGD1,000; and, in default of payment of fne, can impose imprisonment
for a term not to exceed six months.
Penalties and interest charges on the underpayment of tax are not deductible for
taxpurposes.
The IRAS has obtained training on transfer pricing from other tax authorities and
shares information on a regular basis with other Association of South East Asian
Nations (ASEAN) tax jurisdictions in relation to the taxpayers.
Although Singapore does not mandate contemporaneous documentation
requirements, it requires taxpayers under review to verify and confrm the arms-length
nature of its related party transactions through suffciently detailed and comprehensive
documentation. The documentation should include an analysis of the functions and
risks undertaken by the Singaporean taxpayer and the methodology upon which it
derived the transfer price, including benchmarking.
Availability
The IRAS requires transfer prices to be comparable to industry standards. Comparable
information is available through databases.
In addition to the limited agreements dealing with the taxation of the international
traffc of ships and aircraft, Singapore has a fairly extensive network of comprehensive
double tax agreements modelled based on the OECD convention.
Singapore
The majority of Singapores treaties contain an Associated Enterprises article which
permits the respective tax authorities to adjust the profts of an entity where the
transaction did not occur at an arms-length price. However, very few of its treaties
contain the accompanying relieving provisions in the article that effectively requires
one country to reduce the amount of tax charged to offset the increased tax liability
imposed by the other country as a result of refecting the transaction at arms length.
Where a treaty does not contain the relieving provisions, a taxpayer must apply to
the competent authorities under the mutual agreement procedure (MAP) article to
obtain relief from double taxation. See the Statutory rules section for details relating to
thisprocess.
The treaty provisions and the domestic tax provisions enable Singapores competent
authorities to accede requests from taxpayers for advance pricing agreements (APAs)
and enter into such agreements. See the Statutory rules section for details relating to
this process.
Funding
The IRAS has released transfer pricing guidelines on application of the arms-length
principle to related party loans. Domestic and cross-border loans are covered under
thisguideline.
The taxpayer should adopt the arms-length methodology in related party cross-
border loans. As time is needed to restructure loans to refect an arms-length rate of
interest, the IRAS provides a transitional period of two years starting from 1 January
2009. From 1 January 2011 onwards, IRAS requires all related party cross-border loan
arrangements to refect arms-length conditions.
A number of entities have been set up in Singapore to provide services to related parties
in the region. Transfer prices for such services are typically determined on a cost plus
basis. In the past, IRAS generally accepted the transfer price for management services
where the service actually performed for the beneft of the payer can be identifed
and the transfer price refects at least a 5% proft on the total cost of the service. Note
that IRAS has now issued guidelines on related party services, which states that a 5%
proft is accepted for only routine services. The IRAS would expect a higher proft in
the case of greater value-added services provided by a Singaporean entity, for example,
research and development.
Where a non-resident related party provides management services to a Singaporean
entity, the fee charged to the Singaporean entity is generally deductible if the services
provided can be identifed and the fee is reasonable and appropriate, based on the
costs actually incurred by the service provider. Further, there must be a direct beneft
to the Singaporean entity to receive a deduction. No Singaporean withholding tax is
levied on the payments made by Singaporean entities where services are rendered
outsideSingapore.
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The IRAS is increasingly scrutinising intragroup recharges to ascertain that services
have provided a direct beneft to the Singaporean entity. Taxpayers are required to
justify the level of service received vis--vis the recharge and confrm that the recharges
exclude any shareholder costs.
IRAS has also issued guidelines on the conditions where cost pooling or pass-through
costs are acceptable.
6114. Business profts
Singapores comprehensive double tax agreements contain a Business Profts article
that provides, in general, that business profts of an enterprise are not taxable in
Singapore unless that enterprise has a permanent establishment (PE) in Singapore.
Where an enterprise has a PE in Singapore, only those profts attributable to that PE
may be taxed in Singapore.
Slovakia
62.
International Transfer Pricing 2011 689 Slovakia
6201. Introduction
The Slovak tax system was established in 1993. Tax legislation attempted, in basic
terms, to prevent deviations from arms-length prices in related party transactions.
Since 1993, the tax authorities understanding of transfer pricing principles has
grown signifcantly, and with it the need for taxpayers to comply with arms-length
pricing regulations. One major milestone in Slovak transfer pricing history was
December 2000, when Slovakia joined the OECD. This meant that taxpayers could
adopt the OECD Guidelines with some degree of certainty that the treatment would be
acceptable to the Slovak tax authorities. Furthermore, the Slovak Ministry of Finance
has issued an offcial translation of the Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrations, published by the OECD. Despite this, practical
experience with transfer pricing principles is limited, compared to more developed
countries. However, it is increasing.
6202. Corporate income tax
The Slovak Income Tax Act and Slovak transfer pricing regulations cover foreign
related parties. Foreign related parties are defned as a Slovak tax resident and a non-
Slovak tax resident that are one of the following:
Relatives;
Entities that are economically or personally related; and
Entities with certain other relationships;
Economically or personally related means one of the following:
When one entity directly or indirectly holds more than 25% of the share capital or
voting rights of the other;
An entity and its statutory representative or a member of its supervisory board;
Two or more entities in which a third entity directly or indirectly holds more than
25% of the share capital or voting rights; and
Entities having the same person as their statutory representative or a member of
their supervisory board.
However, according to the full extensive defnition set in the Slovak Income Tax Act, all
companies within the company group most likely qualify as related parties.
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Entities with certain other relationships are parties connected solely for the purpose
of reducing the tax base. Furthermore, a Slovak permanent establishment (PE) and
its foreign headquarters, as well as foreign PEs and their Slovak headquarters, are
also considered foreign related parties. In addition, for Slovak personal income tax
purposes, the Slovak transfer pricing regulations are applicable to any transactions
between an employer and its employee.
Generally, the prices in transactions between foreign related parties are required to be
at arms length.
In 2001, the transfer pricing legislation introduced a number of methods to determine
the arms-length price for cross-border transactions between related parties. These
methods broadly equate to the transaction-based methods and proft-based methods
according to the OECD Guidelines. The transaction-based methods listed include:
comparable uncontrolled price, resale price, and cost plus methods. The proft-based
methods listed include: the transactional net margin and proft split methods.
The Slovak taxpayer can also use a combination of these methods, or choose any other
method, provided the method used is in accordance with the arms-length principle.
However, in general, taxpayers should use transaction-based methods.
There are no formal advance pricing agreements (APAs) in Slovakia. The Slovak tax
authorities can, however, approve a particular method of setting the price in advance.
They are obliged to issue a decision on a particular method to be used if asked by
a taxpayer. However, they do not confrm prices used or publish any benchmarks.
The approved method can be used for up to fve tax periods, and can be extended
for another fve tax periods if the conditions of the operations do not change. The
tax authorities should cancel or amend their decision if the approved method was
approved based on false or inaccurate information provided by the taxpayer or after
the conditions had changed. The tax authorities may also cancel or amend their
decision based on the request of the taxpayer proving that conditions have changed.
In addition, the tax authorities can approve a method for determining the corporate
income tax base of a Slovak permanent establishment of a foreign taxpayer. This
method is usually based on one of the OECD transfer pricing methods.
For certain related party transactions, such as a sale of certain assets or a business, the
Slovak tax authorities generally accept as the arms-length price the value of the items
sold as appraised by an independent, court-approved Slovak valuation expert.
From 2009, all Slovak taxpayers have to report monetary value of intragroup
transactions performed in each particular tax year in their corporate income
taxreturns.
Generally, the burden of proof rests with the taxpayer.
Until 2009, the corporate income tax law did not specify how to prove that intragroup,
cross-border transactions were at arms length.
International Transfer Pricing 2011 Slovakia 691
Slovakia
At the beginning of 2009, the Slovak Ministry of Finance issued a guideline which set
out the content of obligatory transfer pricing documentation (the Guideline). Under
the Guideline, a Slovak companys obligatory transfer pricing documentation should
include information that explains how the prices applied in transactions with foreign
related parties have been set, and justifes their arms-length nature.
The transfer pricing documentation is required for all tax periods during which
the Slovak taxpayer carries out transactions with its foreign related parties. It
must be in Slovak, unless the tax authorities agree to accept documentation in a
differentlanguage.
The transfer pricing documentation with a defned content (full transfer pricing
documentation) is required only for material transactions undertaken by entities that
prepare their fnancial statements based on the International Financial Reporting
Standards (IFRS) for Slovak statutory purposes. However, to be able to justify prices
applied in foreign-related-party transactions, other entities should also maintain
transfer pricing documentation (simplifed transfer pricing documentation).
The full transfer pricing documentation under the Guideline is based in the EU
recommendations, and should include general transfer pricing documentation (a
master fle) and specifc transfer pricing documentation (a local fle).
The master fle includes the following information about the pricing policy within the
entire group or related entities (Slovak and foreign):
The identifcation of group members;
The group ownership structure;
A business description;
Industry identifcation;
The business strategy of the group; and
A description of the functions undertaken and the risks assumed by individual
entities within the group.
The local transfer pricing documentation should contain the following specifc
information about the Slovak entity and its transactions with its foreign related parties:
The identifcation of the entity and its ownership;
A description of the companys business and industry;
The companys organisational structure and a list of foreign related parties;
The companys planned business strategy and business plan;
A list and description of transactions or services provided to foreign related parties;
An overview of the companys intangible assets;
A description of the functions undertaken and the risks assumed by the
Slovakcompany;
Information on the choice and application of transfer pricing methods; and
Information on comparable data (benchmarking study).
Taxpayers are obliged to provide the transfer pricing documentation within 60 days
of the tax authorities request for it during tax inspections. It is therefore important
that the documentation be prepared at the same time that the foreign-related-party
transactions are implemented.
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6204. Value added tax
On 1 January 2010, an amendment to the Slovak VAT Act which introduced transfer-
pricing rules for VAT was introduced. According to the amendment, if the actual price
that a Slovak VAT payer charges for supplies of goods and services to an entity which
is a related party as defned in Slovak VAT law is lower than the market value, then the
tax base shall be the market value if the recipient is either:
Not registered for Slovak VAT; and
A Slovak VAT payer (registered for Slovak VAT as a domestic or foreign entity) but
does not have the right to claim the full input VAT for these goods and services.
Under the amendment, a related party to the VAT payer is, for example, a statutory
body or statutory representative of the VAT payer, an entity who directly or indirectly
owns or controls 10% or more of shares of the VAT payer supplying the goods or
services, or one that is directly owned or controlled by 10% or more of shares of this
VAT payer or employees of the VAT payer.
6205. Other taxes
In Slovakia, gift tax was abolished on 1 January 2004, and real estate transfer tax was
abolished on 1 January 2005.
With respect to real estate tax, the value of the real estate, based on which the tax base
is determined, should generally be set according to the appendix to the Real Estate Tax
Act. In specifc cases, it should be based on the arms-length price, determined by an
independent, court-approved valuation expert who must value the real estate under
specifc regulations.
6206. Customs
Since its accession to the EU on 1 May 2004, Slovakia has followed the EU Customs
Code, based on the transaction value. For sales between related parties, the price
applied in any particular case should approximate the transaction value in sales of
identical or similar goods between buyers and sellers who are not related.
6207. Tax inspection procedures
A tax return can be opened for a transfer pricing inspection and potential additional tax
charges on the grounds of transfer pricing could be assessed for 11 years following the
year or tax period concerned.
According to the Slovak Act on Tax Administration, the tax administrator should
impose a fxed penalty equal to three times the European Central Banks interest rate
on the difference in tax between that shown in the tax return and that determined by
the tax administrator (but not less than 10%).
In the event of late payment of the tax liability declared in the tax return, the tax
administrator should impose interest of four times the European Central Bank of
Slovakias interest rate on overdue tax. This applies to each day of late payment, up to a
maximum period of four years.
International Transfer Pricing 2011 Slovakia 693
Slovakia
As the tax authorities become more familiar with transfer pricing principles and
begin to understand the background to transactions between related parties, the
importance of having suffcient and technically sound documentation increases. The
tax authorities recently started to make special transfer pricing tax inspections and
have formed a specialised group of transfer pricing experts.
The tax offce continues to train a specialised group of staff to handle transfer pricing
audits and has already performed a number of transfer pricing tax inspections of
multinational companies, resulting in signifcant additional tax charges.
Slovenia
63.
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Slovenia
6301. Introduction
Slovene transfer pricing legislation, which generally embraces the OECD Guidelines,
applies to cross-border and domestic inter-company transactions. Supporting transfer
pricing documentation has been required since 2005. As of 2006, the transfer pricing
documentation for cross-border inter-company transactions must be prepared
concurrently; documentation for domestic inter-company transactions needs to be
submitted only upon request from the tax authorities in the course of a tax inspection.
The introduction of Slovenias transfer pricing rules has been accompanied by efforts to
train Slovene tax inspectors in transfer pricing analysis using consultants from foreign
revenue authorities.
Defnition of taxable basis between related parties
The arms-length principle is described in Article 16 of the Slovene Corporate Income
Tax Act (CITA), which is valid from 1 January 2005. In establishing a taxable persons
revenues and expenses, the pricing of transfers of assets (including intangible assets)
between related parties and inter-company services should not be less than the
arms-length amount for revenues, and not greater than the arms-length amount
forexpenses.
Methods for determining the arms-length price
Comparable market prices are determined by one or a combination of the methods
specifed in the OECD Guidelines. The traditional transactional methods specifed in
the OECD Guidelines include the comparable uncontrolled price (CUP) method, the
resale price method and the cost plus method.
Where these traditional transaction methods cannot be applied, the transactional
proft methods (transactional net margin method and proft split method) may be
used.
The Slovene Ministry of Finance issued regulations on transfer pricing which came into
force on 1 January 2007. These regulations set out in more detail the application of the
fve pricing methods in a manner similar to that outlined in the OECD Guidelines.
Provisions in Articles 16 and 17 of the CITA differentiate between the defnition of
related parties, depending on whether the transactions are cross-border or domestic.
International Transfer Pricing 2011 Slovenia 695
Slovenia
Cross-border controlled transactions are transactions between a taxable person
(resident) and a foreign person (non-resident) related in such a way that:
The taxable person directly or indirectly holds 25% or more of the value or
number of shares of a foreign person through holdings, control over management,
supervision or voting rights; or controls the foreign person on the basis of a
contract or terms of transactions different from those that are or would be achieved
in the same or comparable circumstances between unrelated parties;
The foreign person directly or indirectly holds 25% or more of the value or
number of shares of a taxable person through holdings, control over management,
supervision or voting rights; or controls the taxable person on the basis of a
contract or terms of transactions different from those that are or would be achieved
in the same or comparable circumstances between unrelated parties;
The same legal person directly and, at the same time, indirectly holds 25% or more
of the value or number of shares, or participates in the management or supervision
of the taxable person and the foreign person or two taxable persons; or they are
under his control on the basis of a contract or transaction terms different from
those that are or would be achieved in the same or comparable circumstances
between unrelated parties; and
The same natural persons or members of their families directly or indirectly hold
25% or more of the value or number of shares, holdings, voting rights or control
over the management or supervision of the taxable person and the foreign person
or two residents; or they are under their control on the basis of a contract or
transaction terms different from those that are or would be achieved in the same or
comparable circumstances between unrelated parties.
Domestic inter-company transactions are transactions between two taxable resident
persons. Residents shall be related parties if either of the following conditions exist:
They are related in terms of capital, management or supervision by virtue of one
resident, directly or indirectly, holding 25% or more of the value or number of
shares, equity holdings, control, supervision or voting rights of the other resident;
or controls the other resident on the basis of a contract in a manner that is different
from relationships between nonrelated parties; and
The same legal or natural persons or their family members directly or indirectly
hold 25% or more of the value or number of shares, holdings, control, supervision
or voting rights; or control the residents on the basis of a contract, in a manner that
is different from relationships between nonrelated parties.
Related parties are also taxable and natural persons performing business, provided
that such natural persons (or their family members) hold 25% or more of the value or
number of shares or equity holdings; or participate in the management, supervision or
voting rights of the taxable person; or control the resident on the basis of a contract in
a manner that is different from relationships between nonrelated parties.
Notwithstanding the above provisions, the tax base may be adjusted only in cases when
one of the residents: (1) shows unsettled tax loss from previous tax periods in treated
tax period, (2) pays the tax at a rate of 0% or a rate that is lower than 20%, or (3) is
exempt from paying the tax.
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Documentation
A taxable person shall provide and keep the information about related parties, the
types and extent of business transactions with these entities, and the determination
of comparable market prices as prescribed by the Tax Procedure Act (TPA). The
provisions of the TPA on transfer pricing follow the EU Code of Conduct on transfer
pricing documentation for associated enterprises in the European Union (EU TPD).
Therefore, companies need to prepare a masterfle and country-specifc documentation
as described below:
The masterfle should contain at least the description of a taxable person,
group structure, and type of relationship, transfer pricing system, general
business description, business strategy, general economic and other factors and
competitiveenvironment; and
The country-specifc documentation should contain information about transactions
with related entities (description, type, value, terms and conditions), benchmark
analysis, functional analysis, terms of contracts, circumstances that have an
infuence on transactions, application of the transfer pricing method used and
other relevant documentation.
The masterfle must be assembled concurrently, and no later than the submission of the
tax return. The Ministry of Finance determines what information should be provided
upon submission of the tax return.
If the masterfle is not in the Slovenian language, it must be translated on the request of
the tax authorities within a minimum of 60 days.
The Slovene Ministry of Finance has issued explanatory regulations on transfer pricing
and regulations on reference interest rates.
The regulations on reference interest rates defne a methodology for determining a
reference interest rate on inter-company loans between related parties, to be taken
into consideration when determining revenues and expenses. The reference interest
rate is the sum of a variable part of an interest rate (e.g. EURIBOR, LIBOR-USD) and a
markup expressed in basis points, which is determined for a particular maturity period
and depends on the credit rating of the taxable person (borrower/loan provider).
Regulations on transfer pricing replaced the regulations on determination of
comparable market prices and introduced some important changes. The most
important changes are provisions on the use of cost contribution agreements and the
use of the interquartile range. Regulations on the determination of comparable market
prices (valid until 1 January 2007) prescribed the use of the arithmetic mean, while
the new regulations on transfer pricing declare that the interquartile range should be
used when determining an arms-length price. Moreover, the use of multiple-year data
is accepted, which can disclose facts that may have infuenced the determination of the
transfer price. In addition, the regulations defne business interdependence that can be
attained without one party having at least a 25% share in the other party.
The new regulations also pay attention to the loss positions of related entities resulting
from inter-company transactions. This approach tests whether comparable unrelated-
Slovenia
party transactions would be proft-making by considering whether an independent
entity would be in a loss position under the same circumstances.
Disclosure
Entities that have transactions with related parties must supply in the supplement
to the tax return certain information on the value of controlled transactions and
information on interest rates between related parties.
Supplements to the tax return concerning controlled transactions disclose the names
of the entities involved in controlled transactions with the entity that fles the tax
return, the type of relationship and the total value of the controlled transactions
for each related entity separately. A supplement containing information on interest
rates between related parties discloses the total value of received and granted loans,
classifed by each related entity, and specifes whether a related entity has an adjusted
tax base. The supplement must be completed only when the total value of received and
granted loans in the tax period amount to more than EUR 50,000 per related entity, as
provided by regulations on the corporate income tax return, in force as of 29 May 2007.
6304. Legal cases
The Slovene tax authorities began to perform tax inspections concerning the fulflment
of transfer pricing documentation requirements in the second half of 2006. So far,
there have been no legal cases on transfer pricing.
Since documentation requirements for transfer pricing came into force in Slovenia, the
burden of proof is placed on the taxpayer. Taxpayers must keep specifc documentation
proving that they apply transfer prices in line with the arms-length principle. If proper
transfer pricing documentation is in place, together with the corporate tax return, the
burden of proof shifts to the tax authority.
When examining transfer prices, the Slovene tax authorities must determine the arms-
length nature of inter-company transactions using the method(s) previously applied
by the taxpayer, provided that the taxpayer submitted prepared documentation,
used one of the recognised methods and that the method used is supported by
appropriatecalculations.
To date, the Slovene tax authorities have raised the transfer pricing issue only in the
context of regular tax audits. However, a framework is in place for transfer-pricing-
oriented audits to be undertaken.
Any entity engaged in intragroup transactions must be able to support the prices
agreed between related parties meet the arms-length criteria. Failure to comply with
these laws may result in signifcant tax exposure and penalties.
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Sanctions include adjustment of the tax base to increase the tax charge (or reduce a tax
loss), as well as the following penalties:
30% of underpaid tax for micro and small legal entities (underpaid tax from
EUR1,500 to EUR150,000);
45% of underpaid tax for medium and large companies (underpaid tax from
EUR2,000 to EUR300,000);
and additional fnes of up to EUR5,000 for the responsible person, plus late
paymentinterest.
For taxes not paid within prescribed deadlines, late payment interest is levied at a daily
interest rate of 0.0274%.
If adequate transfer pricing documentation is not submitted or is not submitted
according to the terms defned by the tax authorities, the penalty is EUR3,200 to
30,000 for the legal entity and EUR400 to EUR4,000 for the responsible representative
of the legal entity.
The Slovene tax authorities have a specialised group that is trained to perform transfer
pricing examinations.
Comparable information is required to support the arms-length nature of related party
transactions and should be included in the taxpayers transfer pricing documentation.
The arms-length nature of transactions with related parties shall be demonstrated
by applying one or more of the prescribed acceptable methods. Acceptable methods
that can be applied under the CITA include the traditional OECD methods or any
combination of them. The comparable uncontrolled price method is the preferred
method as defned in the regulations on transfer pricing. Additionally, the comparable
uncontrolled price method, resale price method and cost plus method are preferable
methods compared to the proft split method and transactional net margin method. In
practice, it is often not easy to obtain information on comparable uncontrolled prices.
In such cases, a transactional net margin method is used.
The Slovene tax authorities have access to the Amadeus database and local databases
containing fnancial information for Slovene companies, such as GVIN and IBon. In
accordance with the Slovenian Companies Act, companies and sole proprietors are
required to submit annual reports that are publicly available.
The Slovene tax authorities have a preference towards using local comparable
companies for benchmarking purposes, although a Pan-European benchmark may also
be accepted.
Transfer pricing is an area of increasing interest for the Slovene tax authorities. So far,
they have not concentrated on any particular industry, but special attention has been
directed towards management fees and royalties charged between related parties.
Slovenia
Currently, there is no legal basis for an APA in Slovenia. Although the new tax
legislation contains provisions on binding tax rulings, obtaining a binding ruling for
transfer pricing purposes has not been made possible.
Although the Slovene tax authorities have not been considered aggressive, their
approach to transfer pricing issues is expected to change. The expanded practical
training and experience of tax auditors will raise the profle of transfer pricing issues
in tax audits. It is also expected that the tax authorities will have to deal with a higher
number of complex transfer pricing issues.
6313. OECD issues
Slovenia is not a member of the OECD. However, transfer pricing legislation and
the tax authorities have generally adopted the arms-length principle and methods
provided by OECD Guidelines.
There is no evidence of joint investigations.
Thin capitalisation provisions restricting the tax deductibility of interest expenses
on related party loans came into force in Slovenia on 1 January 2005. The tax
deductibility of interest payments on loans granted by a related party (a party that
owns at least 25% of the shares or voting rights in the taxpayer or vice versa) is
generally restricted (but not for banks and insurance companies), where the amount of
loans exceeds a certain multiple of the shareholders share in the equity of the taxpayer
in a particular tax period (see below regarding the debt-to-equity ratio).
Loans from third parties for which the shareholder issues a guarantee and loans
granted by a bank that are linked to a deposit of the shareholder in the same bank
are also subject to the thin capitalisation rules. The size of the shareholders share in
the equity of the loan recipient is calculated as an average of the subscribed capital,
retained net profts and the capital reserves held on the last day of each month in the
taxation period.
The Slovenian tax provisions related to thin capitalisation are less rigorous than in
some comparable EU tax jurisdictions.
The applicable debt-to-equity (D/E) ratio is as follows:
8:1 D/E ratio applies for the years 2005, 2006 and 2007;
6:1 D/E ratio applies for the years 2008, 2009 and 2010;
5:1 D/E ratio applies for the year 2011; and
4:1 D/E ratio applies for the following years, starting from 2012.
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For companies receiving management services, the general rules on the deductibility of
expenses apply. In effect, this means that the payment would be tax deductible where
the company received a beneft for the service provided, the payment was connected
with the companys trade and the cost did not exceed an arms-length price.
A company providing management services should be remunerated for those services
on an arms-length basis. Usually, a company providing services is remunerated
on a cost plus basis to represent a market value for the provision of the services. A
service provider may, in general, divide its fee between the recipients of the services
by applying a direct charge method or an indirect charge method. The direct charge
method is used only when there is a clear connection between the services rendered by
the management services provider and the costs resulting from the provision of those
services for every recipient within the group. In all other cases, an indirect charge
method is allowed.
Spain
64.
International Transfer Pricing 2011 701 Spain
6401. Introduction
During the last few years, the Spanish tax authority has increased its awareness
of and attention to transfer pricing. The legislation enacted in 1995, the statutory
regulations approved in 1997 and modifcations effective as of 1 December 2006,
include the general principles for dealing with transactions between related parties.
They also state the procedure to be followed by taxpayers seeking advanced pricing
agreements (APAs) and the basic procedure to be followed by tax auditors in the feld
for reassessing the transfer price agreed between related parties.
Article 16 of Spanish Corporate Income Tax Law (CITL) was modifed by Law 36/2006,
which came into force on 1 December 2006, and affects transactions carried out in
fscal years starting after that date. The new legislation provides that transactions
between related entities and persons, including domestic as well as cross-border
transactions, should be priced at arms length for tax purposes. It is aimed at bringing
Spanish transfer pricing legislation into line with best international practice, as
provided in the OECD Guidelines and the European Union Joint Transfer Pricing
Forum (JTPF). Previously, making adjustments to arms-length prices was a power of
the Spanish tax administration only. It is important to note that the modifcations have
been included as part of the Bill of Measures Against Tax Fraud, which highlights the
level of importance being given to transfer pricing in Spain.
Spains legislation concerning transfer pricing is contained in Articles 16 and 17 of Law
36/2006, modifying the CITL, in Royal Decree 1793/2008 of 3 November, amending
the CITL Regulations and in Article 41 of Law 35/2006, modifying the Personal Income
Tax Law (PITL).
The legislation provides that for corporate tax purposes related party transactions
should refect arms-length pricing. The transfer pricing methodologies described in
the Spanish transfer pricing legislation largely follow those contained in the OECD
Guidelines. The new legislation includes the proft-based method transactional net
margin method (TNMM) which was not formally accepted in the previous legislation.
Furthermore, this legislation specifes the existence of a transfer pricing methodologies
hierarchy and specifes that, where possible, the transactional methods should be used
to establish an arms-length price in preference to proft-based methods.
Article 41 of the PITL establishes, as a general principle, that transactions between
related persons or entities will be priced in accordance with the arms-length principle.
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Spain 702 www.pwc.com/internationaltp
The procedure for establishing the arms-length value and, where necessary, for
substituting the value declared in a taxpayers return is set out in Articles 16 and 17 of
the CITL.
The procedure to be followed by tax authorities when seeking to apply the arms-length
principle through the course of a tax inspection is stated in Article 16 of the Corporate
Income Tax Regulations (CTR). A brief description is as follows. First, if the other
party of the related party transaction has also been taxed under the CITL or PITL, it is
notifed by the tax authorities that the transaction has been placed under scrutiny. This
notifcation explains the reasons for the adjustment to the companys proft and the
methods, which could be used in determining the normal market value. The related
party has 30 days to present any facts or arguments that it believes are pertinent to
thematter.
Having examined both related parties arguments, and immediately prior to preparing
the document in which the arms-length value shall be established, the methods and
criteria to be taken into account are made available to the parties. The parties then
have 15 days in which to formulate additional arguments and whatever documents and
evidence they deem appropriate.
Either party has the right to dispute the outcome of the proceedings, in due course.
If they do not, the normal market value established by the tax authorities becomes
effective for all tax periods under assessment in accordance with Articles 16 and 17
of the CITL. If the outcome is indeed contested by either of the related parties, its
application is suspended pending a fnal decision. In the meantime, tax assessments
are deemed to be provisional.
The Spanish CITL includes provisions dealing with APAs. APAs can be unilateral or
bilateral, and normally refer to pricing arrangements but can also cover research and
development (R&D) expenses, management fees and thin capitalisation. Separate
provisions deal with contributions made for R&D purposes and management fees.
6403. Documentation
Documentation is now also a requirement, with Spanish taxpayers required to produce
group-level and taxpayer-specifc documentation for each tax year. Until now, no
requirement for formal documentation existed, with the exception that during an
inspection, explanations could be demanded, as with any other transaction that
infuences tax results.
In this sense, Article 16.2 of the CITL establishes as a general rule that related persons
or entities must keep available for the tax authorities such documentation as from
the end of the voluntary return or assessment period in question. The royal decree
implements this statutory requirement by drawing on the principles contained in the
EU Code of Conduct on transfer pricing documentation and requires the taxpayer to
produce, at the request of the tax authorities, documentation, which, in turn, is divided
into two parts:
Documentation relating to the group to which the taxpayer belongs; and
Documentation on the taxpayer itself.
International Transfer Pricing 2011 Spain 703
Spain
With regard to the frst year in which the documentation obligations must be applied,
the documentation obligations must be deemed to apply to transactions performed
on or after 19 February 2009. However, the taxpayer is required only to keep
documentation available for the tax inspectors on or after 25 July 2010.
The royal decree also establishes the following instances in which there is no
documentation requirement for related party transactions:
Transactions carried out within a consolidated Spanish fscal group;
Transactions carried out by economic interest groups and temporary business
associations; and
Transactions involving the purchase or sale of publicly traded shares.
At the same time, the royal decree establishes reduced documentation obligations
for (1) related party transactions involving small companies (net revenues for the
consolidated group of less than EUR 8 million in the previous tax year) and (2)
individual persons. Finally, it should be noted that documentation is required for
transactions with entities, related party or not, resident in tax havens.
6404. Legal cases
Under the former legislation (1978 CITL), the Central Treasury and Tax Court
(Tribunal Econmico Administrativo Central (TEAC), an administrative body included
within the Tax Administration but acting independently of the tax audit authorities),
had created a solid administrative doctrine that was consistently applied. It also
established some important principles for dealing with transfer pricing issues. These
principles are set out below:
Comparable uncontrolled market price
1. The establishment of a comparable uncontrolled market price is extremely diffcult
and requires that:
a. The same geographical market is used as a reference;
b. Similar or identical goods be compared;
c. The volume of transactions compared is identical;
d. The comparison be made at the same stage of the production/distribution
process; and
e. The transactions being compared are carried out within the same period
oftime.
Transfer pricing adjustments
2. Where the above information is not available, transfer pricing adjustments may be
made by a tax inspector in accordance with the OECD Guidelines (i.e. using the
resale price or cost plus), taking the following issues into consideration:
a. To make an adjustment to reported profts successfully, the authorities must
prove that the transaction has not been carried out at market value. The fact
that the transactions are between related companies does not automatically
mean that the transfer price does not comply with the arms-length
standard;and
b. The legal bases and reasons behind the normal market value proposed by the
authorities must be disclosed, otherwise the taxpayer could be deprived of
information necessary to defend its position.
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Intragroup services
3. Referring to intragroup services, the Ministry of Finance issued some rulings on the
matter stating that:
a. For valuation purposes, any method included in the 1979 OECD Guidelines
could be applied.
b. The burden of proof lies with the taxpayer. The taxpayer is therefore required to
prove that:
1. The services have in fact been provided;
2. The service provider incurred in expenses when rendering such services;
and
3. The service provided added economic value to the related entity receiving
such services.
Additionally, under the former legislation, the courts ruled on some legal cases that
followed the above-mentioned principles.
Regarding the current legislation, the Spanish tax authorities and the jurisprudence
issued by the tribunals have widely used the OECD Guidelines to apply or interpret the
Spanish transfer pricing rules and regulations.
In particular, the TEAC is making an extensive and intensive use of the OECD
Guidelines. Some interesting TEACs resolutions are mentioned below:
RTEAC 7 June 1994; RTEAC 22 October 1997; RTEAC 29 January 1999;
RTEAC 9 March 2000; RTEAC 1 December 2000; RTEAC 26 March 2004; and
RTEAC 8 October 2009; RTEAC 22 October 2009.
Until recently, the Spanish High Court of Justice (STS) ruled on just a few cases
regarding transfer pricing issues. In line with the heightened interest given to transfer
prices in 2007, these rulings went against the taxpayer. The rulings dealt with various
related party transactions, including management fees, customs regulations and
purchase of active ingredients.
STS 11 February 2000; STS 15 July 2002; and
STS 4 December 2007; STS 22 January 2009; STS 30 November 2009.
6405. Management services and R&D cost-sharing
arrangements
The section of the legislation dealing with management services is now included
within a more general defnition of services. The deduction of expenses for services
provided by related parties is subject to the condition that the services provided
produce or can produce an advantage or beneft to the receiver.
Where it is not possible to separate the services provided by the entity (i.e. directly
charging), it is possible to distribute the total price for the services between all
benefciaries of the services in accordance with rational distribution criteria. These
criteria need to take into account not only the nature of the service but also the
circumstances surrounding the provision of services as well as the benefts obtained
(or that can be obtained) by the benefciaries of the services.
Spain
The deduction of expenses derived from cost-sharing arrangements (not only related to
R&D) between related parties is subject to the following:
The participants to the arrangement must be able to access the property (or the
rights to the property having similar economic consequences) of the resulting
assets or rights being subject of the cost-sharing arrangement;
The contribution of each participant must take into account the anticipated
benefts or advantages that each participant expects to obtain in accordance with
rationalcriterion;
The agreement must contemplate variations in circumstances and participants,
establishing compensatory payments and any other adjustments that may be
considered necessary; and
The agreement must comply with the documentation requirements to be
established at a later date.
The statutory regulations state that taxpayers should value transactions with their
related parties at market prices and also indicate how that value has been calculated
(Article 16 of the CITL and Article 41 of the PITL).
This represents an important change to the rules that has been introduced by the new
legislation (previously the burden of the proof lay with the tax authorities).
Should any discrepancies regarding the suitability of the transfer prices arise in the
course of a tax review, it is in the taxpayers interest to present as much evidence as
possible in support of its prices. Detailed evidence presented by the taxpayer helps
reduce the likelihood of the authorities proposing an adjustment and imposing
penalties. For these reasons, it is necessary that the taxpayers comply with the
obligation to produce documentation.
Spanish tax inspectors operate on three levels: national, regional and local. National
and regional specialist units are responsible for all tax affairs dealing with companies
or groups of companies which may deserve close attention for reasons such as size,
importance of operations, a distinguished reputation in an economic sector, volume
of sales, etc. Such companies and groups are subject to tax audits on a recurring basis.
Smaller companies are dealt with at the local level. Transfer pricing issues, until
recently, have been considered part of a general tax audit and not the subject of special
investigation. However, with the new legislation, transfer pricing audit activity has
increased signifcantly. Already audits have been launched whose scope is limited to an
analysis of the arms-length nature of inter-company prices.
the tax authorities
In principle, the tax authorities are empowered to collect all the information and data
necessary to conduct a tax audit. In general, taxpayers are obliged to provide the tax
authorities with such information. Failure to present the accounting registers and
documents, which companies are required to keep by law, or failure to provide any
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data, reports, receipts and information relating to the taxpayers tax situation, may be
considered as resisting or hindering the tax audit.
In general terms, all taxpayers are obliged to present, by law or under a specifc request
by the tax authorities, any relevant information for tax purposes they may have
with respect to third parties, in connection with business, fnancial or professional
relationships held therewith. Any information presented to or obtained by the tax
authorities is considered to be confdential and can be used only for tax purposes and
may not be disclosed to third parties, except in those cases stated by law.
Each inspector is assigned a Personal Confdential Tax Audit Plan for the period, which
includes all the taxpayers to be audited by his/her team.
Each taxpayer is entitled to be informed upon commencement of a tax audit, the
nature and scope of the audit about to take place, as well as its rights and obligations
during the course of such proceedings. The tax audit proceedings must be concluded
within 12 months, although, under certain circumstances, this period may be extended
to an additional 12 months.
Inspections are normally conducted at the companys main offces or at the tax
authorities offces.
The procedure is deemed to be completed when the tax auditor considers that all the
necessary information required to put together a reassessment proposal has been
obtained. Prior to the tax auditor drawing up his/her proposal, the taxpayer is given
the opportunity to formulate allegations. A tax inspection usually concludes with a
reassessment proposal, which the taxpayer can accept or reject in part, or in whole.
Under the royal decree, tax inspectors must fle a separate transfer pricing assessment,
distinct from any assessments related to other income tax obligations. The contents of
the transfer pricing assessment must include a justifcation of the arms-length value
as determined by the tax inspector and an explanation of how the arms-length value
wasdetermined.
In the event that the taxpayer does not accept the inspectors proposal, a writ of
allegations may be presented to the inspectors superiors. Based upon this writ and the
tax inspectors extended report, the superior offcer can confrm, modify or cancel the
additional assessment.
If the taxpayer is dissatisfed with this decision, an appeal may be fled with the offce
or directly with the TEAC. At this stage of the procedure, the additional assessment
must be paid or guaranteed. An appeal against the decision passed by the TEAC may be
fled with the ordinary courts of justice.
Spain
With regard to the new requirement of documentation, the provision of incomplete,
inaccurate or false documentation or where the declared values do not coincide with
the values derived from the documentation would imply penalties.
The penalty applied depends on whether the tax administration assesses a transfer
pricing adjustment:
If there is no adjustment, a penalty of EUR1,500 is imposed for each missing,
inaccurate or false data item; or EUR15,000 for a collection of missing, inaccurate
or false data item; and
If there is an adjustment, a penalty of 15% of the adjusted amount is imposed, with
a minimum of double the penalty that would have been assessed if no adjustment
had been made.
However, prior to imposing a penalty under the general regime, the tax authorities
must prove that the taxpayer has behaved in a negligent manner. The taxpayer is
considered to have acted with due diligence when he/she presents a reliable and full
statement and makes the relevant self-assessment under a reasonable interpretation of
the regulations, including compliance with the documentation requirement.
A special procedure exists for imposing penalties, which is independent of the normal
tax audit procedure. Such a procedure may be commenced by the tax inspector or by
a special offcer assigned by the chief tax inspector. The tax inspector must provide
all relevant data or proof to justify the penalty being imposed. The taxpayer may
formulate allegations and present its consent to, or disagreement with, the proposed
penalty. The penalty is automatically reduced by 30% if the taxpayer agrees with the
penalty proposal.
The taxpayer may appeal against the proposed penalty without necessarily paying or
guaranteeing the amount of the penalty being imposed.
Currently, a specialist unit dealing with transfer pricing issues is being established. The
regional and national tax offces, which are responsible for the larger companies or
multinational companies, normally deal with transfer pricing issues during the course
of a general tax audit.
In addition, signifcant resources are being made available to improve inspectors
ability to successfully undertake audits, and active training is taking place. Tax
inspectors currently act on their own, although this does not rule out the possibility
that they could receive assistance from in-house experts. Additionally, tax inspectors
are able to exchange information under the principles established in the OECD Model
Tax Convention and in the European Directive 2004/56 on Mutual Assistance.
The new transfer pricing legislation, for the frst time, explicitly recognises the
transactional net margin method as an accepted method for justifying the arms-length
nature of prices.
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Availability
Annual accounts (including the notes to the accounts and directors report) are
offcially registered and therefore publicly available. Databases containing detailed
fnancial information of Iberian companies are available. In certain industries (e.g. the
pharmaceutical industry), more detailed information concerning product pricing and
proft margins may be obtained. Spanish tax authorities have a natural tendency to
employ local comparable companies for benchmarking purposes.
The tax authorities have confrmed their use of databases such as AMADEUS and
SABI (the Bureau Van Dijk database containing companies located within the
Iberianpeninsula).
Tax authorities have also confrmed that they do not use secret comparables, although
very often they request information from other companies that operate in the same
sector. This information may be requested individually for specifc transactions or in a
general manner. In some cases, such information has been used by the authorities to
justify a transfer pricing reassessment.
Transfer pricing is an area of increasing interest for the Spanish tax authorities. So far,
they have not concentrated on any particular industry, although emphasis has been
placed on the automobile, computer/software and pharmaceutical industries.
Special attention has been directed towards management fees and royalties. In
addition, the Spanish tax authorities are quite sensitive to so-called business
transformations and may assert that a permanent establishment (PE) exists of a
foreign party to which signifcant business functions and risks have been transferred.
Regarding management fees, and as noted, the Spanish tax authorities expect to see
the application of rational and continuous cost-allocation criteria and actual evidence
of the benefts received from the services.
In principle, when a transfer pricing adjustment affects transactions between a
Spanish company and a non-resident, the mechanisms laid down in the relevant
double taxation treaty should be applied. Where the non-resident is within the EU,
the provisions of the Arbitration Convention relating to the elimination of double
taxation (EC Directive 90/436) can be applied. In relation to MAP proceedings arising
from the mechanisms laid down in the double taxation treaties or the provisions of the
EU Arbitration Convention, the Royal Decree 1794/2008 of 3 November, approving
the regulations on direct taxation-related mutual agreement procedures, establishes
different regimes (and the phases within each regime), depending on whether the
procedure is initiated by the Spanish or the foreign competent authorities, and
depending on which tax administration (Spanish or foreign) has made (or makes)
the assessment. In addition, this royal decree regulates the procedure to allow for the
suspension of the tax payments when a MAP is initiated.
Spain
Spanish law provides taxpayers with a statutory right to seek advance pricing
agreements (APAs). The general regulations are contained in paragraph seven
of Article 16, and Royal Decree 1793/2008 regulates in detail the procedure for
processing and deciding on APAs between related persons or entities, whether of a
unilateral nature with the Spanish tax authorities, or bilateral or multilateral, involving
other tax authorities.
However, until the royal decree is formally adopted, the APA requirements are
contained in Articles 1729 of the CTR, which are also applicable to contributions
to R&D expenses, management support services and even in respect to the thin
capitalisation rules. Both unilateral and multilateral APAs are possible in Spain.
The tax inspection department of the Spanish national tax agency (AEAT) is the
administrative body in charge of dealing with APA requests. The procedure for
applying for an APA is a two-step process. Step one is a prefling waiting period of one
month, after which the taxpayer is informed of the basic elements of the procedure and
its possible effects. Step two is the actual fling, which takes approximately six months
in the case of unilateral APAs.
The information provided to the tax administration in the prefling and fling stages
is used exclusively within the context of the APA, and is applicable only for such
purposes. The fnal resolution is effective for the period of time decided in the
agreement, but cannot exceed four years. Additionally, it can be determined that
the APA affects the operations of the year in which the APA is agreed as well as the
operations of the prior year, as long as the time limit for the tax return/declaration has
not been passed.
If the taxpayers proposal is not approved, the taxpayer has no right to appeal the
decision. Taxpayers often fle an alternative APA after negotiating any points of
contention of the initial proposal with the tax authorities.
The Spanish tax authorities have shown a positive response in the processing and
ruling of APAs. Furthermore, providing that no signifcant changes in the underlying
conditions of the APA occur, a taxpayer may request an APA renewal.
In practice, there is little communication between the income tax and the customs
authorities, despite the fact that there is nothing to prevent an exchange of
information. Interestingly, transfer pricing adjustments for income tax and corporate
tax purposes do not necessarily need to be refected in returns fled for customs or for
any other indirect taxes.
Laws 35 and 36/2006 introduced some points related to the value added tax.
Concerning this tax, it is necessary to evaluate the operations according to the arms-
length standard when there is a directive which provides this. These laws also provide
for the liability in cases of collaboration in fraud.
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6417. OECD issues
Spain is a member of the OECD and endorses the OECD Guidelines. Actual
endorsement of the OECD Guidelines is stated in Law 36/2006, which now includes
the transactional net margin method in the Spanish legislation. This method was
informally accepted before the new legislation in some specifc cases, given appropriate
justifcation; however, it is now formally accepted as a transfer price method.
There is nothing in Spanish law to prevent the authorities from joining with authorities
of another state to establish a joint investigation of a multinational company or
group. In fact, on more than a few occasions the Spanish authorities have followed
suchprocedures.
Financial transactions are included within the general transfer pricing regime.
Additionally, there are rules concerning thin capitalisation as explained below:
On 31 December 2003, the Offcial Bulletin of the State published a change to Article
20 of the Spanish CITL. This article previously established that accrued interest would
be considered as dividends when a Spanish entitys debt with foreign related entities
exceeded three times the Spanish entitys net worth.
In particular, the CITL stated that when a companys direct or indirect net interest-
bearing borrowings from non-resident related individuals or legal entities, excluding
fnancial institutions, are greater than three times the companys fscal capital, the
interest accruing in respect of the surplus should be regarded as dividends. When
applying this rule, the average net interest-bearing borrowings and the fscal capital
over the fscal year under review shall be used. The fscal capital consists of the
companys net worth, not including the profts/loss for the year.
The changes to the Spanish CITL indicate that effective 1 January 2004, Article 20 does
not apply when the foreign-related entity is a resident in an EU member state, unless
the territory is classifed as a tax haven.
These changes stem from the ruling passed by the European Court of Justice on the
LankhorstHohorst case, which concluded that thin capitalisation rules such as those
outlined in Article 8 of the German Corporate Income Tax Code (similar to Article 20 of
the Spanish CIT Law), discriminate against noncountry residents who are EU residents,
and thus are inconsistent with the EU Treaty (Article 43, Freedom of Establishment).
Rulings
With respect to the thin capitalisation rules, a few relevant rulings are
mentionedbelow:
The thin capitalisation rules are also applicable to indirect loans where the
related entity, although it is not the lender in itself, assumes the risk arising as a
consequence of possible insolvency of the borrower (DGT 24 March 1998);
Spain
Another ruling (DGT 7 July 1998) dealing with thin capitalisation rules within a
group of companies subject to a tax grouping regime, stated that for determining
both the net interest-bearing borrowings and the fscal capital, each entity should
be considered on a standalone basis (i.e. it is not possible to aggregate such
magnitudes considering the group as a whole); and
Finally, an interesting binding ruling dated 4 September 2001 refers to a request
by a company, resident in Spain, which has received a loan from its headquarters
in the US, re-lending part of the loan to a wholly owned affliate company, also
resident in Spain.
Interpretation of the law leads tax authorities to understand that the provision applies
only to indebtedness between a resident and a non-resident company. Therefore, the
expression net remunerated indebtedness direct or indirect should be understood
between the resident company and the non-resident company, regardless of how the
former uses that loan.
This means that for purposes of determining whether thin capitalisation rules apply,
the resident company cannot use as a measure of net remunerated indebtedness the
difference between the loan received from its headquarters and the part of that loan
that was re-lent to its subsidiary.
Also, from the Tax Administrations perspective, there is an indirect indebtedness
between the resident affliate and the headquarters. Therefore, the conditions of
thin capitalisation would also apply to the affliated company that received part of
the loan. Consequently, the effects of recharacterisation of interest of the affliated
company takes place in the inquiring resident company that re-lent part of the loan to
its subsidiary, because it is the one that is actually paying interest to its non-resident
headquarters.
Net interest-bearing borrowings
The law refers to net interest-bearing borrowings. This means that if a companys
balance sheet refects both interest-bearing liability balances and interest-bearing
asset balances with related entities over the year, then the level of borrowings to be
compared with the average fscal capital for the year will consist of the net balance (i.e.
assets less liabilities). It is evident that there are few cases in which a Spanish company
requires fnancing from its group in order to carry on its business and, at the same time,
provides fnancing to other related companies abroad.
Proposal to the authorities for a higher ratio
Taxpayers may submit a proposal to the tax authorities for the application of a ratio
other than the 3:1 ratio mentioned above (i.e. via an APA). This proposal must be
based on the fnancing that the taxpayer would have been able to raise from nonrelated
persons or entities in arms-length conditions. This option is not applicable to the
operations made with or by persons or entities residing in countries or territories
considered as tax havens by the Spanish local regulations.
Accrued interest
The CITL provides that accrued unpaid interest relating to the surplus net interest-
bearing borrowings is to be regarded as dividends for tax purposes. This implies
that the interest accrued but not mature, which relates to this surplus, will not be
deductible, even though it has not been credited to the lenders particular account but
merely recorded in accrual accounts.
Sweden
65.
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Sweden
6501. Introduction
On 1 January 2007, the Swedish legislation dealing with transfer pricing was extended
substantially. The statutory rule of the Swedish Income Tax Act (SITA) adopting the
arms-length principle for transactions between related enterprises was supplemented
by formal documentation requirements. Parallel to this legal framework, two cases
did, during the 1990s, establish important principles for dealing with transfer pricing
issues. These principles concern, in particular, the areas of thin capitalisation and the
circumstances in which transfer pricing adjustments may be made.
It is worth noting that, in general, the Swedish Tax Agency (STA) is becoming
more interested in transfer pricing, using the regular tax audit as an opportunity to
investigate transfer pricing issues. Even though the activities of the STA until now have
been constrained by a lack of resources, the last few years have shown an increased
focus on transfer-pricing-related issues through a number of detailed standard
questions in tax audits, including questions about what comparable transactions or
companies have been used as a basis for determining the transfer prices. Furthermore,
a number of new cases concerning the provision of central support services show an
increased focus on transfer pricing. A highly skilled, specialised team has also been
established within the STA to continuously develop the general awareness within the
transfer pricing area. This team assists the general tax auditors of the STA with transfer
pricing issues and performs its own targeted audits towards large companies.
Sweden has only one statutory rule on transfer pricing. Originally included in the tax
code in 1929, it is now found in Chapter 14 Section 19 SITA. This section adopts the
arms-length principle for transactions between related enterprises and authorises an
increase in the taxable income of a Swedish enterprise equal to the reduction of income
resulting from transactions that are not at arms length. Besides the arms-length rule,
Chapter 19 Section 2b of Law 2001:1227 introduced documentation requirements
for all corporations registered in Sweden that conduct cross-border controlled
transactions. It is now compulsory to prepare written documentation on all cross-
border transactions with associated companies. The statutory addendum came into
effect as of 1 January 2007.
International Transfer Pricing 2011 Sweden 713
Sweden
In connection with the documentation requirement, administrative guidelines (SKVFS
2007:1) were issued by the STA on 14 February 2007. Moreover, the STA published
regulations that provide further details as well as examples related to the transfer
pricing documentation requirements. Guidelines and regulations are applicable
retroactively as of 1 January 2007 and are further commented on below. Generally,
the documentation requirements cannot be considered to be overdemanding on the
taxpayers in an international comparison.
6504. Legal cases
During the last few years, relatively few transfer pricing cases have reached the lower
courts and the Court of Appeal. However, there have been two important cases from
the Supreme Administrative Court that should be noted. The frst, Mobil Oil (1990),
concerned thin capitalisation and the second, Shell Oil (1991), concerned the pricing
of crude oil and freight. The tax authorities lost both cases.
The principle established by the Mobil Oil case is that, generally, thin capitalisation
cannot be challenged in Sweden using the arms-length rule.
The Shell case clearly demonstrates three points. First, the STA bears the full burden
of proof in transfer pricing matters. Second, consideration of whether an arms-length
price has been charged should not be restricted to the facts arising in a single year, but
rather, a span of years should be considered. Third, if a transfer pricing adjustment is
to be justifed, there must be a deviation from arms-length pricing that is signifcant
in size. Moreover, the Shell case was the frst case in which the courts referred to the
principles laid down in the OECD Guidelines on transfer pricing.
As a consequence of the STAs increased focus on various transfer pricing issues, a
number of interesting cases are currently in the lower administrative (tax) courts. One
of these cases from an Administrative Court of Appeal concerns incorrect pricing of
interest payments on intragroup loans. The outcome of this case is that for intragroup
loans, the interest rates used and their consistency with the arms-length principle need
to be well documented. Otherwise, companies may have the interest rate adjusted to
an average banking interest rate (equal to an average of Swedish banks interest rate on
loans to nonfnancial companies).
Other cases concerning support services and interests on loans, usually provided from
the parent company to the beneft of subsidiaries, have also been dealt with by Swedish
courts. This large number of cases by Swedish standards in a short period of time
shows that the STA have acquired additional resources and have increased their focus
on transfer pricing issues.
The STA bears the full burden of proof when trying to establish that a transfer pricing
adjustment is necessary. To support the adjustment, the STA must show that:
The party to whom the income is transferred is not liable to taxation in Sweden on
that income;
Sweden 714 www.pwc.com/internationaltp
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They have reasons for believing that a community of economic interests exists
between the contracting parties;
It is clear from the circumstances that the contractual conditions have not been
agreed upon for reasons other than economic community of interest;
The adjustment does not depend upon consideration of the facts applying to one
year in isolation; and
There has been a signifcant deviation from the arms-length price, suffcient to
justify an adjustment.
According to the new requirements in force since 1 January 2007, transfer pricing
documentation has to provide for the following information:
General description of the company, the organisation and its activities;
Information about the nature and extent of the transactions;
Functional analysis;
Description of the transfer pricing method chosen; and
Benchmark analysis.
Companies entering into transactions of limited value can beneft from simplifed
documentation requirements. Transactions of limited value are defned as intragroup
transactions of goods for a value of less than approximately SEK25 million per
company within a multinational enterprise, and for other transactions, a value of less
than approximately SEK 5 million. The other transactions do not cover the transfer of
an intangible asset. If such a transfer occurs, no simplifed documentation requirement
applies. The simplifed documentation requirement consists of the following
information in a summary or schematic form and at a general level:
Legal structure of the group;
Organisation and operations of the tested party;
A short description of the counterparties to the transactions, including their
mainactivities;
Actual transactions nature, extent, value together with the transfer pricing
method applied;
How the arms-length principle is met; and
Comparable transactions, if appropriate and if any are identifed.
The EU Code of Conduct and the EU TPD are explicitly accepted in Swedish legislation.
The 250 largest Swedish multinational groups are, on average, audited every fve years.
A few hundred foreign-owned companies are audited more regularly. Transfer pricing
is currently given a high priority in Sweden, and the audits present an opportunity for
the authorities to focus on the companies transfer pricing policies.
During the course of the audit, the STA may examine all intragroup transactions.
The audits are always conducted at the company premises, with key personnel being
interviewed. The conduct of the taxpayer during the examination is likely to affect the
Sweden
outcome of the audit, and the early assistance of a competent tax adviser is therefore
highly recommended. Where the STA believes that the arms-length standard has not
been applied, it might sometimes be possible to achieve a negotiated settlement.
the tax authorities
The STA may request copies of any information that is kept on the premises of the
taxpayer, and it has the power to search the premises if it considers this to be necessary.
An appeals procedure is available to the taxpayer, but it is a time-consuming process.
The procedure on tax cases in the frst instance of the Administrative Courts normally
takes two to three years, and perhaps just as long in the Administrative Court
ofAppeal.
Penalties are normally levied at a rate of 40% of the additional tax due. Penalties
paid are not tax-deductible. The documentation requirements do not include
specifcpenalties.
The tax authority resources available to conduct transfer pricing audits have
historically been limited. Today, a specialised transfer pricing team is established in the
STA which is continuously recruiting more inspectors and acquiring new competence
within the transfer pricing area. The effect of this team is clearly shown in the
increased number of cases brought before the courts. This specialised team assists the
general tax auditors in the STA with transfer pricing issues as well as performs its own
targeted audits towards large companies.
In accordance with the legislation, the determination of an arms-length price
has to be based upon prices that would be agreed between unrelated parties in a
comparable situation. In determining the relevant price, the STA prefers the traditional
transactional methods, but with no preferred order of use. If none of these methods
can be used, then a transactional proft method may be used. The STA considers that
the transactional net margin method (TNMM) will be the most used of these methods
to test the arms-length character of transfer prices.
The fnancial statements of all Swedish companies are publicly available in Sweden.
Databases containing this information may be accessed in the search for comparables.
The STA has also gained access to the most common databases used for comparability
searches, such as the European database AMADEUS and various royalty databases.
In recent tax audits, the STA has prepared extensive lists of questions regarding the
audited companys comparable data.
S
All industries and related party transactions can be audited. The most common
questions about intragroup transactions still relate to loans and payments for services
such as business support services. Questions related to product sales and payments
(such as royalties) for intangible property are, however, becoming more common
in tax audits. With the implementation of documentation requirements, an audit
undoubtedly implies a scrutiny of the complete documentation.
Swedish law, currently, has no regulation that automatically relieves a company from
economic double taxation caused by an adjustment of its transfer prices. The problem
of double taxation is, instead, usually handled through tax treaties. Swedish tax
treaties are usually based on the OECD Model Tax Convention. Some older agreements
existing between Sweden and developing countries are based on the UN Model
TaxConvention.
Sweden has entered into bilateral tax treaties with the majority of countries in which
Swedish multinationals conduct business. These agreements provide a good basis
for the elimination of economic double taxation for both Swedish multinationals and
foreign multinational companies conducting business in Sweden.
The competent authority procedure functions fairly well in Sweden. According to the
Ministry of Finance, full or partial relief has historically been obtained in more than
90% of cases where competent authority relief has been claimed. The competent
authoritys responsibility and the mutual agreement procedures (MAPs) were recently
transferred to the STA. However, one problem with competent authority claims is the
amount of time necessary to settle each case. After the transfer of responsibility for
the MAPs to the STA, the effectiveness of these procedures has increased considerably.
Delays in current processes are often the result of delays in the other countries. The
normal handling period for the competent authority procedures is about two years.
Sweden has signed the EU Arbitration Convention which applies from 1 November
2004. The EU Arbitration Convention constitutes a powerful incentive for the STA to
make every effort to ensure that the administrative process is more effcient, and to
reach a mutual agreement in relation to all MAPs within the set time limit of two years.
As of 1 January 2010, the Law (2009:1295) on Advanced Pricing Agreements
Regarding International Transactions (law on APAs) entered into force in Sweden. The
STA was appointed as competent authority for the administration of APAs.
Under the law on APAs, any corporation which is (or is expected to become) liable
to taxation, in accordance with Swedish taxation regulations and which is subject to
the provisions of a tax treaty, can apply for an APA. The application shall be made in
writing and shall contain all information deemed necessary to enable the STA to make
a fair decision as to the appropriateness of the taxpayers suggested transfer pricing
set-up. Prior to fling an application, the taxpayer may request a prefling meeting with
Sweden
the STA to discuss the conditions of a potential APA and what information should be
included in the application.
A Swedish taxpayer can apply for either a bilateral or a multilateral APA. The APA is
based on a mutual understanding between the countries involved for a predetermined
period of three to fve years.
The STA is authorised to grant an APA if the relevant transaction can be regarded
separately from any other intragroup transactions, and if suffcient information is
provided to the STA to enable it to determine whether the proposed set-up is at arms
length. Some of the basic information which must be fled in order for the STA to grant
an APA is a functional analysis, an economic analysis and a comparables search, which
supports the selection of transfer pricing methodology.
An APA is granted only if the mutual understanding between the countries involved
refects the basis of the taxpayers application or if the taxpayer approves any
amendments proposed in the STAs decision. An APA is normally not granted if the
transaction is considered to be of limited importance or of minor value.
In cases where a taxpayer seeks an APA, the STA charges an administration fee which
is based on the type of application. The following fees apply in relation to each country
involved in the relevant transaction:
SEK150,000 (approx. EUR15,000) for an application of a new APA;
SEK100,000 (approx. EUR10,000) for an application regarding renewal of a
previous APA; and
SEK125,000 (approx. EUR12,500) for an application regarding renewal of a
previous APA (including amendments).
The current documentation guidelines provide for a general framework. The
documentation guidelines issued by the STA clarify certain aspects of the legislation,
but certain areas may lead to conficts in interpretation for which it may be up to case
law to solve.
We are currently not aware of any cooperation between customs authorities and the
STA, since they are separate government bodies.
6517. OECD issues
Sweden is an OECD member state. There was a Swedish representative on the OECD
Transfer Pricing Task Force, and Sweden has agreed to the OECD Guidelines.
The STA has taken part in simultaneous tax audits from time to time and is particularly
likely to join with other Nordic countries in such audits. Also, the STA has taken part in
a few simultaneous audits with the US and German tax authorities, respectively.
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A principle established by the Mobil Oil case is that the arms-length principle cannot
be used to challenge a taxpayer on the grounds of thin capitalisation. Furthermore,
there are no rules dealing specifcally with thin capitalisation and no set permissible
debt-to-equity ratios. Interest paid to a foreign associated entity is deductible for tax
purposes without any restrictions as long as arms-length interest rates are applied.
However, in special situations with unique circumstances, interest deductions may
be challenged and therefore, even if the tax authorities have not yet successfully
challenged any instances of thin capitalisation, taxpayers should remain cautious in
this area.
Switzerland
66.
International Transfer Pricing 2011 719 Switzerland
6601. Introduction
Switzerland believes that transfer pricing matters cannot be addressed by legislation
and therefore has no plans to issue any domestic provisions on transfer pricing in the
near future. Swiss tax authorities, however, are becoming increasingly concerned that
taxpayers may transfer profts without economic justifcation to countries with strict
transfer pricing rules and documentation requirements in order to avoid challenges
by the respective local tax authorities. In this context, Swiss tax authorities take an
increasing interest in a companys transfer pricing position in order to defend their own
position. In addition, some cantonal tax authorities have begun to particularly focus
on low-risk/low-proft entities located in Switzerland. Further, the tax authorities have
begun to also focus tax audits on principal companies in Switzerland, which would
include transfer pricing.
Switzerland follows the OECD Guidelines as closely as possible and recognises the
arms-length principle based on interpretation of actual legislation. To clarify transfer
pricing issues, Switzerland offers an informal procedure for agreeing pricing policies
inadvance.
Whilst Swiss tax law neither contains a defnition of the arms-length principle, nor
specifcally addresses the issue of transfer pricing between related parties, there is
some legal authority for adjusting the profts of a taxpayer on an arms-length basis.
This legal authority is found in Article 58 of the Federal Direct Tax Act as well as in
Article 24 of the Harmonisation of the Cantonal Tax Laws Act, which both defne the
calculation of a taxpayers taxable net proft. Importantly, Articles 58 and 24 deny a tax
deduction for expenditure that is not commercially justifable, and this provides the
basis for an adjustment to profts for non-arms-length terms.
Services
Other regulations deal with the requirement for Swiss subsidiaries and permanent
establishments (PEs) of foreign companies to include a proft markup when recharging
the cost of performing services to a foreign-related company. No markup is required,
however, where there is evidence that the marked up price would be substantially
different from the price that would have been paid in a comparable uncontrolled
situation. In addition, an instruction issued in Circular Letter No. 4 on 19 March 2004
provides guidance on the treatment of certain services that do not require a cost plus
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Switzerland 720 www.pwc.com/internationaltp
methodology (e.g. certain fnancial services and general management services) and
encourages a review of the methods and margins (or prices) charged for rendering
such services when evaluating whether such charges were made on an arms-length
basis. Nevertheless, in most cases, the past practice of charging cost plus 5%10%
should meet the third-party comparison test and remain acceptable to the tax
authorities under the new regulations.
Note that, since the cantonal authorities are not bound by the instructions of the
Federal Tax Administration when assessing taxes, there is some room for differences in
approach between cantons. Therefore, it is possible that the cantonal authorities may
adopt different methods of calculating the base of costs to be marked up.
Interest payments
Switzerland maintains regulations concerning permitted tax-deductible interest rates
on loans. The Federal Tax Administration regularly issues instructions on the safe
harbour maximum and minimum interest rates as set by reference to the prevailing
interest rates in the Swiss market. If a loan is in a foreign currency, the relevant market
interest rates apply, which is, effectively, an application of the arms-length principle. In
practice, there is an interdependence of permissible interest rates and the permissible
amount of debt in the context of thin capitalisation. If companies deviate from the safe
harbour rates, it is strongly advised that they maintain documentation to support the
arms-length nature of the rates applied, as there have been an increasing number of
audits in this area.
6604. Legal cases
Several cases on transfer pricing have been brought before the Swiss courts, especially
concerning the interpretation of costs which are not commercially justifable (e.g.
non-arms-length transactions of management services, licence fees or excessive
interest rates on loans made by a shareholder to a company), the use of company assets
by the shareholder on privileged terms, and the restructuring of sister companies by
means of non-arms-length transactions.
The burden of proof within Switzerland lies with:
The taxpayer regarding the justifcation of tax-deductible expenses; and
The tax authorities regarding adjustments which increase taxable income.
This effectively means that a taxpayer has to prove to the Swiss tax authorities that
the price it has paid for its tangibles, intangibles and any services it has received
from a related party satisfes the arms-length principle (i.e. justifes their tax
deductibility). On the other side, the Swiss tax authorities responsibility is to prove
that the compensation for any services rendered by the taxpayer or any tangibles
or intangibles transferred to a related party does not reach an arms-length level.
However, if a taxpayer fails to produce the documents required by the tax authorities,
this burden of proof also reverts to the taxpayer. Therefore, Swiss taxpayers should
maintain appropriate documentation to justify all income and expenses resulting from
related party transactions. This is specifcally true with regard to licence fees charged
to a Swiss entity or support and defence of low profts in connection with limited-risk-
typeentities.
International Transfer Pricing 2011 Switzerland 721
Switzerland
In general, the attitude of the Swiss tax authorities towards transfer pricing in
the course of tax audits has become more aggressive, especially when non-Swiss-
headquartered companies are in a loss position.
Companies can be selected for investigation if relevant proft-level indicators (e.g. gross
margin, net margin or return on capital) differ signifcantly from what is considered
reasonable, or if the company is thinly capitalised.
Provision of information and duty of the taxpayer to cooperate with the
tax authorities
The tax authorities may request any information that is relevant for properly assessing
a companys profts. If the taxpayer does not comply, fnes may be imposed and the
burden of proof moves from the tax authorities to the taxpayer.
The normal tax audit procedures are performed by the cantonal tax authorities in
respect of cantonal and federal taxes. It is normal in Switzerland for the outcome of
such an investigation to be decided as a result of negotiation, but if no agreement can
be reached, an adjustment is imposed. In practice, the conduct of the taxpayer during
the investigation can signifcantly affect the size of any adjustment cooperation is
more likely to lead to a satisfactory resolution.
It has been noticed, however, that the Federal Tax Department is becoming more
aggressive and is intensifying audit procedures, in particular regarding withholding
tax in connection with hidden distribution of profts based on non-arms-length
transactions and with respect to Swiss value added tax (VAT).
If the taxpayer disagrees with the assessment, he or she is entitled to make a formal
appeal to the tax authorities. If the appeal is partly or entirely dismissed, then the
taxpayer has the right to appeal to the Cantonal Tribunal and ultimately to the Swiss
Federal Supreme Court.
Penalties apply where an adjustment is required as a result of a transfer pricing
investigation in connection with a criminal proceeding (e.g. in the case of tax fraud).
These penalties are not tax deductible. The level of penalties imposed depends on the
extent to which the taxpayer has defaulted and can be set as a multiple of between one
and three times the additional tax revenue.
No penalties apply on transfer pricing adjustments during a normal tax assessment.
Further, for Swiss withholding tax purposes, any transfer pricing adjustment
and the repayments or the issuance of credit notes by the Swiss company due to
adjustments made by foreign tax jurisdiction and to the extent not agreed in a mutual
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understanding procedure are considered as deemed dividend distributions and are
therefore subject to 35% Swiss withholding tax or grossed-up to 54% if the Swiss
withholding tax charge itself is not borne by the benefciary.
The resources available to the Swiss tax authorities depend to a great extent on the
canton involved. Zurich, for example, has its own experts, while small cantons are
largely dependent on the experts within the Federal Tax Administration.
If challenged by the Swiss tax authorities, taxpayers must demonstrate that
any transfer prices were based on sound economic and commercial reasoning.
Documentary evidence, such as board minutes detailing the assumptions made and
the expectations of the pricing policy, would normally be required. Furthermore, there
is generally no publicly accessible information on which to base a comparables study.
Information on comparable types of operations is, in practice, easily accessed by the tax
authorities (secret comparables).
A pan-European benchmarking analysis generally supports the defence of transfer
prices in Switzerland.
All transactions between related companies are equally likely to be challenged,
although loans are more frequently examined. No single industry sector or type of
entity, with exception of low-risk/low-proft entities, appears to be more likely to be
targeted than any other.
Switzerlands competent authority under the tax treaties is the Federal Tax
Administration and the competent authority process is well established. Once a
decision is fnal under Swiss law, competent authority procedures are the only means
for a taxpayer to avoid double taxation.
No formal procedure for agreeing pricing policies in advance with the tax authorities
exists in Switzerland. The advance pricing agreements (APAs) procedure is therefore
informal in its nature. APAs are available to all industries (unilateral and bilateral).
Since the Swiss Tax Authorities believe that transfer pricing issues cannot be resolved
through the provisions of domestic legislation, no signifcant changes to the existing
statutory rules are expected. Indeed, the Swiss approach to transfer pricing issues is to
follow the OECD Guidelines as closely as possible.
International Transfer Pricing 2011 Switzerland 723
Switzerland
Swiss Tax Authorities have better educated tax offcers regarding transfer pricing
issues and use of the options for tax adjustments granted under the existing Swiss
tax legislation. This may have particular implications on costs related to the provision
of services, licence fees and costs for tangible goods charged to Swiss companies,
since the burden of proof in justifying the deductibility of expenses lies with the
Swisstaxpayer.
We also perceive that tax authorities in certain cantons are increasingly insisting on an
arms-length remuneration for assumed intellectual property transferred in connection
with a transfer of business opportunities similar to the German discussion.
The customs authorities assess customs duties and levy VAT on imported goods
(the ordinary VAT rate is 7.6%). Consequently, information is regularly exchanged
between the customs and VAT authorities. Since the VAT authorities themselves
form a subdepartment of the Federal Tax Authorities, the trend towards exchange of
information between the VAT and the income tax authorities is increasing.
Consequently, transfer pricing adjustments should be considered for income tax as
well as VAT purposes. An adjustment to the returns made for customs duty purposes
is generally not required, since Swiss customs duty is based on weight and not on
monetary value (although there are a few exceptions).
6617. OECD issues
Switzerland is a member of the OECD and has accepted the OECD Guidelines on
transfer pricing without reservation.
In an instruction issued 4 March 1997, the Director of the Federal Tax Administration
informed the cantonal tax authorities about the contents of the OECD Guidelines on
transfer pricing and asked the authorities to observe these guidelines when adjusting
profts or when assessing multinational enterprises in the canton.
The Swiss authorities do not join with the tax authorities of another country to
participate in a joint investigation.
As previously noted, the Federal Tax Administration frequently issues instructions
in connection with minimum and maximum permissible interest rates. If interest
rates charged are not within the specifed range, then the rate may be adjusted. In
conjunction with this practice, specifc legislation indicates the permissible debt-to-
equity ratios. At the federal level, an instruction was released in June 1997 according to
which the debt-to-equity ratio must be determined based on the fair market value of a
companys assets. The Federal Tax Administration believes that the amount of available
borrowings should be determined depending on the category of assets (receivables,
participations, loans, property, installations, machinery, intangibles). Regarding
fnance companies, the safe harbour ratio is 6:1. The same rules apply to Cantonal Tax
Law based on Article 29 (a) of the Act on Harmonisation of Cantonal Tax Laws.
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Some fexibility is available in the application of these rules, particularly where
they interact with the instructions on permissible interest rates. Thus, where the
combination of a modest interest rate with excessive indebtedness results in an
interest charge that is arms length, given the amount of debt that would normally be
permissible, it is unlikely that any adjustment would be made to the actual interest
paid. Obviously, an excessive interest rate on a high amount of debt would not
beacceptable.
The charging for management services by Swiss service companies and PEs is subject
to instructions from the Federal Tax Administration. Specifc guidelines regulate the
costs to be recharged and the method of calculating an appropriate proft element.
Generally, a cost plus approach is deemed appropriate (see Section 6603).
Taiwan
67.
International Transfer Pricing 2011 725 Taiwan
6701. Introduction
Article 43-1 of the Income Tax Act is an anti-tax-avoidance provision added when
the act was amended in 1971. In drafting Article 43-1, Taiwan authorities consulted
Section 482 of the US Internal Revenue Code along with general tax-agreement
practices in various countries. However, because the provision failed to explicitly
specify standards to determine non-arms-length business operations or transactions
and related (tax) adjustment methods, it lacked general rules for taxpayers and
collectors to follow. As a result, the provision has proved ineffective.
To establish an enforceable transfer pricing regime, the Ministry of Finance (MOF)
resolved in the 40th National Tax Conference report to establish a multinational
enterprise transfer pricing audit mechanism. To implement this resolution, the MOF
amended the Assessment Rules for Income Tax Returns of Proft-Seeking Enterprises
on 2 January 2004, by adding Article 114-1, which lays down the related methods for
adjusting transfer pricing.
On 28 December 2004, in accordance with the rules in Article 80, paragraph fve,
of the Income Tax Act, the MOF promulgated Regulations Governing Assessment of
Proft-Seeking Enterprise Income Tax on Non-Arms-length Transfer Pricing (referred
to in this overview as transfer pricing assessment regulations or the assessment
regulations), in the hope of establishing a comprehensive assessment system. For
details, see A Summary of Regulations Governing Assessment of Proft-Seeking
Enterprise Income Tax on Non-Arms-Length Transfer Pricing issued by the MOF.
The transfer pricing assessment regulations consist of seven chapters and 36 articles.
Article 43-1 of the Income Tax Act requires the taxpayer to apply the arms-length
principle when conducting transactions with related parties. If an arrangement with a
related party is found to be inconsistent with the arms-length principle and resulted
in reduction or evasion of tax, the competent tax authority may make an adjustment.
The adjustment should be in accordance with the arms-length principle and subject to
approval by the MOF.
Article 6 of the transfer pricing assessment regulations specifcally provides that
when a proft-seeking enterprise fles its income tax returns, it must perform a self-
assessment in accordance with regulations. The self-assessment looks at whether its
controlled transactions meet the arms-length principle, and if not, the enterprise must
decide what the arms-length results of its controlled transactions would have been.
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Likewise, when the tax-collection authorities in charge undertake adjustments and/
or assessments to determine if controlled transactions meet the arms-length principle,
they must adhere to the same guidance.
Where a business enterprise has a subordinate or controlling relationship with another
foreign or domestic business enterprise and has not conformed to Article 43-1 of the
Income Tax Act; Article 50 of the Financial Holding Company Act; and Subparagraph
1, Paragraph 1, Article 42 of the Enterprise Merger and Acquisition Act, the business
enterprise will be subject to the transfer pricing assessment regulations.
Previously, the burden of proof that a transaction was not conducted at arms length
rested with the tax authorities. The tax authorities were required to prove that the
taxpayer intended to avoid a tax obligation. However, under the transfer pricing
assessment regulations, the taxpayer is obligated to conform to relevant regulations in
disclosing information on related party transactions and to prepare relevant transfer
pricing documentation to comply with the laws and regulations while fling the annual
income tax return.
6704. Documentation
When fling income tax returns, proft-seeking enterprises, except for those which
have a turnover amount and controlled transaction amount less than the disclosing
threshold established by the MOF, shall disclose information regarding their related
parties and the controlled transactions with their related parties in prescribed formats.
Information required in the prescribed disclosure formats is as follows:
Related-party organisation chart;
Detailed list of related parties;
Summary table of related party transactions; and
Detailed declaration of related-party transactions.
In addition, proft-seeking enterprises are required to prepare the following documents
when they process their annual income tax declarations:
A comprehensive business overview;
A description of organisation structure;
A summary of related party transactions;
A transfer pricing report;
A statement of affliation (in the case of a subsidiary) and a consolidated business
report of affliated enterprises (of a parent company), as stipulated in Article 369-
12 of the company act; and
Other documents concerning related parties or controlled transactions that
affectpricing.
The transfer pricing report should include the following items:
Industry and economic analysis;
Functional and risk analysis of all the participants of the controlled transaction;
A description of the nature of compliance with the arms-length principle;
A description of the search for comparables;
International Transfer Pricing 2011 Taiwan 727
Taiwan
A description of the selection of the most appropriate transfer pricing method and
the related comparability analysis;
Transfer pricing methods adopted by the other related participants; and
A description of applying the most appropriate transfer pricing method to evaluate
whether the result of the controlled transaction is at arms length and also its
conclusion, including selected comparables, adjustments and assumptions, the
arms-length range, a conclusion as to the arms-length nature of the controlled
transaction, and the transfer pricing adjustment if the controlled transaction is not
at arms length.
Proft-seeking enterprises are required to prepare and submit transfer pricing reports
for the 2005 tax year and onward. However, to alleviate taxpayers burden and
compliance cost, the MOF established a safe harbour rule on 30 December 2005, and
subsequently revised the safe harbour limits on 6 November 2008. Proft-seeking
enterprises whose controlled transactions meet the requirements regulated under
the safe harbour rule may replace their transfer pricing report with other evidentiary
documents which can suffciently prove that the results of such transactions are at
arms length.
The applied transfer pricing methods specifed by the MOF available for each
transaction type are as follows:
Tangible
asset
transactions
Intangible
asset
transactions
Provision of
services
Use of
funds
price (CUP)
v v v
transactions (CUT)
v
Resale price method (RPM) v
Cost plus (CP) method v v v
Comparable prot method
(CPM)
v v v
Prot split method (PSM) v v v

If the taxpayer intends to apply a transfer pricing method other than one of the
previously mentioned methods specifed by the MOF, pre-approval by the MOF
isrequired.
6705. Audit targets
On 2 August 2005, the MOF announced key criteria for its selection of audit targets.
These criteria include any of the following:
Proft-seeking enterprises with a gross proft margin, operating margin or return on
sales ratio that is lower than that of other enterprises in the same industry;
Proft-seeking enterprises that make a loss or a proft far less than that of other
overseas affliated entities, but where the worldwide enterprises group makes a
proft as a whole;
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Proft-seeking enterprises whose proftability during three consecutive years
fuctuates abnormally;
Proft-seeking enterprises that do not disclose controlled transactions in the
prescribed forms;
Proft-seeking enterprises that do not evaluate whether the result of a controlled
transaction is at arms length in compliance with Article 6 of the transfer pricing
assessment regulations or do not prepare the required evidentiary documents;
Proft-seeking enterprises that have controlled transactions with related parties but
without a reasonable arms-length price;
The previous and subsequent years of income tax fling of proft-seeking enterprises
that do not provide required evidentiary documents of controlled transactions in
compliance with Article 22 of the transfer pricing assessment regulations upon tax
authorities transfer pricing investigation and assessment adjustment;
Proft-seeking enterprises that are involved in signifcant or frequent controlled
transactions with affliated entities located in tax havens or in countries with a low
tax rate;
Proft-seeking enterprises that are involved in signifcant or frequent controlled
transactions with affliated entities that enjoy tax incentives; and
Proft-seeking enterprises that are involved in other arrangements that intend to
avoid or reduce tax liabilities.
When a proft-seeking enterprise is perceived to enter into controlled transactions
that are not consistent with the arms-length principle, the collection authorities-
in-charge may initiate an investigation. A proft-seeking enterprise must present the
evidential documentation as listed here within one month of receiving a written notice
of an investigation from the competent tax authority. Those who cannot present such
documentation within the prescribed period, notwithstanding special circumstances,
must apply for an extension before the original due date. The extension may not exceed
one month and is limited to one time only.
Should the tax authority deem it necessary to request additional supporting documents
subsequent to its frst review, the proft-seeking enterprise should provide the
additional supporting documents within one month.
Audit procedures, assessment and corresponding adjustments
The MOF is principally responsible for setting policies and issuing statutory
interpretations; the various regional bureaus of the National Tax Administration
undertake the task of concrete implementation.
The tax authorities may choose from two approaches to conduct the investigation
based on whether the enterprises being audited provide the transfer pricing
documentation as required.
If an enterprise provides adequate transfer pricing documentation, the authorities may
assess its taxable income based on such documentation.
If an enterprise fails to provide the mandated documentation, the authorities may
assess the taxable income based on the information gathered from internal and
external sources.
Taiwan
In either case, the taxable income of the taxpayer is assessed in accordance with
the regulations. However, where there is a failure to provide information regarding
comparables (e.g. on royalty payments), the authorities in charge may assess tax on
adjusted taxable income based on the standard proft margins regulated by the MOF.
If an arms-length adjustment, approved by the MOF, is made by a collection authority
in charge, that authority shall also make a corresponding adjustment to the taxable
income of the counterparty of the transaction if the counterparty is subject to income
tax obligation in Taiwan. If the arms-length adjustment results from an income tax
assessment of a foreign tax jurisdiction under the tax treaty framework, the collection
authority in charge shall also make a corresponding adjustment to the taxable income
of the counterparty which is liable for the income tax obligation in Taiwan, if such
adjustment is perceived as reasonable by the Taiwanese tax authorities.
Before the issuance of the transfer pricing assessment regulations, the law did not
prohibit tax authority investigations and adjustments on prior-year income tax
declarations. Further, the time limit for such investigations and adjustments was
within the scope of the Tax Collection Act. However, as a result of the transfer pricing
assessment regulations, when the tax authority seeks to evaluate the consistency of the
controlled transactions with the results of arms-length transactions, the responsibility
for producing evidence the burden of proof may fall on the tax authority.
If a taxpayer refuses to accept the tax authoritys decision as fnal, the taxpayer may
attempt to protect its interests by fling for administrative remedy and litigation.
If an enterprise is engaged in related party transactions, it must determine the
transaction results in accordance with the transfer pricing assessment regulations and
use the results as its basis to determine taxable income.
Where a proft-seeking enterprise fails to comply with the regulations, thereby
resulting in a reduction of tax liability, and the collection authority in charge has made
adjustments and assessed the taxable income of the enterprise in accordance with the
Income Tax Act and the transfer pricing assessment regulations, a fne may be imposed.
Article 110 of the Income Tax Act stipulates that beginning in year 2005, in addition to
the tax liability assessed, a fne will be imposed at two to three times the tax amount
underreported, depending on the circumstances, for any of the following:
The declared price of a controlled transaction is two times or more than the arms-
length price as assessed by the tax administration or 50% or lower of the arms-
length price;
The increase in taxable income of the controlled transaction as adjusted and
assessed by the collection authority in charge is 10% or more of the annual taxable
income of the enterprise and 3% or more of the annual net business revenue;
The proft-seeking enterprise fails to submit a transfer pricing report and is unable
to provide other documents evidencing that the results of the transaction are at
arms length; and
In other cases, de facto tax shortfall discovered by the collection authority in charge
and the amount of omission or underreporting are signifcant.
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The transfer pricing assessment regulations also provide rules for advance pricing
agreements (APAs) and specify the following particulars:
The criteria and time period for applying for an APA;
Materials that must be provided in an application for an APA;
Notifcation of signifcant changes in conditions and agreement termination;
Period for audit and evaluation by the tax authority;
Signing procedures and application period of an APA;
Content of an APA;
Submission of annual APA reports;
Effcacy of an APA;
Handling of changes in factors affecting prices or profts; and
Extension of an APA.
A proft-seeking enterprise may apply for an APA if it meets all of the
followingrequirements:
The total amount of the transactions being applied for under the advance pricing
arrangement shall be no less than NT 1 billion, or the annual amount of such
transactions shall be no less than NT 500 million;
No signifcant tax evasions were committed in the past three years; and
Documentation required for an APA application, such as a business overview,
relevant information of the related parties and controlled transactions, transfer
pricing reports, etc. shall be provided within the prescribed time limit.
Taxpayers deemed qualifed to apply for an APA should fle an application before the
end of the frst fscal year covered by the APA. The collection authority in charge shall
notify the taxpayer in writing within one month whether the application is accepted.
Once the application is accepted, the taxpayer must provide all required documents
and report within one month from the date the notifcation is received.
The collection authorities in charge shall review and reach a conclusion within a year.
Under special circumstances, the evaluation period may be extended by six months,
and if necessary, by an additional six months.
The collection authorities in charge will carry out discussions with the applicant in
the six months following the date the conclusion is reached. An APA shall be signed
between the collection authority in charge and the applicant upon an agreement being
reached between both parties. Once an agreement is signed, both sides are obligated to
follow its terms.
During the applicable period of the APA, the applicant must submit an annual report
on the execution of the APA to the tax authority during the annual tax fling period.
The applicant also must retain evidential documentation and reports as required.
6710. OECD issues
Although Taiwan is not a member of the OECD, the MOF nonetheless consulted the
legislation and documents of OECD members and other advanced nations while
Taiwan
drafting Taiwans transfer pricing regulations, making these regulations consistent
with international trends and thoughts. This does not mean, however, that all OECD
member nation laws and regulations are applicable to Taiwan.
6711. Special topics
Customs duties and other taxes
Proft-seeking enterprises are reasonably expected, to the extent allowed by law, to
reduce their tax burdens. However, if appropriate transfer pricing policy is not applied
(especially for cross-border transactions), any attempt to reduce taxes will be worthless
if the outcome leads to double taxation or the attraction of other customs duties and/
or an additional value added tax burden. Business enterprises are therefore advised to
give this issue considerable attention.
Transfer pricing on permanent establishment
On 11 January 2007, the MOF issued a ruling which specifes application of transfer
pricing assessment regulations when determining operating proft attributable to the
permanent establishment (PE) of a foreign enterprise in Taiwan in accordance with a
double taxation agreement (DTA).
Under a DTA between Taiwan and a foreign country, if an enterprise of the other
contracting state has PE in Taiwan, and proft attributable to the PE is subject to income
tax in Taiwan, the taxable income should be determined in the following manner:
The PE shall be deemed as carrying out business transactions with the enterprise of
the other contracting state in a capacity of a completely independent enterprise, under
same or similar conditions for the same or similar activities. The income attributable to
the PE shall be determined in accordance with transfer pricing assessment regulations.
Suffcient documentation proving that the attribution of income to the PE is in
compliance with transfer pricing rules must be ready for audit by a collection authority
in charge. If the enterprise of the other contracting state attributes all income from sale
of goods or provision of services in Taiwan to its PE, it is not subject to transfer pricing
documentation requirements.
Where an enterprise of the other contracting state deducts expenses incurred for
carrying out the business of the PE pursuant to relevant rules to determine operating
income under the DTA, it should apply the Taiwan Income Tax Law, proft-seeking
enterprise income tax assessment regulations, transfer pricing assessment regulations
and other relevant rules.
Management services charged to Taiwan entities have come under scrutiny by the
tax authorities. The tax authorities have challenged (1) the necessity of management
services and (2) that the Taiwan entity is realising actual benefts. The burden of
proof has been heavily placed on the taxpayer to persuade the tax authorities that
management expenses are necessary. There is no specifc outline of acceptable
evidence, but detailed records of all expenses charged should be kept in case the tax
authorities challenge management charges.
Thailand
68.
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Thailand
6801. Introduction
While there are no detailed transfer pricing provisions under the Thai tax law, there
is a general requirement that companies transact on an arms-length basis. On 16 May
2002, the Revenue Department introduced its transfer pricing guidelines in the form of
Departmental Instruction (DI) No. Paw. 113/2545. The purpose of the transfer pricing
guidelines is to assist taxpayers in setting arms-length prices for their transactions with
related parties and also to assist revenue offcers in reviewing taxpayers transfer prices
for compliance with the arms-length principle.
Taxpayers are required to self-assess and fle corporate income tax returns within 150
days of the last day of their accounting period. In order to ensure compliance, the
Revenue Department regularly conducts business operation visits/tax investigations
to review major issues and comprehensive tax audits. The burden of proof lies with
thetaxpayers.
During an operation visit/tax investigation, transfer prices may be reviewed. The Thai
Transfer Pricing Guidelines set out the information/documents required to be reviewed
by the revenue offcers. Having well-prepared transfer pricing documentation in place
reduces the risk of adjustments to prices under the general provisions of the revenue
code based on what the revenue offcer considers to be reasonable transfer prices. In
the event that an adjustment is unavoidable, transfer pricing documentation can also
help mitigate the size of the adjustment.
The development in 2009 has been the substantial increase in transfer pricing
investigation activity by the Revenue Department. The transfer pricing group actively
performs transfer pricing investigations. In addition to its normal selection of targets
for transfer pricing investigation, its strategy is to investigate, simultaneously,
competitors within the same industry sector and group companies within the
supply chain. Domestic as well as cross-border related party transactions have been
challenged by the Revenue Department during its tax investigations.
There are only general provisions under the Revenue Code designed to guard against
tax avoidance arising from transactions between related parties conducted at higher or
lower than market price.
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Thailand
On the revenue side, the Revenue Code empowers revenue offcers to:
Make pricing adjustments on the transfer of properties, rendering of services and
lending of money without compensation or with compensation below the market
price without justifable reason; and
Make adjustments on the cost price of imported goods by comparison with the cost
of the same type of goods imported into another country.
On the expense side, the revenue code empowers revenue offcers to:
Disallow a purchase of goods at a price higher than market price without justifable
reason as a tax-deductible expense;
Disallow an expense that is not expended for the purpose of acquiring profts or for
the purpose of business in Thailand; and
Disallow an expense determined on and payable out of profts after the termination
of an accounting period.
These tax provisions apply to domestic as well as cross-border transactions.
6803. Components of the transfer pricing guidelines
DI No. Paw. 113/2545 has the following major components:
Clause 1 states that a company established under Thai law or under a foreign law
must calculate its net proft for the purposes of corporate income tax according to
Section 65 of the Revenue Code;
Clause 2 defnes the term market price as compensation for goods or services or
interest that independent contracting parties determine in good faith in the case of
a transfer of goods, provision of services or lending of money, respectively, which is
of the same type as the related parties transaction on the same date. In this regard,
the term independent contracting parties is defned as parties without direct or
indirect relationships in terms of management, control or shareholding;
Clause 3 suggests pricing methods for determining market price, namely
comparable uncontrolled price, resale price, cost plus and other methods (i.e.
transactional net margin method and proft split method);
Clause 4 lists the documentation that is required to be kept at the offce of the
taxpayer. This documentation includes ownership structure, budget, strategy and
business plan, details of related party transactions, functional analysis, pricing
policy, etc. Where taxpayers can prove through such documentation that the
result of their price setting under the selected method is the market price, revenue
offcers are obliged to use the taxpayers methods for determining taxable income
and expense for the purpose of calculating corporate income tax; and
Clause 5 allows taxpayers to enter into an advance pricing agreement (APA) with
the Revenue Department. To apply for an APA, taxpayers must submit a letter
requesting an APA together with relevant documents to the Director-General of
the Revenue Department in order to set the criteria, methods and conditions with
which the taxpayer must comply.
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6804. Legal cases
No legal cases concerning transfer pricing have been decided by the courts since the
introduction of DI No. Paw 113/2545. To date, cases involving transfer pricing issues
have been settled during the investigation stage, and details are not made available to
the public.
The burden of proof lies with the taxpayer to clear alleged transfer pricing abuses. The
transfer pricing guidelines are designed to assist taxpayers in their efforts to determine
arms-length transfer prices.
In the event of a dispute, the taxpayer must be able to substantiate, with supporting
documents, to the satisfaction of the revenue offcers, the Board of Appeals, or the
courts, as the case may be, that its transfer prices have been determined in accordance
with the arms-length principle.
Taxpayers are not required to submit their transfer pricing documentation with their
annual corporate income tax returns. They are, however, expected to submit it within
one month of a revenue offcers request.
There is no specifc transfer pricing audit; it is undertaken as part of the normal tax
audit process. However, the Revenue Department begins the investigation process by
issuing a letter requesting taxpayers, under their supervision, to provide information
and documents on the adopted transfer pricing practices. Targets are selected for
investigation based on their analysis of the tax returns submitted, and information
obtained from the business operation visit, whereby the revenue offcers visit
companies under their supervision at least once a year to understand the business and
ensure tax compliance.
The criteria used by the Revenue Department to select targets for transfer pricing
investigation include, but are not limited to:
Low profts compared with competitors;
No tax payment for an extended period of time;
Decline in profts after a tax holiday expires;
Profts in promoted business, but losses/lower profts in non-promoted business;
Drastic fuctuations in profts from year to year;
Varied proftability by product;
Payment of royalties/management fees; and
Signifcant related party transactions.
The transfer pricing documentation is reviewed by the Revenue Departments transfer
pricing team. Based on this review and analysis, the revenue offcers typically raise
questions and require more detailed explanations and related documents. Depending
on how well the transfer pricing practices are documented and the completeness of the
supporting documents, the request for additional information and documents can take
many rounds.
Thailand
The Revenue Departments tax investigation process is as follows:
Collect and analyse accounting and tax information/documents;
Challenge and invite the taxpayers representative to discuss the transfer pricing
(and any other tax) issues identifed, and possibly request additional documents;
Review additional documents and consider explanations;
Inform the taxpayers representative of the Revenue Departments opinion;
The taxpayer is requested to fle amended tax returns if in agreement with the
Revenue Departments opinion;
For transfer pricing issues, the Revenue Department issues a summons to audit all
taxes if the taxpayer does not accept its opinion; and
Taxpayers may enter into the appeals process to resolve the dispute if they disagree
with the tax assessment.
The Revenue Department generally requires six months to analyse the information/
documents and reach a conclusion. After notifying the taxpayer of the outstanding
issues, the clarifcation and negotiation process between the taxpayer and the Revenue
Department may take an additional three to 12 months.
In a case where the revenue offcers accept the taxpayers explanations and supporting
documents, the challenges will be dropped. However, the revenue offcers will then
generally redirect their focus to other tax issues, including corporate income tax, value
added tax (VAT), withholding tax, specifc business tax, etc.
In the event that the revenue offcers do not accept the taxpayers explanations and
supporting documents, they will advise the taxpayer to voluntarily fle amended tax
returns to make the required tax adjustments and to pay a surcharge. If the taxpayer
disagrees with the opinion of the revenue offcers, a summons will be issued for a
comprehensive tax audit. The comprehensive tax audit covers all taxes under the
revenue code (i.e. corporate income tax, VAT, and stamp duty). After having completed
the audit, the Revenue Department will issue the notifcation of a tax assessment.
After receiving notifcation of a tax assessment from the Revenue Department, the
taxpayer is required to make an adjustment to the tax return and pay the tax shortfall
together with the related penalty and surcharge. In the event that the taxpayer
disagrees with the Revenue Department, the taxpayer is allowed to appeal to the
Appeals Division of the Revenue Department. The Por. Sor. 6 form must be completed
and submitted to the Appeals Division within 30 days from the date of receipt of the
notifcation of the tax assessment.
The Board of Appeals (BOA) will consider the taxpayers argument and may invite or
issue a warrant to the taxpayer or witnesses for questioning or to provide additional
testimony or supporting evidence. The appeals process on average takes three months
(not including the waiting period). Upon completion, the BOAs ruling will be mailed
totaxpayers.
In the event that the taxpayer disagrees with the BOAs ruling, the taxpayer may
bring the case to the Tax Court within 30 days from the date of receipt of the notice
of the ruling. It should be noted that if a taxpayer fails to cooperate with the Revenue
Department and does not comply with the summons, the taxpayer is not allowed an
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appeal with the Appeals Division. Furthermore, the Tax Court will not accept an appeal
case if the taxpayer fails to fle the appeal with the Appeals Division.
The Tax Court normally takes one to three years to reach a verdict (not including the
waiting period). If the taxpayer disagrees with the ruling of the Tax Court, the taxpayer
is allowed to appeal to the Supreme Court within one month from the date of the
announcement of the Tax Courts judgment. The ruling process at the Supreme Court
may take an additional one to three years (not including the waiting period).
In the case of a tax assessment resulting from a comprehensive tax audit, the taxpayer
is liable to a penalty equal to the additional amount of tax payable. Revenue offcers
have the power to reduce the penalty 50% if they are of the opinion that the taxpayer
had no intention of evading taxes and has cooperated fully during the tax audit. The
Director-General of revenue has the power to waive the penalty if the taxpayer can
demonstrate that he cooperated fully during the audit and had no intention of evading
the tax.
In addition, the taxpayer is liable to a surcharge of 1.5% per month or fraction thereof
of the tax payable or remittable exclusive of penalties. In a case where the Director-
General of revenue has granted an extension of the deadline for the remittance of the
tax and the tax is paid or remitted within the extended deadline, the surcharge will be
reduced to 0.75% per month or a fraction thereof. Unlike the penalty, the surcharge
may not be waived.
There will be no penalty, only a surcharge, if there is tax payable in the case of
voluntary fling of an amended tax return (i.e. no comprehensive tax audit).
The Revenue Department has all taxpayers fnancial information. All taxpayers are
required to fle their audited fnancial statements together with their corporate income
tax returns. The Revenue Department also has access to the Business-on-Line database,
which contains key fnancial data of all companies registered under Thai law.
Other sources of information include other government agencies, such as the Customs
Department, the tax authorities from treaty partners through the Exchange of
Information Article, disgruntled employees, etc.
Comparable information may come from internal as well as external sources. The
Revenue Offcers use internal data, if and when available, to determine whether the
taxpayers transfer prices are at arms length.
External comparable information is also used, especially if internal comparable
information is not available. There is an abundance of potential comparable data, as
all companies established under Thai law are required to fle their audited fnancial
statements with the Ministry of Commerce. This information is available to the public
but can only be retrieved by photocopying the hard copy documents.
Thailand
No particular industry is more at risk of being subject to tax investigation than any
other. However, as Thailand is a manufacturing base for automotive makers and
electronic goods manufacturers, a relatively greater number of taxpayers in the
automotive and electronics industries have been investigated. Taxpayers in other
industries, such as pharmaceuticals, petrochemicals, computers, etc. also have
beeninvestigated.
The Revenue Department has begun to focus on the following related party
transactions as part of its investigation:
Sales and purchases of goods, assets and services;
Transfer and use of know-how, copyrights and trademarks;
Management and administrative fees;
Loan and interest payments;
Research and development expense allocation; and
Commission payments.
Thailand has entered into conventions for the avoidance of double taxation and the
prevention of fscal evasion with respect to tax on income with 54 countries. The
conventions include mutual agreement procedures (MAP), whereby if a taxpayer
considers that the tax assessment of one or both of the contracting states results or
will result for the taxpayer in taxation not in accordance with the provisions of the
conventions, the taxpayer may present the case to the competent authority of the
contracting state. The competent authorities shall endeavour to resolve any diffculties
or doubts arising by mutual agreement.
It should, however, be noted that most of the treaties that Thailand has with other
countries do not allow for correlative adjustment.
In the event that a taxpayer disagrees with a tax assessment of the Revenue
Department, the taxpayer is entitled to seek a ruling from the Revenue Department.
The ruling process, which normally takes six to 12 months, is expected to take longer
in the immediate future due to the potential change in the process resulting from the
recent political turmoil. The MAPs between competent authorities will also take much
longer than in the past.
Clause 5 of DI No. Paw 113/2545 allows taxpayers to enter into an APA with the
Revenue Department. To enter into an APA, the taxpayer must submit a letter
requesting the APA together with the relevant documents to the Director-General of the
Revenue Department in order to set the criteria, methods and conditions with which
the taxpayer must comply.
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Thailand has so far concluded two APAs. Both are bilateral and with Japan. The third
bilateral APA is expected to be concluded within 2010. A number of companies have
requested for bilateral APAs with Japan and other countries. The Revenue Department
is due to issue APA guidelines in 2010.
The current level of interaction between the Revenue Department and other
government departments, such as the Customs Department, is low. However, taxpayers
should ensure that information provided to the various government departments
isconsistent.
6815. OECD issues
Thailand is not a member of the OECD. However, the tax authorities generally
have adopted the arms-length principle and authorise the use of transfer pricing
methodologies (e.g. comparable uncontrolled price, resale price method, cost plus
method, transactional net margin method, and proft split method) endorsed by the
OECD Guidelines in order to determine the market price of a transaction.
The comparable uncontrolled price method, the resale price method, or the cost plus
method are preferred over the transactional net margin method and the proft split
method. However, there is no hierarchy of these three methods. Other methods may be
used if the three traditional transaction methods were found to be inappropriate. There
is also no hierarchy of these other methods.
Cross-border cooperation is common in general tax areas. Such cooperation has
tended to take the form of foreign tax authorities requesting information from the Thai
Revenue Department. However, recently the Revenue Department has increasingly
been requesting information support from foreign tax authorities in those countries
that have entered into double taxation agreements with Thailand.
Thailand currently has no thin capitalisation legislation.
The Thai Revenue Department is currently increasing its focus on management
service fees. The point of concern is whether the management service fees that a
taxpayer pays to a related party are for the direct purpose of acquiring profts for the
companys business in Thailand and whether the fees paid are commensurate with the
beneftsreceived.
Service providers
All costs related to the services provided must be included in determining the
servicecharge.
Thailand
Service recipients
Generally, service recipients need to substantiate that:
Services are rendered;
Services beneft the service recipient; and
Service fee paid was consistent with the arms-length principle.
The service recipient must have documents to support the above. Contracts and
documents showing the costs incurred by the service provider are not suffcient.
The service recipient should keep proper documentation in respect of the services
rendered, showing that the services were for the beneft of the service recipient. A
benchmarking study should also be maintained to demonstrate that the service fee
(as well as other transfer prices) was consistent with the arms-length principle.
Turkey
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Turkey
6901. Introduction
Formal transfer pricing rules were introduced in Turkey on 21 June 2006, under
Article 13 Turkish Corporate Income Tax (CIT) Law (numbered 5520), Disguised Proft
Distribution Through Transfer Pricing. The rules are effective for tax years starting on 1
January 2007 and following.
The regulations under Article 13 follow the arms-length principle, established by the
TP guidelines for multinational enterprises and tax administrations, established by the
Organisation for Economic Co-operation and Development (OECD) guidelines and
are applicable to all fnancial, economic, commercial transactions and employment
relations between associated parties. Details on the application of Article 13 are
provided in a communiqu regarding disguised income distribution via TP (the TP
communiqu), which was frst released on 18 November 2007. A second communiqu
was released on 22 April 2008, as a supplementary document to the frst communiqu.
The legal framework that defnes the current Turkish TP implementation methodology
is included under Turkish CIT law and the related communiqu(s).
The Turkish TP law is part of the Turkish CIT law effective as of 1 January 2007. The
arms-length principle, which is defned in line with OECD guidelines and Article 9
of the OECD Model Tax Convention, is enacted in Article 13 of Turkish CIT law along
with a detailed defnition of related parties, as well as the introduction of methods to
be applied in the determination of the arms-length price. According to the law, related
parties must set the transfer prices for the purchase and sale of goods and services as
they would have been agreed between unrelated parties.
Since the laws enactment, the following has been published to specify the
TPregulations:
General communiqu No. 1 on TP (November 2007);
Cabinet decision on TP (December 2007);
General communiqu No. 2 on TP (April 2008);
Cabinet decision on TP (April 2008); and
Circular on TP (April 2008).
A comprehensive defnition of what constitutes a related party is found in the TP article
under Turkish CIT law. It includes direct or indirect involvement in the management or
International Transfer Pricing 2011 Turkey 741
Turkey
control in addition to the existence of shareholder/ownership relationship. In addition
to transactions with foreign group companies, it includes transactions with entities that
are based in tax havens or in jurisdictions that are considered to be harmful tax regimes
by the Turkish government.
The arms-length principle applies to associated enterprises, which are defned in
Section 4 in the TP communiqu. The term related party refers to:
Shareholders of an entity;
Individuals or entities related to shareholders or the entity itself;
Individuals or entities that are directly or indirectly associated with the entity in
terms of management, audit, or capital;
Individuals or entities that are directly or indirectly under the management, audit
or capital control of the entity or its shareholders;
Shareholders spouses; and
Relatives of the shareholders or their spouses including upper and lower lineage
with third-degree relationships by blood or marriage.
The term natural person in Article 13 of CIT law refers to any person treated as a
natural person who is taxable and their corporations and ordinary partnerships. The
term entity refers to equity companies, cooperatives, state economic enterprises,
associations or foundations, and economic enterprises and joint ventures of such
entities. In applications of Turkeys income tax law, related parties have been found
to cover a shareholders (including partners of general partnerships, ordinary
partnerships and limited partnerships) spouse and any relatives of the shareholder
or his/her spouse including upper and lower lineage with third-degree relationship
by blood or marriage and companies in which they hold direct or indirect ownership
interests, partners to such companies, and companies that are under the management,
audit, or capital control of such companies are all considered to be related entities.
The TP rules defne certain methods for the determination of arms-length transfer
prices. The methods adopted are comprehensively explained by the OECD guidelines
and are as follows:
Cost plus method; and
Resale price method.
The law states that if the above-mentioned methods cannot be used by the company
for certain situations, the taxpayer will be free to adopt other methods. This means
companies can also choose other methods such as the transactional proft methods of
the OECD guidelines (namely proft split and transactional net margin method) for the
determination of the arms-length price if they can prove that the above-mentioned
traditional methods cannot be used.
According to the general communiqu No. 1 on transfer pricing, the other methods are
defned as the following:
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If none of the afore-mentioned methods can be applied, the method determined by
the taxpayer may be used as the most appropriate method for the transactions. The
defnitions of the transfer pricing methods are defned in the general communiqu No.
1 on transfer pricing.
Comparable uncontrolled price method:
In the comparable uncontrolled price method (CUP), if the internal comparables
are suffcient to reach an arms-length price, there is no need to fnd an external
comparable. If there is no internal comparable, external comparables should be used
after making a comparability analysis and the required amendments.
Cost plus method:
In the cost plus method, all the direct costs, indirect costs, common costs related to
service or product and operation costs should be considered.
If there is a difference between the accounting systems of related and unrelated
transaction processes, the required amendments should be made.
Resale price method:
The resale price method evaluates the arms-length character of a controlled
transaction by reference to the gross proft margin realised in comparable uncontrolled
transactions, and is most useful where it is applied to marketing operations, such
asdistributors.
Proft split method:
The proft split method is based on the distribution of the operating proft or loss
amongst related parties according to their functions performed and risks assumed.
Transactional net margin method:
The transaction net margin method (TNMM) is applied according to the net operating
proft margin that is found considering the costs, sales or any other appropriate base.
There is also the possibility that the prices to be applied and methods to be used for
determination of the arms-length prices can be agreed with the Ministry of Finance
in the form of an approval/agreement request in advance. This exercise has been
introduced in the 2007 transfer pricing rules for taxpayers who are willing to get
advanced certainty with respect to their transfer pricing issues. The law states that
agreements concluded with the Turkish tax authorities in this respect will be valid for
a three-year period given that the conditions represented in the request do not change.
An announcement regarding the advanced pricing agreement (APA) programme
is expected to be made accompanied by additional explanations from the Turkish
taxauthorities.
Under transfer pricing rules, if the arms-length price is not being used for related
party transactions, then it is regarded as partial or full distribution of the proft in
a disguised manner via transfer prices. The outcome will be that disguised proft
distribution will be considered as dividend distribution from one party to another (or
transfer of proceeds in case of permanent establishments) at the end of the concerned
fscal period. Tax assessments with regard to the wrong transfer prices will be done
accordingly. If the counterparty is a resident corporate taxpayer, a correction process
is made according to corporate tax exemption for profts from participations (i.e.
participation exemption).
Turkey
6903. Tax havens
In addition to inter-company transactions between related parties, the transfer pricing
provisions of CIT Law No. 5520 cover transactions between unrelated parties, where
the foreign party is located in one of the tax havens identifed by the Turkish Council
of Ministers. The council is expected to release a list of such tax havens by the end of
2010, but no such list had been published as of 1 May 2009.
Payments for services, commissions, interest and royalties to parties located in a tax
haven are subject to a 30% withholding tax under Turkish CIT law. However, if the
transactions involve the import of a commodity or the acquisition of participation
shares or dividend payments, the withholding tax is not applicable as long as the
pricing is considered to be arms length.
6904. Deemed dividends
When it is determined by tax inspectors that the price applied in a related party
transaction is not at arms length, the outcome is a tax adjustment on corporate tax
as well as additional dividend tax on the disguised proft distribution. This requires
that if the counterparty is a foreign-based taxpayer, individual or any tax-free person;
corporate dividend tax should be paid over the deemed proft distribution.
6905. Adjustments
Any transfer pricing-related adjustments deemed necessary by the tax inspectors will
be made to the taxpayers earnings after they pay their respective corporate taxes.
Disguised proft distributions through transfer pricing are not accepted as deductible
for CIT purposes. The corporate tax base of the taxpayer will be adjusted, and relevant
corporate tax will be calculated together with the penalties and late payment interest.
Proft that is regarded by the authorities as distributed in a disguised manner through
transfer pricing will be deemed as dividends distributed.
The legislation requires documentation as part of the transfer pricing rules wherein
Turkish taxpayers should keep documented evidence within the company in case of
any request by the tax authorities. The documentation must represent how the arms-
length price has been determined and the methodology that has been selected and
applied through the use of any fscal records and calculations, and charts available at
the taxpayer.
The transfer pricing regulations in Turkey have three basic documentation
requirements:
Electronic corporate tax return form about transfer pricing, controlled foreign
company and thin capitalisation;
Annual transfer pricing report;
Transfer pricing documentation for taxpayers during the application of an APA; and
Annual report for taxpayers under an APA.
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According to general communiqu No. 1 on TP, all corporate taxpayers should submit
a form as an attachment of their annual corporate tax return. The form constitutes the
following parts:
Information about the taxpayer (tax number, corporate name, taxation
period,etc.);
Information about the related parties within the scope of the form (corporate
name, country of residence);
Total amount of transactions that occurred between related parties;
The methods used for the related party transaction or different transactions;
Information about the controlled foreign company of the company (corporate
name, country of residence, etc.); and
Information about thin capitalisation.
On the other hand, corporate taxpayers are obliged to prepare an annual transfer
pricing report in line with the format that is stated in the general communiqu on
transfer pricing. An annual transfer pricing report should be prepared until the last day
of CIT declaration day, which is 25 April. The report shall compose different levels of
information depending on:
Whether the taxpayer is registered to the Major Tax Payers tax offce; and
Whether the taxpayer is operating in free trade zones in Turkey.
According to the above-mentioned distinction:
Corporate taxpayers that are registered to the Major Tax Payers tax offce shall
prepare a report that comprises information about their transactions with their
related parties in and out of Turkey; and
Corporate taxpayers that are operating in free trade zones (FTZ) in Turkey shall
prepare a report that comprises information about their transactions with their
related parties in Turkey.
All other Turkish corporate taxpayers shall prepare a report that comprises information
about their related party transactions with their non-resident related parties.
Documentation deadlines are as follows;
Preparation deadline Submission deadline
Transfer
pricing form
Corporate tax return submission (as an
attachment to the corporate tax return) on
the 25th day of the fourth month following
the end of the scal year
Annual Transfer
pricing report
Corporate tax return
submission on the 25th day of
the fourth month following the
end of the scal year
15 days upon request
Turkey
Disposition of the annual transfer pricing report is mentioned in the related legislation
as follows:
General information: Information about the feld of activity of the taxpayer,
economic conditions of this feld, market conditions and business strategies;
Information about related parties: Information about tax identifcation numbers,
addresses, telephone numbers, etc. of the related parties and the feld of activity of
the related parties as well as economic conditions of this feld, market conditions
and business strategies, functions they generate, risks they assumed and assets
theyowned;
Information about the details of related party transactions: Detailed information
about all transactions and agreements between related parties;
Information about transfer pricing analysis: Detailed information about
comparability analysis, criteria that are used to choose for the comparable
transactions (whether there are corrections on determination of the comparability
the detailed information for that; information, documentation and calculation that
shows the applied TP method is the most suitable as well as the comparison of the
applied method to the other methods; detailed information about the calculations
used to fnd the arms-length price or proft margin; whether an arms-length price
range is determined, and the detailed information on this range); and
Conclusion: Taxpayers that will apply for an APA shall prepare application
documents, and once concluded an APA with the Revenue Administration shall
prepare a separate annual report that takes transfer pricing into consideration from
the APAs point of view. The documents and information required for the annual
report of APA is separately defned in the legislation.
The administration can demand additional information and documents for the annual
transfer pricing report, the APA application and other corporate taxpayers that have
related party transactions when deemed necessary. If the documents are written in a
foreign language, their translation to Turkish is obligatory.
6907. Other documents
Corporate and individual income taxpayers must prepare transfer pricing
documentation. The type of information that is required is outlined in the transfer
pricing communiqu as follows:
Organisation chart and defnition of the companys activities, defnition of related
parties (tax identifcation numbers, addresses, telephone numbers, etc.) and
property relations amongst them;
All the information that includes the functions undertaken and the risks assumed
by the company;
The product price lists in the transaction year;
The production costs in the transaction year;
Invoice information and the number/value of transactions made with related or
unrelated parties in the transaction year;
All the contracts with related parties in the transaction year;
Financial statements of the related parties;
Internal pricing policy of the company, which is applied to related
partytransactions;
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The associated information if related parties use different accounting standards
and methods;
Information related to the ownership of intangible property and values purchased
or paid for intangible rights;
Reason for choosing the transfer pricing method applied and informative
documents related to the application of the transfer pricing method (internal and/
or external comparability analysis);
Calculations used to determine the arms-length price or proft margin and detailed
information related to assumptions;
Method used to determine the arms-length price range, if any; and
Other documents used to determine the arms-length price.
6908. Language for documentation
TP documentation should be prepared in Turkish.
In addition to the specifc transfer pricing regulations, additional requirements or rules
covering transfer pricing contained in other legislation include:
Turkish tax procedural law article with regard to the determination of the market
value of goods;
Turkish value added tax (VAT) law article stating if the tax base for goods and
services is unknown, the market prices based on the nature of the transactions will
be the tax base;
Turkish income tax law Article 41 includes partnerships and real persons subject to
income within the scope of transfer pricing;
Case law on an excessive number of decisions of Turkish tax courts after cases have
been discussed at courts where tax inspectors challenged the transfer prices and
eventually the disguised proft distribution of the taxpayer; and
Case law on tax rulings on the subject.
6910. Legal cases
In 2008, the Turkish Ministry of Finance signifcantly increased its number of transfer
pricing audits against companies, with a particular emphasis on the pharmaceutical,
automotive and fast moving consumer goods sectors. In the course of these audits, the
Ministry of Finance has focused on the following transfer pricing issues:
Pricing of raw materials traded amongst related parties, with the government
relying on industrial benchmarking studies that omit relevant risks and functions;
Continual losses in previous years by companies that operate primarily through
related companies abroad; and
Management fees and indirect cost allocations.
It is expected that the companies will face different levels of tax audits under the
subject of transfer pricing in the coming couple of years as the current rules seem to
become a trendy subject to the tax inspectors.
Turkey
In Turkey, the burden of proof lies with the party making the claim under Article
3 of Turkish tax procedural law. Establishing proof includes an examination of the
substance of the business event that gives rise to the transaction.
According to the requirements of the transfer pricing law, companies should be ready
to provide evidence in order to explain why they chose to implement a specifc transfer
pricing method. Moreover, responsibility for safe-keeping of the workings/accounts
and sheets for this issue rests with the taxpayers.
In the case of a tax audit, if the tax inspector claims the application of the transfer
pricing method by the company is against the law, then the burden of proof will shift
to the inspector. If a situation is claimed to be clearly lacking in economic, commercial
and logical justifcation, the plaintiff is liable to prove his claim.
Descriptive legislation regarding transfer pricing became effective as of 1 January
2007. Thus, the Turkish tax authorities have limited experience in the setting of arms-
length prices and proft levels. The statute of limitations is fve years as imposed by tax
legislation. As of 2008, open years for tax inspection begins with 2003.
It is not the practice for the Turkish tax authorities to conduct regular tax audits. Under
normal circumstances, the probability of a tax inspection for a Turkish company is
about 2% to 3%, although this dramatically increases depending on which industry has
caught the attention of the tax inspectors. There is no specifc transfer pricing-related
tax audit procedure. However, during the random tax audits, transfer prices can be
questioned by the tax inspectors, and it is expected that transfer pricing will draw
more attention from the tax authorities not only because it is addressed in the new
Turkish CIT law but also because of its relationship to other tax laws such as VAT and
customsregulations.
Assessments are made by the tax inspectors at the end of the tax audit. There is no
administrative appeals procedure, but a special reconciliation with the tax authority is
possible. If parties cannot reconcile at the end of the reconciliation process, then the
taxpayer is able to go to court. Likewise, the taxpayer can choose not to reconcile prior
to the reconciliation process and go to court.
There are no specifc transfer pricing penalties. The penalty provisions of the tax
procedural law apply to those who do not submit the required documentation and/or
where transactions are found to be inconsistent with the arms-length principle. Briefy,
if the proft that is distributed in a disguised manner through transfer pricing shall be
deemed as dividends distributed, then necessary adjustments on taxes will be made
at the hands of the party receiving the deemed dividends. In this respect, the taxes
assessed in the name of the company distributing dividends in a disguised manner
must be fnalised and paid.
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There is no specifc tax loss penalty in Turkish tax legislation for transfer pricing
adjustments. The general tax loss penalty provisions in the Turkish tax procedures
code are applicable. The general tax loss penalty is equal to one fold of the unpaid
tax. Additionally, there is a delay interest applied on a monthly basis (2.5% effective
from 21 April 2006) for the period between the normal due date of the additional tax
assessed and the date of assessment. Further, there is no specifc reduction provision
for transfer pricing-related tax loss penalty assessments; general rules in the Turkish
tax procedures code are applicable. Taxpayers may appeal to the Ministry of Finance
for a reduction in the tax loss penalty through settlement procedures with the tax
authorities either before or after the imposition of the assessment.
During the tax audits, tax returns of the comparable companies may be used by
the tax authority. There is no special unit under Turkish General Directorate of
Internal Revenue to deal with transfer pricing issues. Local tax inspectors possess a
high level of industry-specifc knowledge, and they may use a variety of sources for
benchmarking such as fnancial data published by listed companies as well as data
from other taxpayers. The lack of statistical information for determining the proft
margin of specifc activities and the lack of local databases directly affect the accuracy
of benchmarking studies.
Moreover, as mentioned in Section 6506, by using the annual form, inspectors
may assess the amount of related party transactions in a year and initiate an
investigationaccordingly.
In local terms there is no available local data or database for benchmarking. Only the
fnancial statements of public companies are declared to the public, and within this the
right question is: Are foreign comparables acceptable to local tax authorities? For the
time being, not only do local rules fail to provide a clear answer but also Turkish tax
authority is currently silent to this question. As there is no specifc prohibition, it might
be inferred that foreign comparables pan-European should be acceptable if no
domestic comparables are available.
All industries and related party transactions can be reviewed under the scope of tax
audits. Intragroup borrowing is one topic of special interest. The amount of debt and
the interest calculations may be challenged. There is a recent trend of auditing the
transactions (commercial and/or fnancial) between headquarters and branches/group
entities in Turkish FTZs. Payments for services such as management fees have, for some
time, been a particular focus for inspectors.
Turkish tax treaties (currently with 68 jurisdictions) contain relevant mutual
agreement procedure (MAP) articles. Countries that have signed a double tax treaty
(DTT) with Turkey may, in theory, pursue competent authority relief as a means of
Turkey
preventing double taxation arising from tax adjustment. However, in practice there
are very rare cases where MAPs are initiated, meaning the MAP has not been tested by
Turkish taxpayers as a means of preventing double taxation.
As part of the Turkish transfer pricing legislation, the APA procedure has been
introduced for corporate taxpayers who desire to obtain some certainty with respect
to their transfer pricing issues. It is stated in the legislation that agreements concluded
with the Turkish tax authorities in this respect will be valid for a three-year period,
maximum. If the administration identifes that the demand for the agreement interests
more than one country and if there are already APAs considering the other county/
countries, the administration may give its decision based on these agreements.
The corporate taxpayers that are registered to the Major Tax Payers tax offce may
apply for an APA beginning from 1 January 2008. APA applications are possible for
taxpayers that are registered to other tax offces as of 1 January 2009. Moreover, after
1 January 2009, taxpayers that operate in FTZs in Turkey may apply for their related
party transactions with their related parties in Turkey.
APA application process includes the following steps:
Preparation of documentation as specifed in legislation;
Preassessment (assessment of documents and applications completeness);
Analysis of documentation and arguments presented; and
Approval or rejection of the application.
Nine months prior to the end of the validity of the agreement, a taxpayer may apply for
its renewal.
The lack of a reliable database that contains Turkish third-party comparables may
prove to be problematic. It is expected that the Ministry of Finance will invest in
training and the establishment of a technical infrastructure to deal with taxpayers
requests and to determine procedural methodology in relation to transfer pricing.
The customs rules in Turkey are not specifcally coordinated with the transfer pricing
rules. The customs authorities have their own legislative guidance for the treatment
of inter-company transfers of imported/exported material. Additional TP regulations
may create the need to incorporate customs practices into joint legislation. There have
been joint efforts by customs and tax authorities to work on the transactions and to
investigate import prices in specifc industries. For example, reports have been written
by a customs inspector that challenged import prices.
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6922. OECD issues
Turkey is a member country of the OECD and acknowledges the organisations transfer
pricing guidelines. On the other hand, as Turkeys transfer pricing regulations are
new and at the development stage, they have yet to fully incorporate all the principles
contained under the OECD Guidelines. The current transfer pricing law provides an
impetus for the adoption of improved transfer pricing regulations in accordance with
best international practice.
The thin capitalisation issue is rearranged in the Turkish CIT law Article 12. According
to the article, if the ratio of the borrowings from shareholders or from persons related
to the shareholders exceeds three times the shareholders equity of the borrower
company at any time within the relevant year, the exceeding portion of the borrowing
will be considered as thin capital.
The scope of the term related parties consists of shareholders and the persons who
are related with the shareholders that own 10% or more of the shares, voting rights or
right to receive dividends of the company.
The shareholders equity of the borrower company is defned as the total amount
of the shareholders equity of the corporation at the beginning of the fscal year, or
the difference between the assets and liabilities of the company. If the company has
negative shareholders equity at the beginning of the year, then any borrowings from
related parties will be considered as thin capital.
If thin capitalisation exists, the interest paid or accrued, foreign exchange losses and
other similar expenses calculated over the loans that are considered as thin capital are
treated as non-deductible for CIT purposes. Moreover, the interest paid or accrued and
similar payments on thin capital will be reclassifed at the end of the relevant fscal year
as distributed dividends and will be subject to withholding tax.
Although in the past the law did not provide defnitive legislation relating to
management services, the new transfer pricing article takes the OECD Guidelines as
a basis. Through these developments, management services may be subject to greater
scrutiny under the transfer pricing regulations.
As per Turkish transfer pricing regulations, management services refer to one of
thefollowing:
The services performed by the corporate headquarters to other related group
companies; and
The services that are rendered by one group company to another.
These services are usually considered as services that ensure intragroup management,
coordination and control functions. The costs of these services are undertaken by the
main company, a group member who is responsible for this purpose or another group
member (group services centre).
Turkey
From a Turkish transfer pricing-regulations perspective, the following points have to be
taken into consideration:
Whether the service has been rendered;
Whether the receiver company(s) needs the service; and
Whether the price of those services is at arms length.
The payments that fail the above-mentioned points may be criticised from a transfer
pricing viewpoint and may be non-deductible from a corporate tax point of view.
United Kingdom
70.
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United Kingdom
7001. Introduction
In recent years, the most signifcant change has been the introduction by Her
Majestys Revenue and Customs (HMRC) (the successor to the Inland Revenue) of
a new framework for handling all transfer pricing enquiries. The Transfer Pricing
Group (TPG) was introduced in April 2008, and all enquiries are now subject to its
governance and procedures (see Section 7006).
Transfer pricing disputes in the UK are usually resolved by negotiation between HMRC
and the taxpayer. Until recently, there was little case law, but in 2009 the tax tribunal
found in favour of HMRC in DSG Retail and others v HMRC, the UKs frst substantive
transfer pricing case (see Section 7004).
A large amount of guidance material is published by HMRC on its interpretation of
the law and how it assesses transfer pricing risks. This is in HMRCs International
Manual, which is available to the public via the HMRC website (www.hmrc.gov.uk)
(see Section7003).
The UKs current transfer pricing rules TIOPA 2010, Part 4 were enacted in February
2010 and take effect for all accounting periods ending on or after 1 April 2010.
TIOPA 2010 represents a restatement of the previous rules which were contained in
ICTA 88, Schedule 28AA, including later amendments, and which took effect for all
accounting periods ended on or after 1 July 1999. TIOPA 2010 was part of the UK
governments project to update and consolidate a wider body of personal and corporate
taxlegislation.
The UK rules are widely drafted and are intended to cover almost every kind of
transaction. Since 1 April 2004, the rules have applied to UK-to-UK transactions, and
thin capitalisation rules have been wholly within the transfer pricing regime (see
Section 7019).
Self-assessment
UK enterprises are required to self-assess their compliance with the arms-length
principle in fling tax returns. Where they would have lower taxable profts or greater
allowable losses calculated on the basis of the actual provision for the transaction
than if calculated on the basis of the arms-length provision, they are regarded as
an advantaged person. Such companies and partnerships must identify and make
transfer pricing adjustments when submitting their tax returns under self-assessment.
International Transfer Pricing 2011 United Kingdom 753
United Kingdom
An important implication of this approach is the potential for interest and penalties for
carelessness. Penalties are discussed at Section 7009.
The rules apply a one-way street approach. Taxpayers are required to make transfer
pricing adjustments where these result in increased taxable profts or reduced
allowable losses in the UK, but are not permitted to make adjustments that result in
decreased taxable profts or greater allowable losses. A decrease in the taxable profts
or increase in allowable losses of the UK enterprise may be effected only through the
operation of the competent authority procedures of the relevant double tax agreement
(DTA) or, in the case of a UK-to-UK adjustment (see below), through a compensating
adjustment that allows a disadvantaged person involved in the transaction to
calculate their tax on the same basis by making a compensating adjustment to their
taxable profts or losses. Such an adjustment can be made only by a disadvantaged
person, and can be made only in respect of a transaction where a transfer pricing
adjustment has been made by an advantaged person.
The participation condition
The legislation applies to transactions where the participation condition is met.
This is widely defned in the legislation but generally means a transaction or series
of transactions involving entities where one party controls the other, or both parties
are under common control. The parties exerting control may include companies,
partnerships and, in certain circumstances, individuals.
Control for the purposes of this legislation is defned in CTA 2010, Section 1124
(formerly ICTA 88, Section 840). It is important to note that control is not confned to
situations where one party is the majority shareholder in the other. Effectively, control
exists where one party has the power to ensure that the affairs of another party are
conducted in accordance with the frst partys wishes.
The concept of control set out in CTA 2010, Section 1124 is subject to important
extensions for transfer pricing purposes under TIOPA 2010, Part 4 (and formerly ICTA
88, Schedule 28AA):
The rules apply to many joint venture companies where two parties each have an
interest of at least 40%; and
Attribution rules are used to trace control relationships through a number of levels
in determining whether parties are controlled for the purposes of the transfer
pricing rules.
Further changes known as the acting together rules affecting fnancing deductions
were made with effect from 4 March 2005. These changes were triggered by structures
adopted by private equity houses but have wide-ranging effect beyond private equity
(see Section 7019).
Concept of provision
The legislation uses the concept of provision made by means of a transaction or
a series of transactions to describe the situations to which the legislation applies.
Provision is undefned within the legislation, although it is understood that the use of
the term is intended to allow the wider consideration of all the terms and conditions
surrounding a transaction or series of transactions in deciding whether it has been
conducted at arms length. According to HMRC, provision is broadly analogous to the
phrase conditions made or imposed in Article 9 of the OECD Model Tax Convention
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and embraces all the terms and conditions attaching to a transaction or series of
transactions. While it might be argued that the term provision is arguably wider than
the phrase conditions made or imposed, HMRC takes the view that the scope of the
UK legislation can be no wider than the scope of Article 9, as informed by the OECD
Transfer Pricing Guidelines.
In a recent tax case, DSG Retail and others v HMRC (TC00001), the tribunal accepted
a broad interpretation of the term provision, in line with Article 9 of the OECD
Model Tax Convention, which refers to conditions made or imposed between two
enterprises. The court also accepted that a provision may exist where there is no
formal or enforceable conditions (e.g. a contract), accepting that Schedule 28AA
(the applicable legislation in the case), which refers to informal arrangements and
understandings, applied (see Section 7004).
OECD Guidelines
The legislation is drafted to explicitly require that the rules be construed in such
manner as best secures consistency between the domestic legislation and Article 9 of
the OECDs Model Tax Convention and the OECD Guidelines.
Branches and permanent establishments
TIOPA 2010, Part 4 (and formerly ICTA 88, Schedule 28AA) cannot be applied to
dealings between a branch or permanent establishment and the company of which
it is a part, since the two are not separate legal entities. Instead, other sections of the
legislation as well as the Business Profts article of the relevant DTA operate to tax the
appropriate amount of proft in the UK. In the case of an overseas branch or permanent
establishment of a UK company, the profts of the branch are taxed as part of the profts
of the UK company. In the case of a UK branch or permanent establishment of an
overseas company, income arising directly or indirectly through or from the branch is
taxable in the UK under ICTA 88, Sections 11 and 11AA and Schedule A1. The transfer
pricing rules in TIOPA 2010, Part 4 can of course be applied to transactions involving
related parties of the legal entity to which the branch or permanent establishment
belongs. Hence, an overseas associated company of a UK company is also a related
party of an overseas branch or permanent establishment of that UK company, and
TIOPA 2010, Part 4 could be applied to transactions between the two overseas entities.
HMRC does not make secondary adjustments, such as deemed distributions or deemed
capital contributions, when it makes a transfer pricing adjustment, as there is no basis
in UK law for such adjustments.
Where the primary adjustment is made by a treaty partner, HMRC considers the
merits of claims to deduct interest relating to the deeming of a constructive loan by a
treaty partner following a transfer pricing adjustment. The claim would, however, be
subject to the arms-length principle and would be considered in the light of relevant
provisions relating to payments of interest. Where a treaty partner applies a secondary
adjustment by deeming a distribution to have been made, this is now normally exempt
from tax in the UK under the recently introduced dividend exemption rules.
UK-to-UK transfer pricing
When it was originally enacted, ICTA 88, Schedule 28AA included an exemption for
UK-to-UK transactions, subject to certain restrictions. With effect from 1 April 2004,
the government removed the exemption for UK-to-UK transactions from the transfer
United Kingdom
pricing legislation, primarily due to its concern that the existing rules might be held to
be in breach of the Treaty on the Functioning of the European Union (TFEU).
As there is no consolidated tax return in the UK, the UK-to-UK transfer pricing
potentially has an impact where there is tax at stake, either because of particular
tax planning arrangements or where some more routine aspect of the tax system
(such as losses in one company in the group) means that there is tax to be collected.
One particular area where the amended rules have an effect is where no charge
is currently made, for example, for services or for the use of assets (including
intellectualproperty).
However HMRC has no great desire to tie up resources investigating UK-to-UK
transactions where the tax risk is low and experience of the level of such enquiries by
HMRC since UK-to-UK rules were introduced generally supports this. Additionally,
there is a corresponding adjustment mechanism to effect relief on the counter side of a
UK-to-UK transaction for which an adjustment has been assessed.
Concessions and exemptions
There are limited exemptions from the UK transfer pricing rules for small- and
medium-sized enterprises (SMEs), where the defnition of SMEs is assessed at a group
level. Groups with more than 250 employees, turnover of more than EUR50 million or
a balance sheet worth more than EUR43 million do not qualify for the exemption, nor
do SMEs entering into transactions with a tax-haven entity. Because denomination of
these thresholds are in euros (as the defnition of SMEs is an EU one), exchange rate
movements may have an impact on a given SME groups qualifcation for exemption
from the transfer pricing rules from one year to the next. The exemption does not
apply where the enterprise has transactions with or provisions which include a related
enterprise in a territory with which the UK does not have a double tax treaty with an
appropriate nondiscrimination article. Such transactions remain subject to the UKs
transfer pricing rules.
HMRC has also reserved the right to direct that the rules apply to medium-sized
companies where it considers that transfer pricing has been manipulated egregiously.
7003. Other regulations and guidance
HMRC manuals are prepared for internal use by the tax authority and are updated
periodically. They are also publicly available, including online versions accessible on
the HMRC website. In general, these manuals provide a detailed description of how
the tax authority interprets the existing legislation and a rationale and explanation
of its development. The International Manual contains guidance on the principles of
double taxation relief, an introduction to DTAs and guidance on controlled foreign
companies (CFCs) legislation, guidance on transfer pricing, cross-border fnancing and
thin capitalisation legislation, and practical advice to HMRC offcials on conducting
enquiries in these areas.
On transfer pricing specifcally, this manual provides guidance on the factors HMRC
should consider when applying the legislation, such as the circumstances indicating the
presence of potential transfer pricing issues to address and matters to consider when
deciding whether to pursue an enquiry and how enquiries are to be progressed through
the TPG governance framework. The manual contains training and instructional
material aimed at specialists in the TPG and at HMRC staff in local offces who are part
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of the team dealing with transfer pricing enquiries. The practical guidance on transfer
pricing covers the following main areas:
Risk assessment and case selection, including general and specifc risks;
The conduct of an enquiry and how this works within the TPG governance; and
The settlement of cases and dealing with resulting issues such as the mutual
agreement procedure and advance pricing agreements.
7004. Legal cases
Until recently, the few cases brought before the courts on transfer pricing issues in
the UK had largely concerned procedural and interpretative issues rather than the
substantive application of the rules. The early case law, such as Watson v Hornby
(1942), Sharkey v Wernher (1955) and Petrotim Securities Ltd v Ayres (1963),
established the principle of arms-length prices for transactions between related
parties as now embodied in the legislation. Two more recent cases are of importance
in the interpretation and application of the legislation which preceded ICTA 88,
Schedule28AA.
Ametalco UK v IR Commrs (1996)
The facts of Ametalco concerned the nature of the transactions to which the transfer
pricing legislation could be applied. The UK company had, at the request of its
parent, advanced an interest-free loan to a related company. Under the provisions of
ICTA 88, Sections 770 to 773, the tax authority claimed the right to impute notional
interest on the loan and tax the consequent notional income in the hands of the UK
lendingcompany.
The Revenue maintained that the legislation applied to all types of transaction,
including loans or advances of money, and, in its view, this type of transaction was
covered by ICTA 88, Section 773 as a business facility of whatever kind. Various
arguments to refute this position were advanced by the taxpayer, but these were
rejected by the Special Commissioners who decided in favour of the Revenue.
This case was important in relation to the old legislation, since it clarifed the position
with regard to the applicability of the legislation to loans and interest in general, and
interest-free loans in particular.
Glaxo Group Ltd v IR Commrs (1995)
In Glaxo Group Ltd, several companies in the Glaxo group had many years of open
(unagreed) assessments as a result of unresolved appeals. The Revenue suspected
that the companies had been engaged in transactions with related parties on a non-
arms-length basis and sought to increase the open assessments to refect transfer
pricingadjustments.
Glaxo contended that transfer pricing adjustments had to be effected by raising new
assessments and not by amending existing open assessments. There was then a six-year
time limit on new assessments (except in cases involving fraud or negligence) and this
would have limited the adjustments the Revenue could make. It was held that transfer
pricing adjustments could be made to open assessments.
In addition to these court cases, appeals on transfer pricing which are now heard in
the frst instance by the tax tribunals (previously the Special Commissioners) create
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a rebuttable presumption on the interpretation of the legislation and can establish the
facts of a case and the transfer pricing methodologies that should be applied.
Special Commissioners decision Waterloo plc and other v IR Commrs
(2001)
In this case, the Special Commissioners considered the transfer pricing rules in
connection with the costs associated with the operation of international share plans
by Waterloo plc (the name of the company was made anonymous in the published
judgment). The Special Commissioners held that Waterloo plc should be taxed as if
it had charged a fee to its overseas subsidiaries for providing share benefts to their
employees, and that an upward adjustment to Waterloos taxable profts should be
made under the transfer pricing rules.
The Special Commissioners decided that providing the ability for the employees of
the subsidiaries to participate in the option arrangements was a business facility.
The Special Commissioners accepted that the options were remuneration for the
employees. The parent company therefore provided some of the remuneration of
employees of the subsidiaries, by means of the totality of the arrangements. Provision
of remuneration to the subsidiaries was the valuable business facility in question.
The business facility was made directly to the subsidiaries employing the individuals
who participated in the option arrangements. ICTA 88, Section 770 as amended by
Section 773(4) required a giving of facilities to a recipient not a clear transaction
with a sale and a purchaser therefore, there was no need to identify a transaction
directly between the parent and the subsidiary. The Special Commissioners decided
that there was a clear, valuable beneft from the share scheme to the subsidiary
employing the relevant employees, and the value of that beneft was capable of
being calculated. On a wider level, the case provides a presumption that ICTA 88,
Section 773(4) allowed the Revenue to tax the total facility provided intragroup
and did not require a transaction-by-transaction analysis: the phrase business
facility is a commercial not a legal term, and that where a commercial term is
used in legislation, the test of ordinary business might require an aggregation of
transactions which transcended their juristic individuality (paragraph 57 of the
publisheddecision).
Following this reasoning, Waterloo plc failed in its argument that ICTA 88, Section 770
did not apply because the transactions took place between persons not under common
control (i.e. the share scheme trustee and Waterloo plc).
The Revenue issued guidance on its view of this case and, more recently, on the
application of the arms-length principle to share plans in light of the accounting
rules for share-based payments under IFRS, which now apply to accounting periods
beginning on or after 1 January 2005.
Tax tribunal decision DSG Retail and others v HMRC (TC 00001) (2009)
This case was the frst UK litigation in which issues of transfer pricing methodologies
and the application of the OECD Transfer Pricing Guidelines was heard in detail.
This is widely known as the Dixons case because it concerns the sale of extended
warranties to third-party customers of Dixons, a large retail chain in the UK selling
white goods and home electrical products. The DSG group captive (re)insurer in the
Isle of Man (DISL) insured these extended warranties for DSGs UK customers. Until
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1997 this was structured via a third-party insurer (Cornhill) that reinsured 95% on to
DISL. From 1997 onwards the warranties were offered as service contracts that were
100% insured by DISL. The dispute concerned the level of sales commissions and proft
commissions received by DSG.
The First Tier Tax Tribunal rejected the taxpayers contentions that the transfer
pricing legislation did not apply to the particular series of transactions (under ICTA 88
Section 770 and Schedule 28AA) essentially the phrases facility (Section 770) and
provision (Schedule 28AA) were interpreted broadly so that there was something to
price between DSG and DISL, despite the insertion of a third party and the absence of a
recognised transaction between DSG and the other parties involved.
The tribunal also rejected potentially comparable contracts that the taxpayer had
used to benchmark sales commissions on similar contracts on the basis that the
commission rate depended on proftability, which itself depended on the different
level of loss ratios expected in relation to the products covered. A much more robust
looking comparable provider of extended warranty cover offered as a benchmark for
the market return on capital of DISL was also rejected owing to its differing relative
bargaining power compared to DISL. This third-party re-insurer was considered to be
a powerful brand providing extended off-the-shelf warranty cover through disparate
distributors the tribunal noted that DSG had a strong brand, powerful point of sales
advantage through access to customers in their shops and could easily have sourced the
basic insurance provided by DISL elsewhere.
The overall fnding of the tribunal was that, to the extent that super profts were
available, these should be distributed between the parties according to the ability of
each party to protect itself from normal competitive forces and each partys bargaining
power. The tribunal noted in this context that DISL was entirely reliant on DSG for its
business. According to the facts of this case, the super profts were deemed to arise
because of DSGs point-of-sale advantage as the largest retailer of domestic electrical
goods in the UK and also DSGs past claims data. DISL was considered to possess
only routine actuarial know-how and adequate capital, both of which DSG could fnd
foritself.
As a result, the tribunal thought that a proft-split approach was the most appropriate,
whereby DISL was entitled to a market return on capital, with residual proft over and
above this amount being returned to DSG via a proft commission.
This decision is important in an understanding of HMRCs likely future approach to
transfer pricing cases and to future litigation in this area. It offers valuable insights into
consideration of:
The level of comparability demanded to support the use of comparable
uncontrolled prices;
Selection of the appropriate tested party in seeking to benchmark a transaction;
The importance of bargaining power;
The tribunals acceptance and approval of proft split as the most appropriate
methodology; and
HMRCs expectation that a captive insurer that is underwriting simple risks,
particularly where the loss ratios are relatively stable and predictable, and that
does not possess signifcant intangibles or other negotiating power, should not
expect to earn more than a market return to its economic capital.
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It is debatable whether this success in the tribunal will encourage HMRC to take
more transfer pricing cases to litigation. Litigation is a costly process for both sides,
and subsequent cases may not go as well as this case did for HMRC. At present there
does not appear to be a backlog of transfer pricing cases in the UK awaiting litigation,
indeed, all the indications are HMRC will be keener to resolve disputes with taxpayers
on a more collaborative basis and will be more inclined to take cases to facilitative
mediation rather than litigation (see Section 7015).
Under the UKs current legislation, the burden of proving that transfer prices are
at arms length falls on the taxpayer. The act of submitting the return under self-
assessment implicitly assumes that the taxpayer has made all necessary adjustments to
taxable profts to take account of non-arms-length pricing.
Where HMRC considers there has been tax revenue lost as a result of negligence or
carelessness (for accounting periods ending on or after 1 April 2009), the burden of
proving that this was a result of the taxpayers negligence or carelessness rather than
for the reasons given by the taxpayer falls on HMRC.
7006. Tax audits
Under self-assessment, a company submits a corporation tax return and its statutory
accounts, with a due date for submission normally within 12 months after the end of
the accounting period to which the return relates. HMRC may commence an enquiry
into the return by issuing a formal notice by the local tax inspector with responsibility
for the company, within specifed time limits. Once an enquiry has been initiated, the
scope may extend to anything covered in the tax return, including transfer pricing.
HMRC is not obliged to state reasons for initiating an enquiry.
Transfer pricing enquiry governance and management
In 2008, HMRC revised its practices and procedures through the introduction of the
Transfer Pricing Group, largely to achieve the objectives set out in the Varney Report
on Links with Large Business. Specifcally, HMRC aims to provide greater certainty, an
effcient risk-based approach to dealing with tax matters, a speedy resolution of issues
and greater clarity through the effective consultation and dialogue.
In relation to transfer pricing, HMRC stated that it aims to conclude most enquiries
within 18 months, with only the most high-risk and complex cases taking 36 months.
The introduction of the TPG and its governance framework together with resources
available to the transfer pricing teams dealing with enquiries is intended to enable
HMRC to deliver this objective.
Transfer pricing team
Working enquiries on a team basis marks a signifcant change from HMRCs previous
approach to transfer pricing. The size and make-up of a transfer pricing team is
dependent on the scale and complexity of the enquiry. The team is usually led by the
HMRC customer relationship manager (CRM) of the business and consists of other
members of the case team working for the CRM as well as members from various
disciplines, including at least one transfer pricing specialist from the TPG.
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The TPG consists of dedicated transfer pricing specialists based in the Large Business
Services or in Large and Complex (part of Local Compliance) and other specialists,
such as economists, systems analysts and specialist investigators. The role of the
transfer pricing specialist is to support the team as appropriate, from providing
specialist advice to hands-on involvement.
Practices and procedures
Each transfer pricing case passes through a series of stage gates. The adoption of
stage gates in the enquiry process aims to provide a structured and consistent approach
in relation to the management and governance of enquiries. Each stage gate centres on
a key decision that needs to be made and approved before the enquiry proceeds to the
next gate.
The decision at each stage gate is subject to review and approval. The approval
process consists of a panel process, although in some instances to aid swift resolution
of enquiries a panel member can take a decision without the full panel. There are
two panels, one for the Large Business Service and one for Local Compliance, which
are made up of senior transfer pricing specialists and senior managers. The most
important decisions in larger cases are escalated to the Transfer Pricing Board that is
responsible for the settlement parameters for the majority of the largest HMRC transfer
pricingenquiries.
Stage Gate 1: Risk assessment
A risk assessment typically comprises an evaluation of the quantum risk, behavioural
risk and transaction risk.
Quantum risk relates to the value of tax at stake. In this regard, a transaction is
considered high risk if the value of the transaction is such that incorrect pricing
could lead to a signifcant understatement of taxable profts;
Behavioural risk considers the systems and processes the business has in place to
manage its transfer pricing issues; and
Transaction risk is concerned with the nature of the transaction and such issues as
its complexity and whether it involves points of principle.
In HMRCs view, a risk assessment carried out by HMRC should ideally include the
review of the following information:
Company information readily available to HMRC, including:
a. A review of transfer pricing documentation;
b. A detailed examination of six years consolidated group accounts and of
accounts of individual UK and appropriate non-UK entities;
c. Consideration of the group structure and identifcation of tax haven/shelter
countries;
d. A review of industry trends, details of the companys position within its market
sector, and recent developments within the group (new acquisitions, new
locations, etc.); and
e. A review of databases for multiple-year data and potential comparables.
Information on transactions with related enterprises in other jurisdictions,
including a review of company returns in other jurisdictions. Note that to obtain
information on other jurisdictions in a multinational group, HMRC would need to
ask the UK business specifcally for this or obtain the information via the exchange
of information procedures contained in double tax treaties or under EU rules; and
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Information from other parts of HMRC. This would include details of the PAYE
scheme (the mechanism for collecting employment tax) which can provide the
transfer pricing team with information not otherwise available, for example on
share options reported for highly paid employees and not booked in the local
accounts. The team may also obtain details of VAT registrations and the movement
of goods from which they could identify the price of goods moving into and out of
the UK.
As part of the risk assessment, the CRM will often invite the tax manager of the
UK business to discuss the main tax risks, including transfer pricing, with a view
to establishing the overall risk rating of the business. If this leads the CRM to think
there are transfer pricing risks that need to be explored in more depth, the CRM and
possibly a transfer pricing specialist from the TPG may ask to see representatives of the
business, including those outside the tax function, to discuss these risks in more detail.
A business may choose whether to cooperate with such a request, understanding the
potential negative impression that may be created if it decides not to cooperate with
the pre-enquiry process. In the event that a business is unwilling or unable to take part
in these discussions, the decision at this stage on whether to request the opening of a
formal enquiry will be based on such information available, such as statutory accounts
that accompany tax returns and information received from an overseas jurisdiction.
Stage Gate 2: Business case
The outcome of the risk assessment would normally be a decision as to whether there
are transfer pricing points that would justify further investigation. If there are such
cases, the next action would be to develop a business case for opening an enquiry.
The business case is the formal justifcation for opening an enquiry and normally
includes, but is not limited to, the following:
A description of the issues in point;
Risks involved in settling the case;
The resource required to conduct the enquiry; and
Estimate of the timescale for completing the enquiry.
The business case is an internal HMRC document and is not provided to the business.
Although there is no statutory obligation, HMRC usually communicates to a business
the reason for initiating an enquiry. The appropriate panel then reviews the business
case and makes a decision on opening an enquiry. If the case is regarded as reasonably
straightforward, the enquiry is typically settled within 18 months from being opened.
However, for cases that are more complex and/or high risk, the typical time to a
decision to settle or litigate is 36 months.
Stage Gate 3: Timetable and action plan
HMRC use action plans and timetables which act as roadmaps for the enquiry. As the
UK does not audit businesses on-site, as happens in other jurisdictions, information,
including contemporaneous transfer pricing documentation, is normally requested
by way of correspondence. The taxpayers response is also written, providing the
documentation, data and information requested together with analysis to support
its position. Subsequent meetings take place between HMRC and the taxpayer at
which the information provided to HMRC and areas of particular concern can be
discussedfurther.
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Stage Gate 4: Review
The enquiry and its timetable should be reviewed every six months. The objective of
this stage is to ensure that the enquiry is progressing in accordance with the action
plan and to explore whether the enquiry strategy should be revisited.
Stage Gate 5: Resolution decision
This stage occurs when suffcient information is available and suffcient analysis has
been carried out for HMRC to decide the acceptability of the pricing under enquiry and
what adjustments, if any, are necessary. A submission is made to the appropriate panel
to review the options for resolution. The options are:
Close the enquiry without adjustment;
Seek a negotiated settlement, in which case the panel advises the transfer pricing
team of the parameters within which they can settle the case by making an
adjustment to the taxable profts or allowable losses; and
Progress to litigation which HMRC usually considers only for cases that ft within
the litigation criteria of the Litigation and Settlement Strategy, typically those
where points of principle are involved or a large amount of tax is at risk.
At the end of an enquiry, HMRC issues a closure notice, which presents conclusions
as to the correct amount of tax payable. The taxpayer has 30 days to make necessary
amendments to its tax return. Beyond that, HMRC may amend the return within the
next 30 days.
Triggers for a transfer pricing enquiry
HMRC identifed the following risk areas that are most likely to trigger a full transfer
pricing enquiry:
The existence of tax haven entities HMRC identifes groups with entities located
in tax havens and seeks to establish whether their proftability is commensurate
with the level of functions, assets and risks relating to these entities. For example,
limited functions undertaken by entities located in tax havens that enjoy healthy
profts may give rise to a transfer pricing enquiry;
Lower returns in the UK than in the group generally HMRC identifes businesses
with proft margins that are lower in the UK than in the group generally and seeks
to establish why this is the case;
The UK business produces only a routine, low-margin proft HMRC identifes
companies that possess the resources to generate high-margin profts, yet produce
only a routine, low-margin proft. To understand the potential proftability of
a particular entity, HMRC is interested in whether there is, for example, heavy
investment in the entity, a highly skilled and remunerated technical or R&D
workforce or intangibles (e.g. trade names, know-how, patents);
Royalty or management fee payments from the UK business that do not appear to
make commercial sense and which substantially impact on the UK profts. Examples
of such payments include:
a. A brand name unknown in the UK;
b. Technology to which signifcant value has been added by processes carried out
in the UK;
c. Nebulous bundles of intangibles; and
d. Poor performance over a number of years. Persistent losses attract the attention
of HMRC, and HMRC looks for evidence that there is a clear prospect of a return
to profts in later years to justify the risk of continuing losses.
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Changes in the risk profle and hence the reward of the UK business. Examples of
this include:
a. Distributor becomes commissionaire (and net profts decrease);
b. Full manufacturer becomes contract manufacturer;
c. R&D activities that once generated royalties move to contract basis; and
d. Cost-sharing arrangements are introduced.
HMRC concedes that consideration should be given to both the potential tax at risk
and the level of diffculty in establishing the arms-length price, although there is no de
minimis limit in the UKs transfer pricing legislation.
The International Manual provides further detailed practical guidance and examples of
HMRCs approach and interpretation of transfer pricing principles.
7007. Information powers
Changes to HMRCs general information powers were introduced with effect from
1 April 2009. HMRC can require any person to provide them with information or
to produce documents by way of a written notice. They must allow the person a
reasonable period of time to produce the information or documents. The person
receiving the information notice may appeal against it, unless the notice is to produce
the statutory records that the person is obliged to keep or if the tribunal approved the
issue of the notice.
Penalties may arise for failing to comply with an information notice, or concealing,
destroying or otherwise disposing of documents, or providing inaccurate information,
or a document containing an inaccuracy, in response to an information notice.
If the taxpayer does not provide information in response to HMRCs requests, where
considered necessary, HMRC may enter a companys premises and inspect the
premises, assets and documents on those premises that relate to transfer pricing issues
under enquiry. HMRC cannot search premises, nor search for assets or documents.
Normally, HMRC must give the occupier of the premises at least seven days notice of
an inspection. An unannounced or short-notice inspection is possible, but this must be
agreed by an authorised HMRC offcer or approved by the tax tribunal.
HMRC also has powers enabling it to obtain information from third parties where it
considers such information would be helpful in progressing enquiries. However, such
powers are used rarely and in extreme circumstances, since these powers are viewed
by the HMRC itself as controversial and requiring sensitive handling. Failure to provide
information as requested is more likely to result in an estimated assessment being
raised, for which the company must then provide the evidence to refute it.
HMRC does not have the power to directly obtain information on non-UK-resident
parents of UK companies, nor on fellow subsidiaries (in non-UK-controlled groups)
that are not UK resident. Note, however, that the UK has an extensive double tax treaty
network, and, as a result, is able to request such information under the Exchange of
Information article. HMRC also increasingly uses the provisions of the EU Mutual
Assistance Directive that provides for member states to exchange information on
taxpayers and embark on simultaneous controls where the tax position of a taxpayer
and related entities are of interest to more than one member state (see Section 7018).
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Where there is an open enquiry or HMRC has issued a closure notice, amended the
taxpayers return or made a discovery assessment, the taxpayer may ask for the case
to be listed for hearing by the tax tribunal. Alternatively, from April 2009, the taxpayer
may require HMRC to review the point at issue, or HMRC may offer the taxpayer a
review (Tax Management Act 1970 section 49A). If a review takes place, HMRC may
uphold, vary or cancel its original view of the matter, and must notify the taxpayer of
its conclusion within the following 45 days, or other agreed period (TMA 1970 section
49E). If HMRCs review is unfavourable and the taxpayer does not wish to accept it,
the taxpayer must fle an appeal to the tax tribunal within 30 days, otherwise HMRCs
review conclusions are treated as having been agreed.
The tax tribunal has also made it clear that it will expect parties to disputes involving
complex facts such as transfer pricing to have sought an internal review or considered
other forms of dispute resolution, such as facilitative mediation using an independent
mediator, before such cases are brought before the tribunal.
The taxpayer or HMRC may appeal against a decision of the First Tier tax tribunal
on a point of law (but not a question of fact). This appeal is normally then heard by
the Upper Tier Tax Tribunal and from there the Court of Appeal and, possibly, the
UK Supreme Court, although few tax cases are heard by this court. If a question of
European law is involved, any of these courts can refer the case to the European Court
in Luxembourg.
Specifc penalty provisions for transfer pricing have not been formulated and the
general rules are to be applied. These general rules were considerably revised with
effect for return periods beginning on or after 1 April 2009. For earlier periods, the
previous legislation in Finance Act 1988 needs to be consulted.
For return periods ending on or after 1 April 2009, penalties may be levied for certain
acts or omissions, depending on the offence. The penalties of most relevance to
transfer pricing are for:
Failure to notify chargeability to tax;
Failure to provide information or documents under a formal notice to do so (See
Section 7007 above); and
Filing an incorrect tax return.
Interest is normally charged on tax underpaid and is calculated from the day on which
the tax was originally due.
There are two requirements for a penalty to be chargeable: (1) a loss of tax or an
increased claim to a loss or repayment; (2) the inaccuracy is careless, deliberate
or deliberate and concealed. There is no penalty if the inaccuracy occurs due to a
mistake or despite taking reasonable care. In determining the level of the penalty in
cases where losses are claimed, tax penalties apply in the same way as if there were
additional tax. For returns relating to earlier periods, a penalty may be due if an
incorrect return is fraudulently or negligently submitted.
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Interest or penalties paid are not tax-deductible. In some cases the professional fees
incurred in the course of the HMRC enquiry are also not tax-deductible.
One of the main concerns of business in relation to transfer pricing and penalties is
what is meant by carelessness (or negligence under the previous rules), given
that what is an arms-length price is a matter of judgment and there is not usually one
right answer. HMRCs view is that where a taxpayer can show that it has made an
honest and reasonable attempt to comply with the legislation, no penalty is imposed,
even if there is an adjustment. Indeed, the onus is on HMRC, as it is more likely to be
the case, to show that there has been a careless or deliberately careless inaccuracy by
the taxpayer before a penalty can be charged.
While there is no legal defnition of carelessness, taxpayers are obliged to do what
a reasonable person would do to ensure that their returns are made in accordance
with the arms-length principle. HMRC suggests that this would involve but would not
necessarily be limited to:
Using their commercial knowledge and judgment to make arrangements and set
prices that conform to the arms-length standard;
Being able to show (e.g. by means of good quality documentation) that they made
an honest and reasonable attempt to comply with the arms-length standard; and
Seeking professional help when they know they need it.
The emphasis is very clear that to avoid any suggestion of carelessness, the taxpayer
must have set and documented a reasonable transfer pricing policy and must in
practice implement and apply that policy correctly and consistently. HMRC has
also made it clear that documentation does not in itself relieve a taxpayer from the
possibility of a penalty if that documentation does not show that the business had good
grounds for believing its arrangements and prices to be in accordance with the arms-
length principle.
Range of penalties
The amount of penalty that may be charged refects the degree of culpability. Whereas
there is no penalty for a mistake, failure to take reasonable care may incur a penalty
of up to 30% of the potential lost tax revenue. If the inaccuracy is deliberate but not
concealed, a maximum penalty of 70% may be charged, rising to a 100% penalty if the
inaccuracy is deliberate and concealed. All penalties can be mitigated depending on
the quality of the disclosure.
Where an inaccuracy has resulted in an amount of tax being declared later than it
should have been, the potential lost revenue is 5% of the delayed tax per year or part of
a year.
These changes in the UKs penalty regime are expected to result in a signifcant increase
in the number of penalties generally applied to companies. It remains to be seen what
specifc impact they will have on transfer pricing enquiries, where the incidence of
penalties have previously been very low.
Notwithstanding the change in the burden of proof on transfer pricing with the
introduction of self-assessment, unlike many other transfer pricing regimes, the UK
has not issued specifc regulations governing the documents that a taxpayer is required
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to prepare to support its transfer pricing. Instead, the UK has preferred to rely on the
general rule for self-assessment that requires taxpayers to keep and preserve the
records needed to make and deliver the correct and complete return.
There has been some relaxation of HMRCs expectations on documentation in
conjunction with the removal of the UK-to-UK exemption in 2004. In particular, whilst
HMRC requires that there be evidence available to support arms-length pricing at
the time a tax return is submitted, the material recording of that evidence may be
prepared and provided to HMRC in response to a specifc request rather than as a
matter of course. Failure to respond to such a request within a reasonable time exposes
a company to the risk of penalties.
HMRC provides guidance in its International Manual on record-keeping requirements.
HMRC specifes the following four classes of records or evidence that need to
beconsidered:
Primary accounting records The records of transactions occurring in the course of
the activities of a business that the business enters in its accounting system. These
records are needed to produce accounts and the results (in terms of value) of the
relevant transactions. In the context of transfer pricing rules, these are the actual
results. They may or may not be arms-length results and are generally created at
the time the information entered the business accounting system;
The tax adjustment records The records that identify adjustments made by a
business on account of tax rules in order to move from profts in accounts to taxable
profts, including the value of those adjustments. These adjustments might include
the adjustment of actual results to arms-length results due to transfer pricing rules.
These records do not need to be created at the same time as primary accounting
records, but do need to be created before a tax return is submitted for the period
inquestion;
The records of transactions with associated businesses The records in which a
business identifes transactions to which transfer pricing rules apply; and
The evidence to demonstrate an arms-length result The evidence with which
a business demonstrates that a result is an arms-length result for the purpose
of transfer pricing rules. This evidence needs to be made available to HMRC in
response to a legitimate and reasonable request in relation to a tax return that has
been submitted. Although the business would need to base relevant fgures in its
tax return on appropriate evidence, it is possible that, when the return is prepared,
the material recording of that evidence may not exist in a form that could be made
available to HMRC.
HMRC also quotes the discussion of documentation requirements in Chapter V of the
OECD Transfer Pricing Guidelines that the demonstration of an arms-length result
should be in accordance with the same prudent business management principles
that would govern the process of evaluating a business decision of a similar level of
complexity and importance.
To be able to support the view that the pricing method chosen results in arms-length
terms, it is often necessary to include in that documentation a study of third-party
comparables, usually requiring a comparison with comparable third-party transactions
or with proftability earned by third parties. Without this, HMRC may regard any
documentation as incomplete. To be satisfed that these comparables are truly
comparable, or to evaluate the results obtained, it may well be necessary to carry
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out a detailed analysis of the risks and functions undertaken by a particular business
(functional analysis).
Acceptable transfer pricing methods
HMRC has stated that the comparable uncontrolled price (CUP) method is the simplest
and most accurate of the OECD methods and is the preferred method where there
are comparable uncontrolled transactions. However, where it is diffcult to identify
comparable uncontrolled transactions in practice, HMRC looks to use another OECD-
approved method, including TNMM and proft splits and looks for the most appropriate
method in the circumstances of the case.
The key resource for transfer pricing enquiries is the TPG (as discussed in Section 7006
above). Within the TPG, a centralised specialist transfer pricing unit, which is part of
HMRCs Business International directorate, has responsibility for the policy on transfer
pricing and technical aspects of the legislation. It has traditionally been involved
in the transfer pricing enquiries into large multinational groups, as well as housing
the mutual agreement procedure (MAP) and the advance pricing agreement (APA)
programme management.
7011. Use and availability of information on comparables
HMRC has widely adopted the principles in the OECD Guidelines, and, therefore
closely follows the OECD guidance on comparability. Information on comparables
plays a crucial element in defending transfer pricing policies in the UK.
HMRC is expected to fully support the proposed revisions to Chapters I to III of the
OECD Guidelines and will take the necessary legislative steps to retain the consistency
with TIOPA 2010, Part 4 and the new guidelines.
Availability of company information
All UK companies, public and private, are required to prepare statutory accounts and
fle these with the Registrar of Companies at Companies House. Certain companies,
such as small- or medium-sized companies, need to provide only abbreviated accounts
with a limited amount of detail. Copies of these accounts are publicly available, but
their usefulness may be limited by the amount of detail given.
HMRC has access to its own sources of comparable data and also uses commercially
available databases of company results. These contain a summary of each
companys fnancial results for several years, hence facilitating access to potentially
comparableinformation.
HMRC and company advisers are bound by confdentiality considerations in respect of
information obtained through work on other companies for the purposes of disclosure
to third parties. In reality, both parties accrue considerable expertise and knowledge
through the consideration of relevant issues, which can be used in future enquiries.
However, HMRC does not overtly use secret comparables to challenge taxpayer
prices, although it might use them in selecting cases for enquiry.
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No transactions or industries are excluded from the scope of the transfer pricing
legislation. If a particular industry or issue has come to the attention of the TPG,
HMRC is likely to use the information and experience gained in dealing with one
taxpayer in enquiries into other similar taxpayers. Within the TPG, there is increasing
specialisation in certain industry sectors, such as fnancial services, automotive,
consumer goods and pharmaceuticals. Oil and gas cases are also dealt with by
specialists within the Oil Offce of HMRCs Large Business Service (LBS). The LBS
has also established industry specialists within a number of offces to focus on
particularsectors.
In short, all transactions and industries are at risk of a transfer pricing enquiry in the
UK. There has been a tendency in the past for queries to be raised not in connection
with specifc industries but in respect of certain inter-company transactions. In
particular, focus was given to transfer pricing related to interest, royalties and
management fees, rather than the transfer pricing of goods and services.
However this is changing with more experience and the specialist approach introduced
by the TPG. The risk-based approach to enquiries explained at Section 7006 should
now govern the focus of most HMRC enquiries.
In connection with the operation of the mutual agreement procedure (MAP), the
following points should be noted:
The designated competent authority in the Business International directorate deals
with cases presented under the MAP in respect of transfer pricing (other than oil
cases, which are dealt with by the Oil Offce in the LBS);
HMRC may provide a unilateral solution to instances of economic double taxation,
or consult under the MAP to try to reach agreement with the other tax authority in
a way that eliminates the double taxation;
There is no guarantee that a corresponding adjustment will be made, since the two
tax authorities are not required to reach a resolution under the MAP;
If a UK company is considering seeking a corresponding adjustment as a result
of an adjustment by an overseas tax authority, a protective claim should be made
as soon as possible to avoid a situation where the time limit for a corresponding
adjustment has expired;
The provisions of TIOPA 2010, Sections 124 and 125 (formerly ICTA 88, Section
815AA) clarify the time limits applicable to the MAP. In the absence of a specifc
time limit in a treaty, a time limit of six years from the end of the accounting period
to which the adjustment relates applies for making claims in respect of cases
presented to the UK competent authority;
TIOPA 2010, Sections 124 and 125 explain how an agreement reached under the
MAP is put into effect in the UK. The UK legislation also enables consequential
claims to be made within 12 months of the notifcation of a solution or mutual
agreement. This allows, for instance, additional loss-relief claims to be made even
though the normal time limits for a loss claim may have expired; and
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There is no formal method of making a case under the MAP in the UK. The taxpayer
should simply apply in writing stating the details of its case, including the years
concerned, the nature of the case and details of the parties involved.
It is worth noting that some competent authority procedures may take several years
to complete, with no guarantee of a satisfactory outcome. However, regular meetings
between HMRC and certain other tax authorities where the competent authority cases
are likely to be most numerous, such as the Internal Revenue Service (US), the NTA
(Japan) and the SLF/DGI (France), help considerably to resolve MAP cases.
HMRC has traditionally taken a robust line in relation to engaging in MAP discussions
before a transfer pricing adjustment has been made in the UK. This is in contrast
to many other tax authorities that allow MAP proceedings to commence before an
adjustment is fnalised. However, there are indications that the UK practice in this area
may soon be relaxed when new guidance is issued.
HMRC does not make secondary adjustments, such as deemed distributions or deemed
capital contributions, when it makes a transfer pricing adjustment, as there is no basis
in UK law for such adjustments.
Where a treaty partner makes the primary adjustment, HMRC considers the merits
of claims to deduct interest relating to the deeming of a constructive loan by a
treaty partner following a transfer pricing adjustment, especially where it wishes to
encourage the voluntary restoration of funds to the UK. The claim would, however,
be subject to the arms-length principle and would be considered in light of relevant
provisions relating to payments of interest.
Where a treaty partner applies a secondary adjustment by deeming a distribution to
have been made, this would normally now be exempt from tax in the UK under the
dividend-exemption rules.
Arbitration
As a member state of the EU, the UK has signed up to the arbitration procedures of the
EU Arbitration Convention. The convention provides that where the tax authorities
concerned cannot resolve differences through a mutual agreement procedure within
two years, they will be subject to mandatory arbitration procedures. The arbitration
procedure consists of an advisory commission including independent experts who give
an opinion within a specifed timescale. Both tax authorities must act on this opinion or
agree on another course of action that resolves in full the double taxation.
The expected beneft of the convention is that it should ensure that the competent
authorities resolve cases fully within a specifed timescale of two years. While an
increasing number of claims are being made under the convention, very few cases have
gone forward to arbitration, although a large number of claims are now, in theory,
approaching the time limit.
The UK has also included arbitration provisions in its most recent double tax treaties,
such as those signed with France and the Netherlands. The method of arbitration to be
used is not specifed and will presumably be determined on a case-by-case basis.
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The UK has had formal APA procedures since 1999. Before 1999, APAs were possible
only by means of an agreement under a double tax treaty. A Statement of Practice
3/99 (the Statement) provides guidance on HMRCs interpretation of TIOPA 2010,
Part 5 (formerly Sections 85 to 87 of Finance Act 1999), which establish the APA
procedures. In the Statement, HMRC explains how it applies the legislation in practice.
The Statement is to be revised soon, although the update is not expected to result in
major changes in HMRCs approach, other than to relax the complexity threshold for
accepting APA applications and encourage more unilateral APAs.
Applicants and scope
A UK business may request APAs regarding transactions that are subject to TIOPA
2010, Part 4 (formerly ICTA 88, Schedule 28AA). APAs may also be requested by non-
residents trading in the UK through branches or agencies, and by UK residents trading
through branches or PEs outside the UK.
The UK APA process has its origins in the need to resolve complex transfer pricing
issues, or in other cases where there is very signifcant diffculty in deciding the method
to be used in applying the arms-length principle. As the Statement says, [HMRC] does
not regard entering into APAs on less complex matters as a sensible use of resources in
the absence of signifcant doubt as to the manner in which the arms-length principle
should be applied. It may therefore decline to accept applications that do not satisfy
those criteria. No fee is payable in the UK for an APA.
APAs may involve transfer pricing methods covering different types of related party
transactions or only for particular types of transactions, as well as other intragroup
arrangements, including transfers of tangible or intangible property and the provision
of services. APAs may relate to all the transfer pricing issues of the business or be
limited to one or more specifc issues.
Within the Statement, HMRC expressed its preference for including the tax authority of
the related party in the discussions and concluding a bilateral APA. HMRC stated that
it would be prepared to seek to adapt the bilateral framework to reach agreement on a
multilateral basis. However, any multilateral agreement would take the form of two or
more bilateral APAs.
Process
TIOPA 2010, Section 218(1) (formerly Section 85(1)(c) of Finance Act 1999) provides
that the APA process is initiated by a business making an application for clarifcation
by agreement regarding the application of the statutory provisions. The APA process
typically comprises four stages: an expression of interest, the formal submission of
application, evaluation of the proposed methodology and critical assumptions and,
fnally, drawing up the agreement.
At the expression of interest stage, or at the stage when a formal proposal is submitted,
HMRC may exercise its discretion by declining the request for an APA. In that event,
HMRC advises the business of the reasons for doing so, and allows the business the
opportunity to make further representations. A business may withdraw an APA request
at any time before fnal agreement is reached.
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HMRC has stated that it anticipates that all proposals will need to be supported by most
of the following information:
The identifcation of the parties and their historic fnancial data (generally for the
previous three years);
A description of the transfer pricing issues proposed to be covered by the APA and
analysis of the functions and risks of the parties, and projected fnancial data of the
parties in relation to the issues;
A description of the worldwide organisational structure, ownership and business
operations of the group to which the taxpayer belongs;
A description of the records that will be maintained to support the transfer pricing
method proposed for adoption in the APA;
A description of current tax enquiries or competent authority claims that are
relevant to the issues covered by the proposed APA;
The chargeable periods to be covered by the APA;
The identifcation of assumptions made in developing the proposed transfer pricing
method that are critical to the reliability of its application;
A request for a bilateral APA; and
If applicable, representations from the business that HMRC should exercise
its discretion in exchanging information, where the business considers such
information to be trade secrets.
Information supplied by a business in relation to an APA contributes to the pool
of information held by HMRC about that business. HMRC explicitly states that the
information may be used for purposes other than evaluating the APA request.
Nature and term
An executed agreement between the business and HMRC determines the treatment of
the transfer pricing issues for a specifed period of time. The terms of a bilateral APA
also refect the agreement reached between the two tax authorities. If HMRC does
not reach an agreement with the business, HMRC issues a formal statement stating
thereasons.
APAs usually operate prospectively, relating to the accounting periods beginning after
the application is made, although HMRC does allow roll-back of APAs in certain
circumstances, which can sometimes be very helpful in resolving existing transfer
pricing disputes. HMRC expects most APAs to be for a maximum term of fve years.
HMRC considers that APA information is subject to the same rules of confdentiality as
any other information about taxpayers and that the unauthorised disclosure, even of
the existence of an APA, is a breach of that confdentiality.
APA monitoring and renewal
The APA identifes the nature of the reports that the business is required to provide
under the APA legislation. The agreement also provides for the timing of the
submission of these reports, which is typically required annually, coinciding with the
fling date for the tax return.
Reports address whether the agreed-upon method was applied during the year,
the fnancial results produced by the method, and whether there was a mismatch
between prices actually charged and those obtained by applying the arms-length
standard under the agreed methodology. The business also must provide details of
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compensating adjustments made, and an assessment of the continued applicability or
otherwise of the critical assumptions used in the APA.
HMRC has the power to nullify an APA when the business has fraudulently or
negligently provided false or misleading information regarding the APA application.
When considering using this power, HMRC takes into account the extent to which the
terms of the APA would have been different in the absence of the misrepresentation.
An APA may provide for modifcation of its terms in specifc circumstances. For
example, an agreement may provide that when there has been a change that makes
the agreed methodology diffcult to apply but that does not invalidate a critical
assumption, the agreement may be modifed with the consent of the parties.
A business may request the renewal of an APA. The request should preferably be made
no later than six months before the expiration of the APAs current term. However,
HMRC usually accepts requests made before the end of the frst chargeable period
affected by the renewal. If the transfer pricing issues have changed, or a different
method is being proposed, the business must make a new APA application.
Penalties and appeals
A tax-geared penalty is imposed when a business has acted carelessly in making an
incorrect return and tax has been lost as a result. When a return is made in accordance
with an APA, and false or misleading information was submitted carelessly in the
course of obtaining the APA, the agreement is treated as if it had never been made. The
business has the right to appeal against the amount of additions to profts arising as a
result of the revocation or cancellation of an APA.
Advance thin capitalisation agreements
In 2007, HMRC introduced the advance thin capitalisation agreement (ATCA) to
provide certainty to fnancing transactions. These are unilateral APAs and are based
on the same statutory provisions as the normal APA. The process is designed to offer
assistance in resolving transfer pricing issues in relation to fnancing transactions that,
for any particular period, have a signifcant commercial impact on an enterprises proft
or losses.
ATCAs may cover the treatment of a single applicants fnancial instrument or the
treatment of the overall debt position of a group, depending on circumstances. HMRC
issued guidance in relation to which situations are suitable for ATCAs in a Statement of
Practice 04/07. This guidance states that situations suitable for ATCAs include, but are
not limited, to the following:
Intragroup funding outside the scope of treaty applications (e.g. involving a quoted
Eurobond or discounted bond);
Financing arrangements brought into TIOPA Part 4, (formerly ICTA 88 Schedule
28AA by the acting together rules (see Section 7002)); and
Financing arrangements previously dealt with under the treaty route (i.e. as part
of a claim made by the recipient of the interest to beneft from reduced rates of
withholding tax under the provisions of a double tax treaty).
While the ATCA normally applies prospectively in relation to accounting periods
beginning after the application is made, it is possible that an ATCA may be applied
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retrospectively or rolled back as an appropriate means for amending a self-assessment
return or resolving outstanding transfer pricing issues in earlier years.
No further legislative changes are expected. We do, however, anticipate some revisions
to HMRCs Statement of Practice on APAs and its guidance on MAP. These are unlikely
to herald substantive changes in approach, other than providing greater fexibility and
access to these arrangements.
One development is the prospect of HMRC seeking to make more use of collaborative
dispute resolution tools to resolve long-running and diffcult transfer pricing enquiries
as an alternative to litigation. Facilitative mediation is being explored, but it is likely to
be used only in a small number of cases.
There are also likely to be moves by HMRC to establish a number of joint audits with
other tax authorities as part of greater collaboration and cooperation between tax
authorities, which has been endorsed by the OECDs Forum on Tax Administration (see
Section 7018 below).
Another possible development may result from the Thin Cap GLO (see Section 7019)
if the UK Court of Appeal (and possibly other courts) were to take the view that a
commerciality test has to be applied alongside the arms-length test to all transfer
pricing and thin capitalisation enquiries made under the post-2004 rules.
In April 2005, the UK government integrated the Inland Revenue and HM Customs
and Excise into a single department (Her Majestys Revenue and Customs, HMRC). The
Inland Revenues Large Business Offce (LBO) and Oil Taxation Offce and Customs
Large Business Group were also integrated to form a single HMRC Large Business
Service (LBS). The Revenue and Customs tax functions within HMRC are able to
exchange information freely and work together to compare information on particular
groups and industries.
7017. OECD issues
The UK is a member of the OECD and has approved the OECD Guidelines. The UK
legislation in TIOPA Part 4 (and formerly ICTA 88, Schedule 28AA) is required to
be construed in a manner that best ensures consistency with the Guidelines (see
Section7002).
HMRC is able to participate in simultaneous tax examinations with another tax
authority using the exchange of information provisions in their respective double tax
treaty or, in the case of an EU member state, under the provisions of the Council of
Europe/EU Convention on Mutual Administrative Assistance in Tax Matters. Such
bilateral or multilateral examinations were comparatively rare, although there is now
increasing participation by HMRC in simultaneous controls under the Council of
Europe/EU Convention, which include transfer pricing enquiries.
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HMRC is also proactively involved with the OECDs Forum on Tax Administration
in developing proposals for possible joint audits on transfer pricing cases, whereby
HMRC offcials would be part of a team including offcials from one or more other tax
authorities. Together the team would make a joint assessment of transfer pricing risks
across an MNE, or might jointly audit those risks that affected both tax authorities or
divide up the risks between them. This would have the advantage of reducing the cost
to a multinational group of dealing with a number of different audits covering the
same transactions.
Statutory rules
TIOPA 2010, Part 4 (and formerly ICTA 88, Schedule 28AA) includes provisions
that incorporate fnancial transactions. (Until 1 April 2004, thin capitalisation was
generally dealt with separately from transfer pricing legislation). Furthermore,
general legislation enables HMRC to challenge the deductibility of interest paid by
a UK company on a loan from a related party for which the interest rate is excessive
or the amount of the loan itself is excessive. This domestic legislation compensates
for the position existing under many older double tax treaties where there is an
argument that the tax treaty does not provide the authority for the amount of the
loan to be questioned. The measure for determining whether the amount of the
loan or the interest rate is excessive is the arms-length principle that is, whether a
third party would have loaned the company that amount of money or at that interest
rate. The legislation seeks to align the UK position with Article 9 of the OECD Model
TaxConvention.
The consequence of a successful challenge by HMRC is that any interest found to be
excessive, by reference to the interest on the part of the loan found to be excessive or by
reference to the rate of interest, is not allowed as a tax deduction.
There is no formal UK safe harbour debt-to-equity ratio or acceptable interest cover.
However, historically, it has often been suggested that a debt-to-equity ratio of 1:1
and interest cover of 3:1 could be considered to be safe. HMRC had explained its
tendency to accept these ratios on the basis that they refect historical averages and
that its resources are better used to examine cases with more extreme ratios.
However, more recently, HMRC has stressed that each case is examined individually
and the acceptability of a ratio could well be infuenced by the averages for the
particular industry sector, and those may be different from those noted above. Other
ratios are increasingly considered, including the ratio of debt to earnings and other
forms of interest cover. Other factors that HMRC would consider are factors that a
third-party lender would consider, such as the consolidated debt-to-equity ratio of
the borrowers group and the ability of the group to pay interest and repay capital. An
acceptable ratio is, therefore, often a matter of negotiation.
HMRC provides clearance in many cases for loan arrangements, under the ATCA
procedure, as described above in Section 7014. This involves the provision of detailed
documentation of the loan arrangements and valid projections of the taxpayers
interest cover or debt-to-equity ratio. Guidance is given in the International Manual.
This guidance, which was signifcantly updated in a new version released in March
2010, shows how the basic pricing rule under self-assessment is more broadly
formulated than the previous legislation.
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The guidance goes on to cover:
Factors HMRC takes into account in determining whether interest is excessive;
Cases where interest is not recharacterised;
Circumstances where transactions should be considered together in order to
evaluate compliance with the arms-length principle;
Outward investment and where such loans are interest free or at a low rate of
interest, and what factors may be taken into account in recharacterising such loans
as equity;
Interaction of the transfer pricing rules with the UKs legislation on foreign
exchange and fnancial instruments;
Treatment of funding transactions between UK charities and their affliates;
The use of third-party loan agreements as potentially comparable evidence of
arms-length borrowing; and
The acceptability of independent credit ratings and the use of company-produced
credit ratings in pricing debt.
Acting together
Further provisions were introduced by Finance (No. 2) Act 2005, which are
incorporated in TIOPA 2010, Part 4 (and formerly ICTA 88, Schedule 28AA), related
to the manner through which fnancing is effected. These provisions are particularly
aimed at, but not limited to, private equity fnancing.
The changes restrict interest deductions to an arms-length basis, where parties are
acting together in relation to the fnancing of a company. The relevant provisions
apply transfer pricing rules where persons who collectively control a company or a
partnership have acted together in relation to the fnancing arrangements of that
company or partnership. Given the widely drawn provisions, a third-party bank could
be drawn into the rules because it has agreed to provide fnance for a deal, although
such loans are accepted by HMRC as arms length. There are clearance procedures for
companies to obtain certainty with respect to their particular circumstances.
HMRC issued guidance on what constitutes acting together under TIOPA 2010, Part 4
(and formerly ICTA 88, Schedule 28AA), which indicates that acting together can be
construed very widely.
Guarantee fees
TIOPA 2010, Part 4 (and formerly ICTA 88, Schedule 28AA) applies to a provision
effected by one or more transactions. So, when a UK company borrows from a bank
and the loan is guaranteed by its parent, there may be a provision between the parent
and subsidiary. Between independent parties this would usually result in a fee from the
borrower to the guarantor.
The rules provide that the borrowing capacity of a UK company must be considered
without regard to the guarantee. In such a case (e.g. where the subsidiary is able to
borrow more from a third-party bank because of a parental guarantee) there would be
no deduction for the guarantee fee related to the excess borrowing, and there would
be a potential disallowance of interest in excess of what would have been paid in the
absence of the special relationship. This would apply even though the interest is paid to
a third-party bank.
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Where interest is disallowed for a UK borrower, an affliated UK guarantor may be able
to claim the deduction instead.
The value of a guarantee under the arms-length principle depends on its terms. The
arms-length fee should be determined based on what would be charged between
independent parties under the same or similar circumstances. Where a UK parent
provides a guarantee to overseas subsidiaries, in some cases HMRC accepts that a
guarantee may be equity in nature, especially where the borrower is thinly capitalised.
Thin Cap GLO
A recent and ongoing case (which is still under appeal) has strongly called into
question the compatibility of the pre-2004 UK thin capitalisation legislation with
the TFEU. The case, known as the Thin Cap GLO, was heard by the European Court
of Justice (ECJ), which decided that the UK thin capitalisation legislation pre-2004
was a restriction on the freedom of establishment provisions of the TFEU. However,
the ECJ referred the case back to the UK courts to decide the extent to which
the thin capitalisation rules applied and therefore whether these represented a
justifablebreach.
In late 2009, the UK court found that the pre-2004 legislation did represent a
restriction on the freedom of establishment because the legislation did not include a
commerciality test (a separate test to the arms-length test). It ruled that the pre-
2004 legislation should not have applied to thin capitalisation cases where there was a
commercial rationale for the transaction and that taxpayers were entitled to restitution
for taxes paid as a result of the pre-2004 thin capitalisation legislation. (See also Section
7015 on the possible implications of the Thin Cap GLO for post-2004 transfer pricing and
thin cap legislation.)
The UK has enacted no specifc legislation on management services, and, consequently,
where a business in the UK is paying for management services from a related party, the
general rules on the deductibility of expenses applies. In general, the payment is tax-
deductible where the business receives a beneft for the services provided and where
the payment is connected with the business and is at an arms-length price.
Where a UK business is providing services to related parties, it should be remunerated
for those services on an arms-length basis. This usually means that a proft element
should be added to the cost of providing the service and invoiced to those businesses
receiving the beneft of the services (i.e. a cost plus basis) to represent a market value
for the provision of the services. The arms-length value of services can also sometimes
be less than the cost of providing them. In such a situation the service should still be
recharged at the market price (i.e. less than cost), and this principle is recognised in
the OECD Guidelines.
Where services are recharged on a cost plus basis, the amount of the markup is often
the subject of negotiation with HMRC. There are no safe harbours in the UK, and no
guidelines have been published as to standard acceptable rates of marking up costs
in specifed situations. HMRC has typically sought cost plus between 5% and 10% for
low-value UK-provided services. It may well however look for a higher markup if it
considers the services provided to be particularly valuable.
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7101. Introduction
This chapter is devoted to a broad outline of US transfer pricing rules and the
accompanying penalty regulations. Also covered is the US competent authority
procedures, including the Advance Pricing Agreement (APA) programme, and the
interaction of the US rules with the OECD Guidelines.
The importance of the US rules on transfer pricing
The US regulatory environment is of great signifcance for a number of reasons:
The US is a signifcant market for the majority of multinational enterprises, and
therefore compliance with US rules, which remain arguably the toughest and most
comprehensive in the world, is a signifcant issue in international business;
The process of reform of the US transfer pricing regulations in the 1990s, and more
recently with changes in the cost sharing, services, and intangible property transfer
areas, broke new ground these developments tended to infuence other countries
in subsequently increasing the stringency of their own rules. An understanding of
developments in the US and the controversies surrounding them are thus a good
indicator of likely areas of contention in other countries;
The actions of the US have caused controversy with the countrys trading partners,
not all of whom have entirely agreed with the US interpretation of the arms-length
standard. The regulations, together with a greater level of enforcement activity,
have resulted in an increasing number of transfer pricing issues being considered
through the competent authority process under the mutual agreement article of tax
treaties concluded between the US and most of its major trading partners; and
The competent authority process also forms the basis for the APA programme,
which has become an increasingly important mechanism for multinational
enterprises to obtain prospective reassurance that their transfer pricing policies
and procedures meet the requirements of the arms-length standard as well as an
additional mechanism for resolving tax audits involving transfer pricing issues.
Non-US tax authorities and practitioners alike have tended to be critical of the level of
detail included in the US regulations and procedures. However, in considering the US
regime, it is important to bear in mind that unlike many of its major trading partners,
the US corporate tax system is a self-assessment system where the burden of proof
is generally placed on the taxpayer, and where there is an adversarial relationship
between the government and the taxpayer. This additional compliance burden is not
unique to the feld of transfer pricing.
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The rationale underlying the US regulations
In 1986, the US Congress ordered a comprehensive study of inter-company pricing
and directed the Internal Revenue Service (IRS) to consider whether the regulations
should be modifed. This focus on transfer pricing refected a widespread belief that
multinational enterprises operating in the US were often setting their transfer prices
in an arbitrary manner with the result that taxable income in the US may be misstated,
and that the lack of documentation on how the pricing was set made it extremely
diffcult for the IRS to conduct retrospective audits to determine whether the arms-
length standard had been applied in practice.
The history of the US reform process
Since 1934, the arms-length standard has been used to determine whether cross-
border, inter-company transfer pricing produces a clear refection of income for US
federal income tax purposes. The arms-length standard has become the internationally
accepted norm for evaluating inter-company pricing.
In 1968, the IRS issued regulations that provided procedural rules for applying the
arms-length standard and specifc pricing methods for testing the arms-length
character of transfer pricing results. These transaction-based methods, the comparable
uncontrolled price (CUP) method, the resale price method, and the cost plus method,
have gained broad international acceptance.
Congress amended 482 in 1986, by adding the commensurate with income standard
for the transfer of intangible property. At the same time, Congress directed the IRS
to conduct a comprehensive study of inter-company transfer pricing, the applicable
regulations under 482 of the Code, and the need for new enforcement tools and
strategies. The IRS responded to that directive by issuing the White Paper in 1988.
Between 1988 and 1992, Congress added or amended 482, 6038A, 6038C, and
6503(k) to impose on taxpayers new information reporting and record-keeping
requirements and to provide IRS Revenue agents with greater access to that
information. In addition, Congress added 6662(e) and (h) to impose penalties
for signifcant transfer pricing adjustments. In 1992, the IRS issued new proposed
regulations under 482. Those regulations implemented the commensurate with
income standard and introduced signifcant new procedural rules and pricing methods.
These proposed regulations also included signifcant new rules for cost sharing
arrangements. (Discussed in 915 to 922.)
In 1993, the IRS issued temporary regulations that were effective for taxable
years beginning after 21 April 1993, and before 6 October 1994. These regulations
emphasised the use of comparable transactions between unrelated parties, and a
fexible application of pricing methods to refect specifc facts and circumstances. The
IRS also issued proposed regulations under 6662(e) and (h), which conditioned the
avoidance of penalties upon the maintenance of contemporaneous documentation of
how the pricing methods specifed in the 482 regulations had been applied.
In 1994, the IRS issued temporary and proposed regulations under 6662(e) and (h),
applicable to all tax years beginning after 31 December 1993. The IRS also issued fnal
regulations under 482, effective for tax years beginning after 6 October 1994 and
amended the temporary and proposed 6662(e) and (h) regulations, retroactive to 1
January 1994.
International Transfer Pricing 2011 United States 779
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Also in 1994, fnal 482 regulations were issued, which are generally effective for tax
years beginning after 6 October 1994. However, taxpayers may elect to apply the fnal
regulations to any open year and to all subsequent years.
In 1995, fnal regulations on cost sharing were issued (which were subject to
minor modifcation in 1996). These regulations are effective for taxable years
beginning on or after 1 January 1996. Existing cost sharing arrangements were
not grandfathered and had to be amended to conform to the fnal regulations. If
an existing cost sharing arrangement met all of the requirements of the 1968 cost
sharing regulations, participants had until 31 December 1996 to make the required
amendments. Signifcant changes to the rules governing cost sharing transactions
were recommended on 22 August 2005, when the IRS issued proposed cost sharing
regulations. These proposed regulations focus on three new specifed methods of
valuation for determining the arms-length buy-in amount and are described later
in this chapter. At the writing of this chapter, the proposed regulations have not
beenfnalised.
In 1996, fnal transfer pricing penalty regulations under 6662 were issued on 9
February, with effect from that date subject to a taxpayers election to apply them to all
open tax years beginning after 31 December 1993. Revised procedures for APAs were
also issued in 1996. In 1998 the IRS simplifed and streamlined procedures for APAs for
small-business taxpayers.
In 2003, regulations that were proposed in 2002 dealing with the treatment of costs
associated with stock options in the context of qualifying cost sharing arrangements
(see below) were fnalised, and regulations governing the provision of intragroup
services were proposed. The proposed services regulations were replaced by temporary
and proposed regulations (temporary regulations) issued on 31 July 2006. Finally, the
new services regulations were issued on July 31 2009.
Global dealing regulations which primarily impact the fnancial services sector
are expected to clarify how to attribute profts consistent with the transfer pricing
rules when a permanent establishment exists. At the writing of this chapter, these
regulations have not been fnalised.
The Obama Administrations recent budget proposals recommend one direct
change to the section 482 transfer pricing rules. This proposal would seek to
broaden the defnition of intangible property to include goodwill, going concern
value, and assembled workforce for purposes of both the transfer pricing rules
and the rules related to outbound non-recognition transfers of such property. The
proposal would also modify principles for valuing transferred intangible property by
imposing a highest and best use standard and permitting aggregate valuation of
transferredintangibles.
On 1 February 2010 the Treasury released the General Explanations of the
Administrations Fiscal Year 2011 Revenue Proposals, also referred to as the Green
Book. The proposals include two items that could have a signifcant impact on
outbound transfers of intangible property:
1. Tax Currently Excess Returns Associated with Transfers of Intangibles
Offshore;and
2. Limit Shifting of Income Through Intangible Property Transfers.
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The frst proposal, not contained in last years budget, is intended to cap the amount
of US tax deferral on profts earned by controlled foreign corporations from their
use of transferred US intangible assets. The second proposal is a modifed version of
a provision in last years budget. These proposed changes clearly demonstrate the
Administrations belief that income associated with intangible assets is being shifted
inappropriately to low-tax jurisdictions.
The frst proposal would expand the scope of subpart F to include excessive profts
earned on intangible assets transferred from the US to low-tax foreign jurisdictions,
even in cases in which the transfer satisfes the arms length and commensurate-with-
income standards of the US Internal Revenue Code and Treasury Regulations. The
second proposal is similar to one in the 2010 budget, except with a slight modifcation.
Consistency between the US regulations and the OECD Guidelines
At the same time as the reform process was progressing in the US, the OECD was
also revising its guidelines on transfer pricing (see Chapter 3). The OECD Guidelines
are a signifcant point of reference for many of the major trading partners of the US
in dealing with transfer pricing issues. The extent to which the OECD Guidelines are
consistent with the US approach is thus a critical issue for all multinational enterprises
that wish to be in full compliance with local laws in all the jurisdictions in which
they operate but at the same time not be exposed to the risk of double taxation and
penalties. The substantive provisions of the US regulations are compared to the OECD
Guidelines in this chapter (see Section 7114).
482 of the Internal Revenue Code of 1986 (as amended) provides that the Secretary
of the Treasury has the power to make allocations necessary to prevent evasion of
taxes or clearly to refect the income oforganizations, trades or businesses. It also
provides that in respect of intangible property transactions, the income with respect
to such transfer or license shall be commensurate with the income attributable to the
intangible. Detailed Treasury Regulations promulgated under 482 are the main
source of interpretation of both the arms-length standard and the commensurate with
income standard.
7103. The US transfer pricing regulations
The best method rule
A taxpayer must select one of the pricing methods specifed in the regulations to test
the arms-length character of its transfer pricing. Under the Best Method Rule, the
pricing method selected, under the facts and circumstances of the transactions under
review should provide the most reliable measure of an arms-length result, relative to
the reliability of the other potentially applicable methods. The relative reliability of the
various transaction-based pricing methods depends primarily upon:
1. the use of comparable uncontrolled transactions and the degree of comparability
between those transactions and the taxpayers transactions under review; and
2. the completeness and accuracy of the underlying data, and the reliability of the
assumptions made and the adjustments required to improve comparability.
Adjustments must be made to the uncontrolled comparables if such adjustments will
improve the reliability of the results obtained under the selected pricing method.
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Determination of the degree of comparability will be based on a functional analysis
made to identify the economically signifcant functions performed, assets used, and
risks assumed by the controlled and uncontrolled parties involved in the transactions
under review.
Industry average returns cannot be used to establish an arms-length result, except in
rare instances where it can be demonstrated that the taxpayer establishes its inter-
company prices based on such market or industry indices and that other requirements
are complied with. Unspecifed methods may be used if it can be shown that they
produce the most reliable measure of an arms-length result. A strong preference is
given to methods that rely on external data and comparable uncontrolled transactions.
When using a specifed method, a taxpayer is not required to demonstrate the
inapplicability of other methods before selecting its preferred method. However, in
order to avoid potential penalties, a taxpayer must demonstrate with contemporaneous
documentation that it has made a reasonable effort to evaluate the potential
applicability of other methods before selecting its best method (see Section 7109).
The arms-length range
No adjustment will be made to a taxpayers transfer pricing results if those results
are within an arms-length range derived from two or more comparable uncontrolled
transactions. This concept of a range of acceptable outcomes rather than a single arms-
length answer is the key to understanding the fexible application of the arms-length
standard that underlies the US regulations.
Under the regulations, the arms-length range will be based on all of the comparables
only if each comparable meets a fairly high standard of comparability. If inexact
comparables are used, the range ordinarily will be based only on those comparables
that are between the 25th and 75th percentile of results. However, other statistical
methods may be used to improve the reliability of the range analysis.
If a taxpayers transfer pricing results are outside the arms-length range, the IRS may
adjust those results to any point within the range. Such an adjustment will ordinarily
be to the median of all the results.
The regulations permit comparisons of controlled and uncontrolled transactions, based
upon average results over an appropriate multiple-year period. If taxpayers results are
not within the arms-length range calculated using multiple-year data, the adjustment
for a year may be based on the arms-length range calculated using data from only
thatyear.
Collateral adjustments and set-offs
A taxpayer is required to report an arms-length result on its tax return, even if those
results refect transfer prices that are different from the prices originally set out on
invoices and in the taxpayers books and records, and may be subjected to substantial
penalties if they fail to do so. This provision has no direct equivalent in the tax codes of
most of the US major trading partners, and may result in double taxation of income.
In the event of an income adjustment under 482 involving transactions between US
entities, the IRS is required to take into account any appropriate collateral adjustment.
For example, should the income of one member of the controlled group be increased
under 482, other members must recognise a corresponding decrease in income. This
should be distinguished from the treatment of both (1) adjustments involving other
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US domestic taxpayers outside the consolidated group where there is no requirement
for the IRS to allow a corresponding deduction, and (2) foreign initiated adjustments
where it will be necessary to invoke a Competent Authority process as the only means
of obtaining a corresponding adjustment in the US (see below).
Taxpayers may also claim set-offs to the extent that it can be established that other
transactions were not conducted at arms length. The regulations limit such set-offs to
transactions between the same two taxpayers within the same taxable year.
Impact of foreign legal restrictions
The regulations include provisions that attempt to limit the effect of foreign legal
restrictions on the determination of an arms-length price. In general, such restrictions
will be taken into account only if those restrictions are publicly promulgated,
affect uncontrolled taxpayers under comparable circumstances, the taxpayer must
demonstrate that it has exhausted all remedies prescribed by foreign law, the
restrictions expressly prevent the payment or receipt of the arms-length amount, and
the taxpayer (or the related party) did not enter into arrangements with other parties
that had the effect of circumventing the restriction. The regulations also attempt
to force the use of the deferred income method of accounting where foreign legal
restrictions do limit the ability to charge an arms-length price.
Transfers of tangible property
The regulations governing the transfer of tangible property have not changed
substantially since 1992. They continue to focus on comparability of products under
the CUP method, and the comparability of functions under the resale price and
cost plus methods. Comparability adjustments under the regulations must consider
potential differences in quality of the product, contractual terms, level of the
market, geographic market, date of the transaction and other issues. In addition, the
regulations require consideration of potential differences in business experience and
management effciency.
Transfers of intangible property
The implementation of the commensurate with income standard has been a
considerable source of controversy with US trading partners. Some have interpreted
the intent of the regulations to be the consideration for the transfer of an intangible
asset, which is subject to adjustment long after the transfer takes place. This has been
viewed as inconsistent with the way unrelated parties would contract. The primary
objective of this provision is to ensure that the IRS has the right to audit the reliability
of the assumptions used in setting the transfer price for an intangible asset as part of
an examination as to whether the transfer had been made at arms length. As such,
the regulations provide a detailed description of how the consideration paid for an
intangible asset will be evaluated in consistency with the statutory requirement that
the consideration be commensurate with the income derived from exploitation of
theintangible.
In general terms, the need for periodic adjustment to transfer prices for intangible
property depends upon whether the transfer pricing method used to set the
transfer price relies on projected results (projected proft or cost savings). No
periodic adjustments will be required if the actual cumulative benefts realised from
exploitation of the intangible are within a range of plus or minus 20% of the forecast.
If the actual benefts realised fall outside this range, the assumption is that the transfer
price will be re-evaluated, unless any of the further extraordinary event exceptions
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detailed in the regulations are satisfed. The intent behind these regulations is to
replicate what would occur in a true unrelated party relationship if, for example,
one party to a licence arrangement found that unanticipated business events made
the level of royalty payments economically not viable. It also prevents a taxpayer
from manipulating a forecast of benefts that would result in a signifcantly different
purchase price for the intangible.
If no adjustment is warranted for each of the fve consecutive years following the
transfer, the transfer will be considered to be at arms length, and consequently no
periodic adjustments will be required in any subsequent year. If an adjustment is
warranted, there have been recent debates as to whether a taxpayer can affrmatively
invoke the commensurate with income standard. The IRS posits that only the
commissioner has the right to invoke the commensurate with income standard and not
the taxpayer in the 2003 proposed cost sharing regulations.
All prior regulations (including those issued in 1968, 1992 and 1993) provided that,
for transfer pricing purposes, intangible property generally would be treated as being
owned by the taxpayer that bore the greatest share of the costs of development of the
intangible. In contrast, the 1994 fnal regulations provide that if an intangible is legally
protected (e.g. patents, trademarks, and copyrights), the legal owner of the right
to exploit an intangible ordinarily will be considered the owner for transfer pricing
purposes. In the case of intangible property that is not legally protected (e.g. know-
how) the owner continues to be the party that bears the greatest share of the costs
ofdevelopment.
The regulations provide that legal ownership of an intangible is determined either
by operation of law or by contractual agreements under which the legal owner has
transferred all or part of its rights in the intangible to another party. In determining
legal ownership of the intangible, the fnal regulations provide that the IRS may impute
an agreement to convey ownership of the intangible if the parties conduct indicates
that, in substance, the parties have already entered into an agreement to convey legal
ownership of the intangible.
The temporary regulations issued on 1 July 2006 maintained the 1994 fnal
regulations treatment for legally protected intangibles, i.e. the legal owner of the
rights to exploit an intangible ordinarily will be considered the owner for transfer
pricing purposes. However, the temporary regulations redefned the defnition of
owner (for transfer pricing purposes) of intangible property rights that are not legally
protected. Unlike the existing regulations which assigns ownership of such intangibles
to the party that bears the largest portion of the costs of development, the temporary
regulations redefne the owner of such intangibles as the party that has the practical
control over the intangibles. Therefore, eliminating the old developer-assister
rulealtogether.
Given this position, the possibility still exists that there may be a difference of opinion
between the US and other taxing jurisdictions as to who is the primary owner of
some categories of intangible assets for transfer pricing purposes. For example,
taxpayers may fnd that because proprietary rights strategies can vary from country
to country, the treatment of intangibles may not be consistent across countries, even
though the economic circumstances are the same. Taxpayers may also fnd that
trademarks are deemed owned by one party, while the underlying product design
and specifcations are deemed owned by a different party. This is something that all
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multinational corporations should take into account in planning their pricing policies
and procedures.
The IRS has provided rules for determining how the commensurate with income
standard should be applied to lump-sum payments. Such payments will be arms length
and commensurate with income if they are equal to the present value of a stream of
royalty payments where those royalty payments can be shown to be both arms length
and commensurate with income.
In February 2007, the IRS issued an Industry Directive that is expected to indicate
the direction that future IRS audits will take with regard to migrations of intangible
property. The Industry Directive primarily targets pharmaceutical and other life
sciences companies that transferred the operations of former section 936 possessions
corporations to controlled foreign corporations, or CFCs. More broadly, the Industry
Directive underscores the attention that the IRS has been paying to issues surrounding
intangible migration transactions. On 27 September 2007, the IRS issued Coordinated
Issue Paper (LMSB-04-0907-62) addressing buy-in payments associated with cost
sharing arrangements. The Paper covers all industries, suggesting that the IRS is
preparing to more rigorously analyse and examine the key operations and risks related
to the migration of intangible assets in the future.
Provision of intragroup services, use of intangible property and the
GlaxoSmithKline case
In July 2006, the Treasury Department and IRS issued temporary and proposed
regulations governing the provision of intragroup services (these regulations were
superseded by the new services regulations issued on 31 July 2009). The temporary
and proposed regulations followed the pattern established for transfers of tangible
and intangible property by specifying methods that reference prices and margins
earned through transactions with unrelated parties, or by reference to profts earned
by parties performing comparable services for unrelated parties. While the 1968
regulations allowed for an intragroup charge equal to cost for non-integral services, the
temporary regulations set forth a method that allows a taxpayer to charge cost, without
a markup, for certain low-margin services specifed on a good list or for services
where comparable transactions between unrelated parties are performed at prices that
yield a median markup on total costs that is less than or equal to 7%. For more detail
regarding the proposed services regulations, please refer to Section 7105.
The temporary regulations also emphasised the interaction between intragroup
services and the use of intangible property. The temporary regulations provided
numerous examples of situations where a provider of intragroup services would earn
higher margins, or could be expected to share in the profts of the development of
intangible property that is jointly developed by the owner of the property and the
service provider. Research and development (R&D), and the development of marketing
intangible assets in a local market, are examples of high-value services provided in
conjunction with intangible property.
The issue of development of marketing intangibles is at the core of the
GlaxoSmithKline Plc (Glaxo) Tax Court case. In September 2006, the IRS announced
the resolution of the case, the largest tax dispute in the agencys history. The parties
reached a settlement under which Glaxo agreed to pay the IRS approximately USD 3.4
billion. According to the IRS claims, drugs marketed by the UK multinational Glaxo
through a US affliate derived their primary value from marketing efforts in the US
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rather than from R&D owned in the UK. The IRSs position is that the unique nature
of the R&D may explain the success of the frst drug of its kind; however, subsequent
market entrants are successful primarily because of the marketing acumen of the US
affliate. Consequently, the IRS asserted that the rate Glaxos US affliate charged
to its UK parent for marketing services was too low. Furthermore, it argues that the
embedded marketing intangibles, trademarks, and trade names existed and were
economically owned by the US affliate. The IRS adjusted the transfer prices paid by
the US affliate to its parent to a contract manufacturing markup on costs and reduced
the royalties paid by the US affliate for the right to sell the product. Emphasising the
US affliates contribution to enhancing the value of the intangibles, the IRS applied
the residual proft split method, resulting in a majority of the US affliates profts being
allocated to the US.
Some tentative observations may be made as to what the implications of both
the Glaxo case and the temporary regulations may be in the analysis of the use of
marketing intangibles for transfer pricing purposes. The approach proposed by the
IRS under the temporary regulations (and the new services regulations), as well as
in the Glaxo case, might in the future suggest greater reliance by the IRS on proft
split methods where a high value could arguably be attached to marketing services.
With the heightened importance of these issues arising from a US perspective,
tax authorities from other countries may also seek to employ a similar approach
in determining the appropriate return for marketing and distribution functions
performed by affliates of foreign companies, especially where these issues are not
contractually addressed by the parties.
The comparable profts method
The comparable profts method (CPM) may be used to test the arms-length character
of transfers of both tangible and intangible property. Differences in functions
performed, resources used, and risks assumed between the tested party and the
comparables should be taken into account in applying this method.
Proft split methods
Proft split methods are specifed methods for testing the arms-length character of
transfers of both tangible and intangible property. The emphasis on comparable
transactions throughout the regulations, however, is intended to limit the use of
proft split methods to those unusual cases in which the facts surrounding the
taxpayers transactions make it impossible to identify suffciently reliable uncontrolled
comparables under some other method. Proft split methods are appropriate when
both parties to a transaction own valuable non-routine intangible assets.
Specifed proft split methods are limited to either (1) the comparable proft split
method, which makes reference to the combined operating proft of two uncontrolled
taxpayers dealing with each other and whose transactions are similar to those of the
controlled taxpayer, or (2) the residual proft split method, which allocates income frst
to routine activities using any of the other methods available, and then allocates the
residual income, based upon the relative value of intangible property contributed by
the parties. No other proft split methods are treated as specifed methods under the
fnal regulations (although other forms of proft splits might be used, if necessary, as
unspecifed methods). The temporary regulations expanded the potential applications
of the residual proft split method. Whereas under the existing regulations, the residual
proft is split between the parties that contribute valuable non-routine intangibles,
the temporary regulations suggests the residual profts can be split between
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parties that provide non-routine contributions (not necessarily intangibles) to the
commercialventure.
7104. Cost sharing
The US cost sharing regulations
On 31 December 2008 the Treasury Department and the Internal Revenue Service
issued temporary and proposed regulations (Temporary Regulations) providing
guidance on the treatment of cost sharing arrangements (CSAs). The Temporary
Regulations introduce new specifed methods to value buy-in transactions, expand
the scope of buy-ins that must be compensated to include services as well as
intangibles, and impose an adjustment mechanism to limit the profts earned by cost
sharingparticipants.
The IRS issued the Temporary Regulations in temporary and proposed form in order
to allow for further public input before moving them into fnal status. The Temporary
Regulations are effective beginning 5 January 2009, although they do require existing
cost sharing arrangements to conform to explicit administrative requirements in order
to be considered grandfathered.
Determining platform contribution transactions
The Temporary Regulations introduce fve specifed methods for valuing cost sharing
buy-ins, now referred to as Platform Contribution Transactions, or PCTs, and provide
guidance on the use of the best method rule in determining the value of PCTs. These
specifed methods include the Comparable Uncontrolled Transaction (CUT) Method,
Income Method, Acquisition Price Method, Residual Proft Split Method, and Market
Capitalisation Method. In addition, the Temporary Regulations confrm the use of the
arms-length range in determining the value of PCTs.
The Temporary Regulations also signifcantly change the application of the Investor
Model, a concept introduced in the August 2005 Proposed Regulations. The
Investor Model assesses the reliability of a method based on its consistency with the
assumption that the rate of return anticipated at the date of a PCT for both the licensor
and licensee must be equal to the appropriate discount rate for the CSA activity.
Furthermore, this model indicates that the present value of the income attributable
to the CSA for both the licensor and licensee must not exceed the present value of
income associated with the best realistic alternative to the CSA. In the case of a CSA,
the Temporary Regulations indicate that such an alternative is likely to be a licensing
arrangement with appropriate adjustments for the different levels of risk assumed in
sucharrangements.
The IRS also recognises that discount rates used in the present value calculation of
PCTs can vary among different types of transactions and forms of payment.
Defnition of intangibles and intangible development area
The scope of the intangible development area under the Temporary Regulations is
meant to include all activities that could reasonably be anticipated to contribute to the
development of the cost shared intangibles. The Temporary Regulations state that the
intangible development area must not merely be defned as a broad listing of resources
or capabilities to be used.
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The Temporary Regulations also broaden the scope of external contributions that must
be compensated as PCTs to include the value of services provided by a research team.
Such a team would represent a PCT for which a payment is required over and above the
teams costs included in the cost sharing pool.
Periodic adjustments
A signifcant change in the Temporary Regulations is the so-called periodic
adjustment rule, which allows the IRS (but not the taxpayer) to adjust the payment
for the PCT based on actual results. Unlike the commensurate with income rules,
the Temporary Regulations provide a cap on the licensees profts (calculated before
cost sharing or PCT payments) equal to 1.5 times its investment. (For this purpose,
both the profts and investment are calculated on a present value basis.) That is, if
the licensee proft is in excess of 1.5 times its PCT and cost sharing payments on a
present value basis, an adjustment is made using the Temporary Regulations version
of the Residual Proft Split Method. In the example in the Temporary Regulations, this
adjustment leaves the licensee with a 10% markup on its non-cost sharing (non-R&D)
expenses, leaving it with only a routine return. Notably, this periodic adjustment is
waived if the taxpayer concludes an Advance Pricing Agreement with the IRS on the
PCT payment.
There is also an exception for grandfathered CSAs, whereby the periodic adjustment
rule of the Temporary Regulations is applied only to PCTs occurring on or after the
date of a material change in scope of the intangible development area (but see below
for additional commentary). The Temporary Regulations also provide exceptions to
the periodic adjustment rule in cases where the PCT is valued under a CUT method
involving the same intangible and in situations where results exceed the periodic
adjustment cap due to extraordinary events beyond control of the parties.
Transition rules
The Temporary Regulations specify that cost-sharing arrangements in place on or
before 5 January 2009 must meet certain administrative requirements in order to
continue to be treated as CSAs. These administrative requirements are separated into
four categories:
Contractual: Existing cost-sharing arrangements must be amended by 6 July 2009
in order to meet the contractual requirements laid out under Treas. Reg. 1.482-
7T(k)(1);
Reporting: Taxpayers must follow the reporting requirements laid out under Treas.
Reg. 1.482-7T(k)(4), which include the fling of a CSA Statement with the IRS
Ogden campus by 2 September 2009 as well as annually with the taxpayers US
taxreturn;
Documentation: Taxpayers must document that the contractual obligations above
have been met and also maintain additional documentation over and above the
information provided in Treas. Reg. 6662(e); and
Accounting: Taxpayers must maintain suffcient books and records to establish
a consistent form of accounting and currency translation are used, as well as to
explain any material divergences from US GAAP.
The Temporary Regulations indicate that PCT payments made under CSAs in existence
on or before 5 January 2009 will not be subject to the periodic adjustment rules
described above, but rather will be governed by the commensurate with income
adjustment rules. There is an exception, however, for PCTs occurring on or after
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a material change in scope in the CSA, which includes a material expansion of
the activities undertaken beyond the scope of the intangible development area. A
determination of material change in scope is made on a cumulative basis, such that
a number of smaller changes may give rise to a material change in the aggregate. In
addition, grandfathered CSAs are not subject to the requirement of non-overlapping
and exclusive divisional interests.
Reasonably Anticipated Beneft Shares
The Temporary Regulations make an important change to the requirements under
which Reasonably Anticipated Beneft (RAB) ratios are calculated for cost-sharing
arrangements. There is now an explicit requirement that RAB ratios be computed using
the entire period of exploitation of the cost shared intangibles.
7105. Services regulations
The US services regulations
US services regulations were originally issued in 1968. These included the cost safe
harbour rule and priced services at cost. On 10 September 2003, the IRS proposed
new proposed regulations for the treatment of controlled services transactions, which
included a new cost method, the Simplifed Cost Based Method (SCBM), introduction
of shared services arrangements, and required stock based compensation to be
included in the pool of total services costs.
On 4 August 2006, the IRS issued new temporary and proposed services regulations
in response to practitioners feedback from the 2003 proposed regulations. As
anticipated, the IRS and Treasury issued fnal section 482 regulations on 31 July
2009. These regulations provide guidance regarding the treatment of controlled
services transactions under section 482 and the allocation of income from intangible
property. Additionally, these regulations modify the fnal regulations under section
861 concerning stewardship expenses to be consistent with the changes made to the
regulations under section 482.
These regulations are effective 31 July 2009 and apply to taxable years beginning after
31 July 2009. Controlled taxpayers may elect to apply retroactively all of the provisions
of these regulations to any taxable year beginning after 10 September 2003. Such
election will be effective for the year of the election and all subsequent taxable years.
Services cost method
The new services regulations, consistently with the 2006 regulations, include the
Services Cost Method (SCM) which replaced the previously proposed SCBM. Taxpayers
employing the SCM must state their intention to apply this method to their services in
detailed records that are maintained during the entire duration that costs relating to
such services are incurred. The records must include all parties involved (i.e. renderer
and recipient) and the methods used to allocate costs.
The new regulations make certain clarifying changes to the provisions dealing with the
SCM. The fnal regulations incorporate the clarifcations and changes previously issued
in Notice 2007-5, 2007-1 CB 269. Aside from these changes and certain other minor,
non-substantive modifcations, the provisions in the fnal regulations relating to the
SCM and other transfer pricing methods applicable to controlled services transactions
are essentially the same as those in the temporary regulations.
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In addition to the good list and the low-margin services, a taxpayer must also comply
with the Business Judgment Rule, which was effective for taxable years beginning after
31 December 2006 under the proposed and temporary services regulations. This rule
requires taxpayers to conclude that the services do not contribute signifcantly to key
competitive advantages, core capabilities, or fundamental chances of success or failure
in one or more trades or business of the renderer, the recipient, or both.
Consequently, like the temporary regulations, the fnal regulations provide that
services may qualify for the SCM only if they are either specifed covered services as
described in Revenue Procedure 2007-13, 2007-1 C.B. 295, or are services for which
the median arms-length markup is 7% or less. In addition, the services must continue
to satisfy the business judgment rule, which in the fnal regulations is consistent
with the business judgment rule of the temporary regulations as clarifed by Notice
2007-5. With respect to specifed covered services that may be eligible for SCM,
the IRS and the Treasury believe that the list of specifed covered services issued in
Revenue Procedure 2007-13 is generally appropriate, although they will consider
recommendations for additional services to be added to the list in the future.
The regulations also specifcally mentions services where the SCM cannot be employed,
these services include:
Manufacturing;
Production;
Extraction, exploration or processing of natural resources;
Construction;
Reselling, distribution, acting as a sales or purchasing agent, or acting under a
commission or similar arrangement R&D or experimentation;
Financial transactions, including guarantees; and
Insurance or reinsurance.
The IRS received a number of comments on the regulatory provision that requires
stock-based compensation to be included in total services costs for purposes of the
SCM. Some commentators requested further guidance on valuation, comparability,
and reliability considerations for stock-based compensation, while others objected to
the statement that stock-based compensation can be a services cost. On this somewhat
controversial issue, the IRS and Treasury deferred consideration of the comments.
The Preamble to the fnal regulations states: These fnal regulations do not provide
further guidance regarding stock-based compensation. The Treasury Department and
the IRS continue to consider technical issues involving stock-based compensation in
the services and other contexts and intend to address those issues in a subsequent
guidance project.
Proft split method
The Proft Split Method (PSM) under the new services regulations requires the
split of residual profts to be based on non-routine contributions rather than on
contributions of intangibles. The new regulations state that the residual proft split
method may not be used where only one controlled taxpayer makes signifcant non-
routinecontributions.
Contractual arrangements and embedded intangibles
In analysing transactions involving intangible property, the temporary regulations have
retained the emphasis on the importance of legal ownership. When intangible property
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is embedded in controlled services transactions, the economic substance must coincide
with the contractual terms. The economic substance must be in accord with the arms-
length standard.
Ownership of intangibles
The temporary regulations have issued new guidance surrounding the ownership of
intangibles. For transfer pricing purposes, the owner for legally-protected intangibles
is the legal owner. However, in the case of non-legally protected intangibles, the owner
is the party with practical control over the intangible. When the legal ownership
standard is inconsistent with economic substance, these rules may be dismissed.
The temporary regulations eliminate the possibility of multiple ownership of a single
intangible, as is the case under the developer-assister rule in the existing regulations.
The fnal regulations continue without signifcant change in the provisions of the
temporary regulations for identifying the owner of an intangible for transfer pricing
purposes, and for determining the arms-length compensation owing to a party
that contributes to the value of an intangible owned by another controlled party.
Thus, the fnal regulations refect the continuing view of the IRS and Treasury that
legal ownership provides the appropriate framework for determining ownership of
intangibles. The legal owner is the controlled party that possesses legal ownership
under intellectual property law or that holds rights constituting an intangible pursuant
to contractual terms (such as a license), unless such ownership is inconsistent with the
economic substance of the underlying transactions.
Beneft test
The conditions in which an activity is deemed to provide the recipient with a beneft
are as follows:
1. If the activity directly results in a reasonably identifable value that enhances the
recipients commercial position, or that may reasonably be anticipated to do so; or
2. If an uncontrolled taxpayer in comparable circumstances would be willing to pay
an uncontrolled party for the same or similar activities, or the recipient otherwise
would have performed the same or similar activity for itself.
In regards to Passive Association, the new regulations state that if a beneft results from
the controlled taxpayers status as a member of a controlled group, the recipient is
deemed not to obtain a beneft.
Duplicative activities occur if an activity performed by a controlled taxpayer duplicates
an activity that is performed, or that reasonably may be anticipated to be performed,
by another controlled taxpayer on or for its own account, the activity is generally not
considered to provide a beneft to the recipient, unless the duplicative activity itself
provides an additional beneft to the recipient.
Pass-through costs
The new regulations further clarify the rules for pass-through of external costs
without a markup. This generally applies to situations in which the costs of a controlled
service provider include signifcant charges from uncontrolled parties. Rather than
have these costs permitted to pass-through and not be subject to a markup under
the transfer pricing method used to analyse the controlled services transaction, the
new regulations allow for the evaluation of the third party costs (if material) to be
evaluated on a disaggregated basis from the covered service transaction.
United States
Passive association benefts
A controlled taxpayer generally will not be considered to obtain a beneft where that
beneft results from the controlled taxpayers status as a member of a controlled group.
A controlled taxpayers status as a member of a controlled group may, however, is
taken into account for purposes of evaluating comparability between controlled and
uncontrolled transactions.
Stewardship and shareholder activities
The fnal regulations continue without signifcant change the provisions of the
temporary regulations dealing with stewardship expenses. These provisions include
the provisions under the section 482 regulations for determining whether an activity
constitutes a service to a related party for which arms-length compensation is due,
or instead constitutes solely a stewardship activity. They also include the related
regulatory provisions under section 861 dealing with the allocation and apportionment
of expenses. As noted above, like the temporary regulations, the fnal regulations under
Treas. Reg. 1.861-8(e)(4) concerning stewardship expenses have been modifed to
be consistent with the language relating to controlled services transactions in Treas.
Reg. 1.482-9(l). Stewardship expenses, which are defned in the fnal regulations as
resulting from duplicative activities or shareholder activities (as defned in Treas.
Reg. 1.482-9(l)), are allocable to dividends received from the related corporation.
The fnal regulations maintain the narrowed defnition of shareholder activities that
includes only those activities whose sole effect (rather than primary effect) is to
beneft the shareholder. Examples:
1. Preparation and fling of public fnancial statements; and
2. Internal Audit activities.
Stewardship activities are defned as an activity by one member of a group of
controlled taxpayers that results in a beneft to a related member. These services would
be allocated and charged out to the group members. Examples:
1. Expenses relating to a corporate reorganisation (including payments to outside law
frms and investment bankers) could require a charge depending on the application
of the beneft test;
2. Under the temporary regulations, the IRS may require US multinationals to charge
for many centralised group services provided to foreign affliates; and
3. Activities in the nature of day-to-day management of a controlled group are
explicitly excluded from the category of shareholder expenses because the
temporary regulations do not view such expenses as protecting the renderers
capital investment.
Stock-based compensation
The IRS received a number of comments on the regulatory provision that requires
stock-based compensation to be included in total services costs for purposes of the
SCM. Some commentators requested further guidance on valuation, comparability,
and reliability considerations for stock-based compensation, while others objected to
the statement that stock-based compensation can be a services cost. On this somewhat
controversial issue, the IRS and Treasury deferred consideration of the comments.
The Preamble to the fnal regulations states: These fnal regulations do not provide
further guidance regarding stock-based compensation. The Treasury Department and
the IRS continue to consider technical issues involving stock-based compensation in
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the services and other contexts and intend to address those issues in a subsequent
guidance project.
Shared services arrangements
The new regulations provide guidance on the Shared Services Arrangements (SSAs),
which applies to services that otherwise qualify for the SCM, i.e. are not subject to
a markup. Costs are allocated based on each participants share of the reasonably
anticipated benefts from the services, with the actual realisation of beneft bearing
no infuence on the allocation. The taxpayer is required to maintain documentation
stating the intent to apply the SCM for services under an SSA.
Financial guarantees
Financial guarantees are excluded as eligible services for application of the SCM
because the provision of fnancial transactions including guarantees requires
compensation at arms length under the temporary regulations.
Economic substance, realistic alternatives, and contingent
paymentservices
The fnal regulations continue without signifcant change various provisions of the
temporary regulations dealing with the IRSs authority to impute contractual terms to
be consistent with the economic substance of a related-party transaction, including the
provisions addressing contingent payment services transactions. They also continue
without signifcant change the provisions authorising the IRS to consider realistic
alternatives in evaluating the pricing of controlled services transactions. The Preamble
to the fnal regulations, and certain clarifying changes to the regulatory language,
emphasise that the evaluation of economic substance must be based on the transaction
and risk allocation actually adopted by the related parties and based on the actual
conduct of the parties, and that IRS is not authorised to impute a different agreement
solely because there is a dispute regarding the transfer pricing of the transaction. In
addition, the Preamble emphasises that the realistic alternatives principle does not
permit the IRS to recast a controlled transaction as if the alternative transaction had
been adopted, but rather permits the IRS only to consider alternatives in evaluating
what price would have been acceptable to a controlled party.
The new regulations do not require documentation to be in place prior to the taxpayer
fling the tax return. However, documentation prepared after the tax return is fled
would not provide for penalty protection in the event the IRS disagrees with the
application of the method used.
During this transition period, the IRS is providing taxpayers with penalty relief
by not penalising taxpayers that undertake reasonable efforts to comply with the
newregulations.
7106. Legal cases
There are a number of signifcant decided cases involving transfer pricing issues.
United States
The administration of matters related to transfer pricing in the US is based on the
principle that the corporate income tax system relies on self-assessment and that
consequently the burden of proof is on the taxpayer.
7108. Tax audits
The IRS has extensive resources available to pursue feld audits, at the appellate level
and in competent authority procedures, including agents specially trained in economic
analysis. Transfer pricing audits are not limited to cases where avoidance is suspected.
Multinational entities should expect to be called upon to affrmatively demonstrate
how they set their inter-company prices and why the result is arms length as part
of the standard review of their US tax returns. Requests to produce supporting
documentation within 30 days have become a standard feature of the commencement
of such examinations.
7109. The US penalty regime
The fnal penalty regulations
The IRS has stated that the objective of the penalty regime is to encourage taxpayers to
make reasonable efforts to determine and document the arms-length character of their
inter-company transfer prices. The regulations provide guidance on the interpretation
of reasonable efforts.
The regulations impose a 20% non-deductible transactional penalty on a tax
underpayment attributable to a transfer price claimed on a tax return that is 200% or
more, or 50% or less than the arms-length price. The penalty is increased to 40% if the
reported transfer price is 400% or more, or 25% or less than the arms-length price.
Where these thresholds are met, the transfer pricing penalty will be imposed unless the
taxpayer can demonstrate reasonable cause and good faith in the determination of the
reported transfer price.
The regulations also impose a 20% net adjustment penalty on a tax underpayment
attributable to a net increase in taxable income caused by a net transfer pricing
adjustment that exceeds the lesser of USD 5 million or 10% of gross receipts. The
penalty is increased to 40% if the net transfer pricing adjustment exceeds USD 20
million or 20% of gross receipts. Where these thresholds are met, the transfer pricing
penalty can be avoided only if a taxpayer can demonstrate that it had a reasonable
basis for believing that its transfer pricing would produce arms-length results, and that
appropriate documentation of the analysis upon which that belief was based existed
at the time the relevant tax return was fled and is turned over to the IRS within 30
days of a request. The principal focus of the transfer pricing regulations is on these
documentation requirements that must be met if a taxpayer is to avoid the assessment
of a net adjustment penalty.
For both the transactional penalty and the net adjustment penalty, whether an
underpayment of tax is attributable to non-arms-length transfer pricing is determined
from the results reported on an income tax return, regardless of whether those
reported results differ from the transaction prices initially refected in a taxpayers
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books and records. An amended tax return will be used for this purpose if it is fled
before the IRS has contacted the taxpayer regarding an examination of the original
return. A US transfer pricing penalty is not a no fault penalty. Even if it is ultimately
determined that a taxpayers transfer prices were not arms length and the thresholds
for either the transactional penalty or net adjustment penalty are met, a penalty
will not be imposed if the taxpayer can demonstrate that based upon reasonably
available data, it had a reasonable basis for concluding that its analysis of the arms-
length character of its transfer pricing was the most reliable, and that it satisfed the
documentation requirements set out in the new fnal regulations.
The US competent authority has stated that transfer pricing penalties will not be
subject to negotiation with tax treaty partners in connection with efforts to avoid
double taxation.
The reasonableness test
A taxpayers analysis of the arms-length character of its transfer pricing will be
considered reasonable if the taxpayer selects and applies in a reasonable manner a
transfer pricing method specifed in the transfer pricing regulations. To demonstrate
that the selection and application of a method was reasonable, a taxpayer must
apply the Best Method Rule and make a reasonable effort to evaluate the potential
application of other specifed pricing methods. If a taxpayer selects a transfer pricing
method that is not specifed in the regulations, the taxpayer must demonstrate a
reasonable belief that none of the specifed methods was likely to provide a reliable
measure of an arms-length result, and that the selection and application of the
unspecifed method would provide a reliable measure of an arms-length result.
In applying the best method rule, the fnal regulations make it clear that ordinarily
it will not be necessary to undertake a thorough analysis under every potentially
applicable method. The fnal regulations contemplate that in many cases the nature
of the available data will readily indicate that a particular method will or will not
likely provide a reliable measure of an arms-length result. Thus, a detailed analysis
of multiple transfer pricing methods should not be necessary except in unusual and
complex cases.
The regulations specify that the following seven factors should be considered in
determining whether a taxpayers selection and application of a transfer pricing
method has been reasonable:
1. The experience and knowledge of the taxpayer and its affliates;
2. The availability of accurate data and the thoroughness of the taxpayers search
fordata;
3. The extent to which the taxpayer followed the requirements of the transfer pricing
regulations;
4. (4) The extent to which the taxpayer relied upon an analysis or study prepared by a
qualifed professional;
5. (5) Whether the taxpayer arbitrarily sought to produce transfer pricing results at
the extreme point of the arms-length range;
6. (6) The extent to which the taxpayer relied on an advance pricing agreement
applicable to a prior tax year, or a pricing methodology specifcally approved by the
IRS during an examination of the same transactions in a prior year; and
7. (7) The size of a transfer pricing adjustment in relation to the magnitude of the
inter-company transactions out of which the adjustment arose.
United States
In determining what level of effort should be put into obtaining data on which to base
a transfer pricing analysis, a taxpayer may weigh the expense of additional research
against the likelihood of fnding new data that would improve the reliability of the
analysis. Taxpayers are not required to search for relevant data after the end of the tax
year but are required to retain any relevant data that is in fact acquired after the year-
end but before the tax return is fled.
The contemporaneous documentation requirement
To avoid a transfer pricing penalty, a taxpayer must maintain suffcient documentation
to establish that it reasonably concluded that, given the available data, its selection
and application of a pricing method provided the most reliable measure of an arms-
length result and must provide that documentation to the IRS within 30 days of a
request for it in connection with an examination of the taxable year to which the
documentationrelates.
The announcement by the Commissioner of the IRS Large and Midsize Business
Division (on 23 January 2003) indicates that the IRS is stepping up enforcement of the
30-day rule and adopting a standard practice of requiring feld examiners to request a
taxpayers contemporaneous documentation within 30 days at the commencement of
every examination of a taxpayer with signifcant inter-company transactions.
There is no requirement to provide any documentation to the IRS in advance of such a
request, and the tax return disclosure requirements relating to the use of unspecifed
methods, the proft split method and lump-sum payments for intangibles originally
included in the 1993 temporary regulations were not retained in the fnal regulations.
In this respect, the US regime is less onerous than some other jurisdictions (e.g.
Canada Australia, and India). However, in contrast, it should be noted that the IRS
apparently is enforcing tax return disclosure requirements relating to the existence of
cost-sharing arrangements (see above).
Principal documents
To meet this documentation requirement the following principal documents, which
must exist when the relevant tax return is fled, should accurately and completely
describe the basic transfer pricing analysis conducted by a taxpayer:
1. An overview of the taxpayers business, including an analysis of economic and legal
factors that affect transfer pricing;
2. A description of the taxpayers organisational structure, including an organisational
chart, covering all related parties engaged in potentially relevant transactions;
3. Any documentation specifcally required by the transfer pricing regulations;
4. A description of the selected pricing method and an explanation of why that
method was selected;
5. A description of alternative methods that were considered and an explanation of
why they were not selected;
6. A description of the controlled transactions, including the terms of sale, and any
internal data used to analyse those transactions;
7. A description of the comparable uncontrolled transactions or parties that were
used with the transfer pricing method, how comparability was evaluated, and what
comparability adjustments were made, if any; and
8. An explanation of the economic analysis and projections relied upon in applying
the selected transfer pricing method.
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The following additional principal documents must also be maintained by a taxpayer
and must be turned over to the IRS within the 30-day period but do not have to exist at
the time the relevant tax return is fled:
1. A description of any relevant data that the taxpayer obtains after the end of
the tax year and before fling a tax return that would be useful in determining
whether the taxpayers selection and application of its transfer pricing method was
reasonable;and
2. A general index of the principal and background documents related to its transfer
pricing analysis and a description of the record keeping system used for cataloguing
and accessing these documents.
Background documents
Background documents include anything necessary to support the principal
documents, including documents listed in the 6038A regulations, which cover
information that must be maintained by foreign-owned corporations. Background
documents do not need to be provided to the IRS in connection with a request
for principal documents but if the IRS makes a separate request for background
documents, they must be provided within 30 days.
The regulations provide that the 30-day requirement for providing documentation
to the IRS applies only to a request issued in connection with an examination of the
tax year to which the documentation relates. The IRS has stated that it may also seek
to obtain transfer pricing documentation related to subsequent tax years as well. A
taxpayer is not required to comply with that request within 30 days in order to avoid
potential transfer pricing penalties.
7110. ASC 740/FIN 48
Accounting Standards Codifcation 740 (ASC 740), formerly referred to as Financial
Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty
in Income Taxes (FIN 48), specifes a comprehensive model for how companies should
determine and disclose in their fnancial statements uncertain tax positions that they
have taken or expect to take on their tax returns. Existing guidance on the application
of income tax law is complicated and at times ambiguous; thus it is often unclear
whether a particular position adopted on a tax return will ultimately be sustained or
whether additional future payments will be required. As a result of limited specifc
authoritative literature on accounting for uncertain tax positions, signifcant diversity
in practice has developed. This diversity in accounting raised concerns that tax
contingency reserves had become susceptible to earnings manipulations, and that
companies reserves could not reasonably be compared until standards for recording
tax benefts were strengthened and standardised.
Under ASC 740, a companys fnancial statements will refect expected future tax
consequences of all uncertain tax positions. ASC 740 was effective as of the beginning
of fscal years that start after 15 December 2006. The estimation of tax exposure is
to be retrospective as well as prospective. Tax reserves should be assessed under the
assumption that taxing authorities have full knowledge of the position and all relevant
facts. Each tax position must be evaluated on its own merits, without consideration
of offsets or aggregations, and in light of multiple authoritative sources including
legislation and intent, regulations, rulings, and case law, as well as past administrative
practices and precedents.
United States
Two principles central to ASC 740 are recognition and measurement. The principle of
recognition means that a tax beneft from an uncertain position may be recognised
only if it is more likely than not that the position is sustainable under challenge
from a taxing authority based on its technical merits, and without consideration of
the likelihood of detection. With regard to measurement, ASC 740 instructs that the
tax beneft of an uncertain tax position be quantifed using a methodology based on
cumulative probability. That is, a company is to book the largest amount of tax beneft
which has a greater than 50% likelihood of being realised upon ultimate settlement
with a taxing authority that has full knowledge of all relevant information.
Because transfer pricing is a signifcant source of tax uncertainty, it must be considered
in developing a tax provision. The existence of contemporaneous documentation
covering a companys inter-company transactions is not suffcient to eliminate tax
exposure uncertainty associated with those transactions. Often, the uncertainty
associated with transfer pricing relates not to whether a taxpayer is entitled to a
position but, rather, the amount of beneft the taxpayer can claim. The form and detail
of documentation required to support a companys determination of its uncertain tax
positions associated with transfer pricing will depend on many factors including the
nature of the uncertain tax positions, the complexity of the issues under consideration
and the materiality of the dollar amounts involved.
7111. SEC Roadmap: Conversion of US GAAP to IFRS
In November 2008, the US Securities and Exchange Commission (SEC) released its
proposed roadmap for the mandatory adoption of International Financial Reporting
Standard (IFRS) in the US. The proposed roadmap currently provides that US issuers
adopt IFRS for fnancial reporting purposes as early as 2014, with the potential for
voluntary adoption as early as 2009. Although the mandatory conversion date is 1
January 2014, US issuers will be required to issue their fnancial reports with three-
year comparative fnancials, which means that these companies fnancials for the 2012
and 2013 must also be reported under IFRS.
For many US MNCs, the conversion to IFRS presents opportunities for these
companies to harmonise their internal transfer pricing policies, typically based on US
Generally Accepted Accounting Principles (US GAAP), to IFRS, the new accounting
standard of choice for many of the jurisdictions in which their affliates operate.
However, considering the signifcant differences in the accounting for revenue and
expense items between US GAAP and IFRS (e.g. as many as four hundred potential
differences impacting the pre-tax income), the adoption of IFRS also presents many
implementation and risk management challenges that need to be considered well in
advance of the conversion date.
The accounting policies adopted by the MNCs accounting/fnance departments will
have profound impacts on the MNCs transfer pricing footprint, including the planning
and setting of prices, documentation, defence of the groups inter-company policies
in the event of an examination by a taxing authority, and in negotiating tax rulings
advance pricing agreements, and the like. Considering the signifcant impacts IFRS
conversion will have on the MNCs transfer pricing landscape, it is vital that the tax
department be involved, and if not, at the very least, be aware of the implications each
of these policies will have on the transfer pricing aspect of the groups tax profle.
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The 2006 revenue procedure
The competent authority process may be invoked by taxpayers when they consider
that the actions of the US or another country with which the US has concluded a tax
treaty, or both parties, result or will result in taxation that is contrary to the provisions
of atreaty.
Taxpayers have the option of requesting competent authority assistance without frst
seeking a review of issues not agreed in the US by the IRS Appeals Division. Issues may
also be simultaneously considered by the US competent authority and the IRS Appeals
Division. Competent authority agreements may be extended to resolve similar issues in
subsequent tax years.
Under section 12 of the Revenue Procedure, the limited circumstances in which the
US competent authority may decline to take up the taxpayers case with a treaty
partner are enumerated. One such circumstance is if the taxpayer does not agree that
competent authority negotiations are a government to government activity and they
do not include the taxpayers participation in the negotiation proceedings. Another is if
the transaction giving rise to the request for competent authority assistance is a listed
transaction under the US regulations as a tax avoidance transaction.
The scope of competent authority assistance
With one exception, the treaty with Bermuda, all US income tax treaties contain
a Mutual Agreement Article that requires the competent authorities of the two
treaty countries to consult with one another in an attempt to reduce or eliminate
double taxation that would otherwise occur when the two countries claim
simultaneous jurisdiction to tax the same income of a multinational enterprises or an
affliatedgroup.
The Mutual Agreement Article contained in US tax treaties does not require the
competent authorities to reach an agreement eliminating double taxation in a
particular case. Rather, the treaties require only that the competent authorities
make a good faith effort to reach such an agreement. Thus, there is no guarantee
that competent authority assistance will result in the elimination of double taxation
in every case; in practice, however, the vast majority of cases are concluded with
an agreement that avoids double taxation. Latest statistics from the US Competent
Authority offce (for the IRSs fscal 2009) indicates that it was able to obtain full relief
for approximately 95.6% of the cases reviewed with partial relief granted for 3.4% of
cases and no relief granted for only 1% of cases. The 2009 statistics also showed that
the total number of cases continues to increase, but that the number of foreign initiated
adjustments that were withdrawn (60%) has signifcantly increased (historically the
level has typically been 30-35%).
Competent authority negotiations are a government-to-government process. Direct
taxpayer participation in the negotiations is not permitted. However, a taxpayer may
take a very proactive approach to competent authority proceedings, presenting directly
to each government its view of the facts, arguments and supporting evidence in a
particular case. The taxpayer can facilitate the negotiation process between the two
governments by developing alternatives and responses to their problems and concerns.
United States
Competent authority relief is most commonly sought in the context of transfer pricing
cases, where one country reallocates income among related entities in a manner
inconsistent with the treatment of the same transactions in the other country. In
such cases, competent authority relief is intended to avoid double taxation by either
eliminating or reducing the adjustment or by making a correlative reduction of taxable
income in the country from which income has been allocated. In transfer pricing cases,
the US competent authority is guided by the 482 regulations but is not strictly bound
by the regulations and may take into account all the facts and circumstances, including
the purpose of the treaty to avoid double taxation.
Other types of issues for which competent authority assistance may be sought include,
inter alia, withholding tax issues, qualifcations for treaty benefts and zero rate
withholding for dividends and certain treaty interpretative issues.
When to request competent authority assistance
In the case of a US-initiated adjustment, a written request for competent authority
relief may be submitted as soon as practical after the amount of the proposed IRS
adjustment is communicated in writing to the taxpayer. For a foreign-initiated
adjustment, competent authority assistance may be requested as soon as the
possibility of double taxation arises. Once competent authority has been requested,
the applicable treaty may provide general guidance with respect to the types of issues
the competent authorities may address. These issues could be allocation of income,
deductions, credits, or allowances between related persons, determination of the
source and characterisation of particular items of income, and the common meaning or
interpretation of terms used in the treaty.
Pre-fling and post-agreement conferences
The Revenue Procedure provides for a pre-fling conference at which the taxpayer may
discuss the practical aspects of obtaining the assistance of the US competent authority
and the actions necessary to facilitate the negotiations with the foreign treaty partner.
The Revenue Procedure also provides for a post-agreement conference after an
agreement has been reached by the competent authorities to discuss the resolution of
the issues considered. There is no explicit provision for conferences while the issues are
being considered by the competent authorities of both countries but the US competent
authority has a practice of meeting and/or otherwise communicating with the taxpayer
throughout the period of negotiations with the foreign treaty partner.
Small case procedures
To be eligible for the small case procedure, the total proposed adjustments assessments
must fall below certain specifed amounts. Corporations would qualify for this small
case procedure if the proposed adjustments were not more than USD 1 million.
Statute of limitation protective measures
The statute of limitations or other procedural barriers under US or non-US law may
preclude or limit the extent of the assistance available from the competent authorities.
The US competent authority has generally sought to read into treaties a waiver of
procedural barriers that may exist under US domestic law, even in the absence of
specifc language to that effect in the treaty. The same policy is not always followed
by the USs treaty partners. Therefore, a taxpayer seeking the assistance of the
US competent authority must take whatever protective measures are necessary to
ensure that implementation of a competent authority agreement will not be barred
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by administrative, legal, or procedural barriers that exist under domestic law in
eithercountry.
In particular, the taxpayer must take steps to prevent the applicable statute of
limitations from expiring in the other country. If a treaty partner declines to enter into
competent authority negotiations, or if a competent authority agreement cannot be
implemented because the non-US statute of limitations has expired, a taxpayers failure
to take protective measures in a timely fashion may cause the US competent authority
to conclude that the taxpayer failed to exhaust its competent authority remedies for
foreign tax credit purposes.
Some US treaties contain provisions that are intended to waive or otherwise remove
procedural barriers to the credit or refund of tax pursuant to a competent authority
agreement, even though the otherwise applicable statute of limitations has expired.
The 2006 Revenue Procedure warns taxpayers not to rely on these provisions
because of differences among treaty partners in interpreting these waiver provisions.
The limits a treaty may impose on the issues the competent authority may address
are also another reason for a taxpayer to take protective measures to ensure that
implementation of a competent authority agreement will not be barred.
Most US treaties also contain specifc time limitations in which a case may be brought
before the applicable competent authorities. These time limitations are separate
from the domestic statute limitations. For example, the treaty with Canada requires
that the other country be notifed of a proposed adjustment within six years from the
end of the taxable year to which the case relates. This notifcation under the treaty
can be accomplished, from a US perspective, by fling either a competent authority
request pertaining to the proposed adjustments or a letter requesting the preservation
of the taxpayers right to seek competent authority assistance at a later date, after
administrative remedies in the other country have been pursued. If the latter course is
followed, this letter must be updated annually until such time as the actual competent
authority submission is fled or the taxpayer determines it no longer needs to protect its
rights to go to competent authority.
Unilateral withdrawal or reduction of US-initiated adjustments
Where the IRS has made a transfer pricing allocation, the primary goal of the US
competent authority is to obtain a correlative adjustment from the foreign treaty
country. Unilateral withdrawal or reduction of US-initiated adjustments, therefore,
generally will not be considered. Only in extraordinary circumstances will the US
competent authority consider unilateral relief to avoid double taxation.
Repatriation of funds following a transfer pricing adjustment
In 1999, the US issued Revenue Procedure 99-32 that provided for the tax-free
repatriation of certain amounts following a transfer pricing allocation to a US taxpayer,
broadly with the intention of allowing the taxpayer to move funds to refect the agreed
allocation of income following the transfer pricing adjustment. In cases involving
a treaty country, coordination with the US competent authority is required before
concluding a closing agreement with the taxpayer.
The Revenue Procedure requires the taxpayer to establish an account receivable,
which may be paid without any tax consequence, provided it is paid within 90 days
of the closing agreement or tax return fling for the year in which the adjustment was
United States
reported. The following should be taken into account when establishing an account
receivable:
1. Absent payment of the account receivable within 90 days, the amount is treated as
a dividend or capital contribution;
2. The account receivable bears interest at an arms-length rate; and
3. The receivable is deemed to have been created on the last day of the year subject
to the transfer pricing allocation, with the interest accrued being included in
the income of the appropriate corporation each year the account receivable is
deemedoutstanding.
The Revenue Procedure the IRS previously issued in this area provided that previously
paid dividends could be offset by the cash payment made in response to the primary
transfer pricing adjustment. Under the 1999 Revenue Procedure, a taxpayer may only
offset (1) dividends paid in a year in which a taxpayer-initiated adjustment relates if
offset treatment is claimed on a timely income tax return (or an amended tax return)
or (2) in the same year that a closing agreement is entered into in connection with an
IRS-initiated adjustment. In the former case, the dividend is treated as a prepayment of
interest and principle on the deemed account receivable.
Under the 1999 Revenue Procedure, relief is not available, however, with respect to
transactions where a transfer pricing penalty is sustained. Effectively, this requirement
imposes an additional tax for failure to maintain contemporaneous documentation to
substantiate arms-length transfer pricing.
Interest and penalties
The US competent authority generally has no authority to negotiate or provide relief in
respect of interest and penalties.
US procedures
The US was the frst country to issue a formal, comprehensive set of procedures
relating to the issue of binding advance agreements dealing with the application of
the arms-length standard to inter-company transfer prices. Under the procedure,
the taxpayer proposes a transfer pricing method (TPM) and provides data intended
to show that the TPM is the appropriate application of the best method within the
meaning of the regulations for determining arms-length results between the taxpayer
and specifed affliates with respect to specifed inter-company transactions. The IRS
evaluates the APA request by analysing the data submitted and any other relevant
information. After discussion, if the taxpayers proposal is acceptable, a written
agreement is signed by the taxpayer and the IRS.
The procedures specify a detailed list of data that must be provided to the IRS with
the application. There is also a user fee for participation in the programme, which
currently ranges between USD 10,000 and USD 50,000, based on the size of the
taxpayer and the nature of the request.
In the application, the taxpayer must propose and describe a set of critical assumptions.
A critical assumption is described as any fact (whether or not within the control of the
taxpayer) related to the taxpayer, a third party, an industry, or business or economic
conditions, the continued existence of which is material to the taxpayers proposed
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TPM. Critical assumptions might include, for example, a particular mode of conducting
business operations, a particular corporate or business structure, or a range of expected
business volume.
The taxpayer must fle an annual report for the duration of the agreement, which will
normally include:
1. The application of the TPM to the actual operations for the year;
2. A description of any material lack of conformity with the critical assumptions; and
3. An analysis of any compensating adjustments to be paid by one entity to another,
and the manner in which the payments are to be made.
The taxpayer must propose an initial term for the APA appropriate to the industry,
product or transaction involved, and must specify for which taxable year the agreement
will be effective. The APA request must be fled no later than the extended fling date
for the Federal income tax return for the frst taxable year to be covered by the APA.
The effect of an APA is to guarantee that the IRS will regard the results of the TPM
as satisfying the arms-length standard if the taxpayer complies with the terms and
conditions of the APA. The APA may be retroactively revoked in the case of fraud or
malfeasance, cancelled in the event of misrepresentation, mistake/omission of fact, or
lack of good faith compliance, or revised if the critical assumptions change. Adherence
to the terms and conditions may be subject to audit this will not include re-evaluation
of the TPM.
Traditionally, the IRS APA procedures were limited to issues concerning transfer
pricing matters in the context of section 482 of the Internal Revenue Code. However,
effective 9 June 2008 the APA procedures (through Rev. Proc. 208-31) were modifed
to expand the scope of the APA Programmes purview to include other issues for
which transfer pricing principles may be relevant, including: attribution of profts
to permanent establishment under an income tax treaty, determining the amount of
income effectively connected with the conduct by the taxpayer of a trade or business
within the US, and determining the amounts of income derived from sources partly
within and partly without the US, as well as related subsidiary issues. The expansion
of the programmes scope may not necessarily translate into an immediate increase
in the number of non-section 482 cases within the programme as the IRS has
publicly indicated that it will be selective in the cases admitted into the programme.
Nevertheless, the expansion of the programmes scope of review, providing for
other non-section 482 issues that may be resolved through the APA process, is a
welcomeddevelopment.
Rollbacks
APAs may, at the taxpayers request at any point prior to the conclusion of an
agreement, and with agreement of the responsible IRS District, be rolled back to cover
earlier taxable years. This may be an effective mechanism for taxpayers to resolve
existing audit issues.
United States
Bilateral and unilateral APAs impact on competent authority
When a taxpayer and the IRS enter into an APA, the US competent authority will, upon
a request by the taxpayer, attempt to negotiate a bilateral APA with the competent
authority of the treaty country that would be affected by the transfer pricing
methodology. The IRS has encouraged taxpayers to seek such bilateral APAs through
the US competent authority.
If a taxpayer and the IRS enter into a unilateral APA, treaty partners may be notifed of
the taxpayers request for the unilateral APA involving transactions with that country.
Additionally, the regular competent authority procedures will apply if double taxation
subsequently develops as a result of the taxpayers compliance with the unilateral APA.
Importantly, the US competent authority may deviate from the terms and conditions of
the APA in an attempt to negotiate a settlement with the foreign competent authority.
However, the 2006 Revenue procedure includes a strongly worded warning that a
unilateral APA may hinder the ability of the US competent authority to reach a mutual
agreement, which will provide relief from double taxation, particularly when a
contemporaneous bilateral or multilateral APA request would have been both effective
and practical to obtain consistent treatment of the APA matters in a treaty country.
APAs for small business taxpayers and IRS-initiated APAs
In an effort to make the APA programme more accessible to all taxpayers, the IRS
released a notice in early 1998 proposing special, simplifed APA procedures for small
business taxpayers (SBT). The notice provides that a SBT is any US taxpayer with total
gross income less than USD 200 million. Under the simplifed APA procedures, the
entire APA process is accelerated and streamlined, and the IRS will provide the SBT
with more assistance than it does in a standard APA.
In an effort to streamline the APA process, the IRS may agree to apply streamlined
procedures to a particular APA request, even if it does not conform fully to the
requirements for small business treatment.
The IRS has announced a programme under which district examiners are encouraged
to suggest to taxpayers that they seek APAs, if the examiners believe that APAs might
speed issue resolution.
Developments in the APA programme
There is increased specialisation and coordination in the APA offce, with teams
designated to specifc industries/issues, such as automotive, pharmaceutical and
medical devices, cost-sharing, fnancial products and semiconductors.
The APA programme is also getting stricter with its deadlines. From now on, if the date
on which the IRS and the taxpayer have agreed to complete an APA passes and the
case goes unresolved, both parties will have to submit a joint status report explaining
the reason for the delay and mapping out a new plan to close the case within three to
six months. If the IRS and the taxpayer fail to meet the second target date, the new
procedures call for an automatic all hands meeting of key offcials from both sides. For
an APA that has been executed, the taxpayer is required to submit an annual report
showing its compliance with the terms of the agreement. Taxpayers now must also
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submit an APA Annual Report Summary, which is a standardised form refecting key
data, as part of the APA annual report.
7114. Comparison with the OECD Transfer Pricing
Guidelines
The best method rule
As noted in section 7106, the US regulations require application of the Best Method
Rule in the selection of a pricing method. The OECD Guidelines now refer to use of
the most appropriate method which in principle is very similar to the best method
described in the US regulations. A taxpayer does not necessarily have to examine each
method in detail, but must take into account:
1. The facts and circumstances of the case;
2. The evidence available, particularly in relation to the availability of comparable
data; and
3. The relative reliability of the various methods under consideration, which
arguably continues to demonstrate some level of bias towards the use of
transactionalmethods.
Comparability analysis
Both the US regulations and the OECD Guidelines provide that the arms-length
character of an inter-company transaction is ordinarily determined by comparing
the results under the regulations or the conditions under the Guidelines (i.e. in both
cases meaning either prices or profts) of that controlled transaction to the results
realised or conditions present in comparable uncontrolled transactions. Comparability
factors that must be taken into account include functions performed, risks assumed,
contractual terms and economic conditions present, and the characteristics of
the property transferred or the services provided. Determination of the degree of
comparability must be based on a functional analysis made to identify the economically
signifcant functions performed, assets used, and risks assumed by the controlled and
uncontrolled parties involved in the transactions under review.
Both the US regulations and the OECD Guidelines permit the use of inexact
comparables that are similar to the controlled transaction under review. Reasonably
accurate adjustments must be made to the uncontrolled comparables, however, to
take into account material differences between the controlled and uncontrolled
transactions if such adjustments will improve the reliability of the results obtained
under the selected pricing method. Both the US regulations and the OECD Guidelines
expressly prohibit the use of unadjusted industry average returns to establish an arms-
lengthresult.
An important comparability factor under both the US regulations and the OECD
Guidelines is the allocation of risk within the controlled group. The types of risks that
must be taken into account under both sets of rules include: market risks; risk of loss
associated with the investment in and use of property, plant, and equipment; risks
associated with the success or failure of R&D activities; and fnancial risks such as
those caused by currency exchange rate and interest rate variability. In addition, under
both sets of rules the determination of which party actually bears a risk depends, in
part, on the actual conduct of the parties and the degree to which a party exercises
control over the business activities associated with the risk.
United States
Market penetration strategies
Consistent with the US regulations, the OECD Guidelines recognise that market
penetration strategies may affect transfer prices. Both the Regulations and the
Guidelines require that where a taxpayer has undertaken such business strategies, it
must be shown that:
1. There is a reasonable expectation that future profts will provide a reasonable
return in relation to the costs incurred to implement the strategy; and
2. The strategy is pursued for a reasonable period of time given the industry and
product in question.
The OECD Guidelines are generally less restrictive concerning market penetration
strategies than the US regulations, which require a very extensive factual showing
anddocumentation.
Arms-length range
Like the US regulations, the OECD Guidelines provide that no adjustment should be
made to a taxpayers transfer pricing results if those results are within an arms-length
range. The Guidelines do not include specifc rules for establishing the arms-length
range but do recognise that the existence of substantial deviation among the results
of the comparables suggests that some of the comparables may not be as reliable
as others, or that signifcant adjustments to the results of the comparables may
benecessary.
What has to be at arms length? Setting prices versus evaluating the result
The primary focus of the US regulations is on whether a taxpayer has refected arms-
length results on its US income tax return; the actual methods and procedures used by
taxpayers to set transfer prices are not relevant. The OECD Guidelines, however, tend
to focus less on the results of transfer pricing and more on whether the transfer prices
were established in an arms-length manner substantially similar to the manner in
which uncontrolled parties would negotiate prices. Thus, the Guidelines put signifcant
emphasis on factors known by the taxpayer at the time transfer prices were established.
Traditional transactional methods
As noted above the OECD Guidelines express some level of preference for the use of
traditional transaction methods for testing the arms-length character of transfer prices
for transfers of tangible property. These methods include the CUP method, the resale
price method, and the cost plus method. These same methods are specifed methods
under the US regulations.
Under both the US regulations and the OECD Guidelines, the focus is on the
comparability of products under the CUP method, and the comparability of functions
under the resale price and cost plus methods. Under all three methods and under both
sets of rules, comparability adjustments must take into account material differences
in operating expenses, accounting conventions, geographic markets, and business
experience and management effciency.
There are no material substantive differences between the US regulations and the
OECD Guidelines in the theoretical concepts underlying these methods, the manner in
which these methods are to be applied, or the conditions under which these methods
would likely be the best method.
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Other methods
Both the US regulations and the OECD Guidelines provide for the use of other methods
when the traditional transaction methods cannot be used. Under the US regulations,
a taxpayer may use the CPM or the proft split method. Under the Guidelines, a
taxpayer may use the proft split method or the transactional net margin method
(TNMM). In most cases, as explained below, the CPM and the TNMM are virtually
indistinguishable. The emphasis on comparability throughout the US regulations,
however, is intended to limit the use of proft split methods to those unusual cases in
which the facts surrounding the taxpayers transactions make it impossible to identify
suffciently reliable comparables under some other method. The Guidelines, on the
other hand, express a strong preference for the use of the proft split over the TNMM.
Transactional net margin method (TNMM)
TNMM compares the operating proft relative to an appropriate base (i.e. a proft level
indicator) of the controlled enterprise that is the least complex and owns no valuable
intangibles (i.e. the tested party) to a similar measure of operating proft realised by
comparable uncontrolled parties in a manner consistent with the manner in which the
resale price or cost plus methods are applied. The operating rules for TNMM are thus
substantially the same as those for CPM. Both methods require that the analysis be
applied to an appropriate business segment and use consistent measures of proftability
and consistent accounting conventions.
The OECD Guidelines do require that TNMM be applied on a transactional basis. The
precise meaning of this requirement is not clear. It will ordinarily not be possible to
identify net proft margins of comparables on a truly transactional basis, and in many
cases, taxpayers will have diffculty identifying their own net profts on a transactional
basis. In any event, it appears that TNMM is intended to be applied in the same manner
as the resale price and cost plus methods, which ordinarily look to overall gross
margins for an entire business segment for the full taxable year. Presumably, TNMM
should be applied in the same manner.
The OECD Guidelines thus do not prohibit the use of CPM. They do provide, however,
that the only proft-based methods such as CPM and so-called modifed resale price/
cost plus methods that satisfy the arms-length standard are those that are consistent
with TNMM.
Intangible property
In respect to the treatment of intangible property, the OECD issued a chapter
discussing the special considerations arising under the arms-length principle for
establishing transfer pricing for transactions involving intangible property which will
be revised in the near future. The OECD places emphasis on the actions that would
have been taken by unrelated third parties at the time the transaction occurred.
The Guidelines focus on the relative economic contribution made by various
group members towards the development of the value of the intangible and on the
exploitation rights that have been transferred in an inter-company transaction. This
is particularly true in the case of the pricing of marketing intangibles. The Guidelines
thus focus on economic ownership of the intangible as opposed to legal ownership.
United States
The OECD Guidelines do not provide signifcant new guidance for the pricing of
intangibles by providing specifc standards of comparability. The Guidelines, similar to
the US regulations provide that prices for intangibles should be based on:
1. The anticipated benefts to each party;
2. Prior agreement on price adjustments, or short term contracts; or
3. The allocation of the cost or beneft of uncertainty to one party in the
transaction, with the possibility of renegotiation in the event of extreme or
unforeseencircumstances.
The only pricing method that is specifcally approved is the CUP method, which is
equivalent to the comparable uncontrolled transaction (CUT) method in the US
regulations. The Guidelines give a cautious endorsement to the use of proft split
methods or the TNMM when it is diffcult to apply a transactional method. This is not
inconsistent with the outcome that would be expected if the US Best Method Rule
were applied in the same circumstances except for the preference of proft split over
theTNMM.
The redefning of the IP ownership rules for non-legally protected intangibles under
the proposed regulations will likely attract much debate between the US and its treaty
partners who have adopted the OECD Guidelines on this matter. Uncertainties in the
defnition of practical control and economic substance will be the main drivers of
such potential disputes.
Periodic adjustments under the OECD Guidelines
The main area of potential diffculty arises from the focus in the US regulations on
achieving an arms-length result. There is a very evident potential for dispute as to
whether the concept of periodic adjustments under the US regulations (described
above) is at odds with the statements in the Guidelines concerning the use of
hindsight. However, the OECD clearly affrms the right of tax authorities to audit the
accuracy of the forecasts that were used to establish transfer pricing arrangements,
and to make adjustments if the projections on which the pricing was based prove to be
inadequate or unreasonable.
Services
Both the US regulations and the OECD Guidelines focus on satisfying the arms-length
standard by the recharge of costs specifcally incurred by one group member to provide
a service to another group member. Under both the US regulations and the Guidelines,
costs incurred include a reasonable allocation of indirect costs.
As to whether the arms-length charge for services also includes a proft to the service
provider, the Guidelines state that the inclusion of a proft margin is normally part
of the cost of the services. In an arms-length transaction, an independent enterprise
would normally seek to charge for services in such a way as to generate a proft. There
might be circumstances, however, in which an independent enterprise may not realise
a proft from the performance of service activities alone. For example, the services
provider might offer its services to increase proftability by complementing its range
ofactivities.
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The proposed regulations (on Services) are intended to conform the US regulations
to the OECD Guidelines by eliminating the cost safe harbour method for non-integral
activities. However, this intention is partially negated with proposal of the elective
Services Cost Method for certain types of activities deemed low margin services (See
923 to 937).
Documentation and penalties
The OECD Guidelines recommend that taxpayers make reasonable efforts at the time
transfer pricing is established to determine whether their transfer pricing results meet
the arms-length standard, and they advise taxpayers that it would be prudent to
document those efforts on a contemporaneous basis. The Guidelines also admonish
tax authorities to balance their needs for taxpayer documentation with the cost and
administrative burden imposed on taxpayers in the preparation of that documentation.
The Guidelines also note that adequate record keeping and voluntary production
of documents facilitates examinations and the resolution of transfer pricing issues
thatarise.
The OECD Guidelines include a cautious acknowledgement that penalties may play a
legitimate role in improving tax compliance in the transfer pricing area. The Guidelines
encourage member countries to administer any such penalty system in a manner that is
fair and not unduly onerous for taxpayers.
Uruguay
72.
International Transfer Pricing 2011 809 Uruguay
7201. Introduction
In 2007, Uruguay implemented a signifcant and historical tax reform pursuant to
approval of Law 18,083, which incorporates, among other concepts, the personal
income tax (which had been repealed in the early 1970s), the fgure of permanent
establishment, and the concepts of residence and transfer pricing. Notwithstanding,
the source principle is maintained as the basic taxability empowerment criteria.
This law was enacted by the Executive Power on 27 December 2006, and was published
in the Offcial Gazette on 18 January 2007.
Until 2007, Uruguayan tax legislation had not given a general legal solution for the
issue of transfer pricing, except for certain provisions included in the regulations of
business income tax relating to export or import transactions involving merchandise
and some other specifc rulings. Regarding export and import transactions, Article
21 of Title 4 of the 1996 Coordinated Tax Compilation (CTC) and related detailed
regulations contained in Article 19 of Decree 840/988 prescribe consideration of the
wholesalers price plus certain other connected charges for determining the net income
of a local source related to all export and import transactions made by an enterprise
(without differentiating between a related party or a third party). This ruling is
extensive to transactions made between Uruguayan free zones and non-free zone
territory, as stated in Article 8 of Decree 733/991.
Law 18,083 incorporates for the frst time a specifc chapter (Chapter VII of Title 4 of
the 1996 CTC) on transfer pricing under the regulations of Income Tax on Economic
Activities (ITEA), which are in force for fscal years starting from 1 July 2007,
andonwards.
On 26 January, 2009, the regulatory decree was issued (Decree 56/009), containing
detailed regulations on transfer pricing regime. Later, on 24 August 2009, a second
decree (Decree 392/009) was issued clarifying some of those regulations. The
regulations of this decree establishing obligations or burdens for the taxpayer will
become in force for operations made in fscal years starting from 1 January 2009.
In December 2009, the Uruguayan General Tax Bureau (GTB), in agreement with
the Finance Ministry, issued Resolutions 2084/009 and 2269/009, providing further
details about certain key aspects of the existing transfer pricing regulations.
In February 2010, the frst binding consultation regarding transfer pricing was
published by the GTB. The subject of such consultation is the price to be applied in
exports and imports of commodities.
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Uruguay 810 www.pwc.com/internationaltp
As a general principle, the regulations on transfer pricing are applicable to
international transactions made between related parties. However, Uruguayan
legislation has extended the scope of these regulations to transactions carried out
with low-tax or nil-tax jurisdictions or regimes (either international or domestic) and
certain operations through third intermediaries.
Transactions between related parties
Law 18,083 states that transactions between ITEA taxpayers and related parties
or individuals will be deemed arms length for all purposes when the terms and
conditions provided therein are in conformity with normal market practices between
independent parties, without prejudice to the cases of existing limitations for expense
deductions upon computing net taxable income.
In principle, according to the law, the burden of proving that the aforementioned
terms and conditions are not in conformity with market values falls on the GTB, except
in the case of transactions by the ITEA taxpayer with companies in low-tax or nil-tax
jurisdictions or regimes that are presumed not to be arms length.
However, the new documentation requirements imposed by the GTB do transfer such
burden to the taxpayers.
Related parties
The defnition adopted by the law for related parties status is quite broad. Such
relationship is confgured when both parties are subject, directly or indirectly, to
the management or control of the same individuals or legal entities, or when they
have power of decision to direct or defne the taxpayers activities due either to their
participation in capital interest, the level of their credit rights, their functional or any
other type of infuence (whether contractual or not).
Resolution 2084/009 provides an in-depth description of the circumstances under
which a company will be deemed a related party. For the GTB, and without prejudice
to other situations, the related party status will be deemed confgured when
transactions are made between the parties and one of the assumptions detailed below
is inexistence:
An entity has an equity interest of 10% or more in the capital of another entity;
An entity exercises its functional infuence on the other entity;
Two or more entities have, indistinctly:
Another common entity jointly possessing an equity interest of 10% or more in
the capital of each of the above;
Another common entity jointly possessing an equity interest of 10% or more in
the capital of one or more entities together with functional infuence on one or
more of the other entities above; and
Another common entity possessing functional infuence simultaneously on each
of the other entities above.
An entity holding the voting rights as necessary to determine the decision-making
of the other entity or to prevail on the competent decision-making body of the
otherentity;
International Transfer Pricing 2011 Uruguay 811
Uruguay
Two or more entities having an entity in common that holds the voting rights as
necessary to determine the decision-making of the other entity or to prevail on the
competent decision-making body of those two or more entities;
An entity enjoying the exclusive right as agent, distributor, concessionaire or
supplier of goods, services or rights of the other entity;
An entity participating in fxing policies in the areas of business, procurement of
raw materials, production or marketing and trading of the other entity;
Two or more entities having a common entity jointly participating in fxing policies
in the areas of business, procurement of raw materials, production or marketing
and trading of those two or more entities; and
An entity taking charge of the losses or expenses of another entity.
The GTB also describes some situations in which the functional infuence is deemed
to be in place, whenever:
Two or more entities have common directors, managers or other staff members
holding decision powers to provide guidance or to defne the activities of
theentities;
An entity provides to the other entity proprietary technology or technical
knowledge that constitutes the basis for the activities of the latter;
Two or more entities agree to contractual clauses that assume a preferential nature
in comparison with those granted to third parties under similar circumstances,
such as volume discount arrangements, fnancing for transactions or delivery
onconsignment;
An entity develops signifcant activities only in relation to the other entity, or its
existence is justifed only in relation to the other entity, giving rise to situations
such as being the sole supplier or sole client;
An entity provides substantially the funding required for the business activities of
the other, by means of granting loans and submitting guarantees of whatever type
in the case of fnancing provided by a third party;
The directors, managers, or other staff holding decision powers in an entity receive
instructions from the other entity or act in the interest of the latter; and
There are agreements, circumstances or situations whereby the management of an
entity is entrusted to an entity holding a minority capital interest in the frst entity.
Countries or regimes with low taxation or nil taxation
The operations undertaken by taxpayers with countries or regimes with low or nil
taxation will be perceptively treated as related parties (without admitting proof to
the contrary) and will be considered as not being in conformity with normal market
practices or values between independent parties.
The following operations are included in this category:
1. Transactions with non-residents who are domiciled, organised or located in
countries of low or nil taxation;
2. Transactions with non-residents who are benefciaries under a special regime of
low or nil taxation; and
3. Transactions carried out with entities operating in customs areas (including those
within Uruguayan territory) and benefting from a regime of low or nil taxation.
Consequently, transactions with entities operating in such areas (e.g. Uruguayan or
foreign free zones) would fall under this category.
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The countries and regimes referred to in cases (1) and (2) above were enumerated
taxatively in the Decree 56/009 (33 countries or jurisdictions were listed). Regarding
operations referred to in case (3), the Decree 392/009 defned the concept of customs
areas that beneft from a regime of low or nil taxation. Customs areas comprise
the free zones, free ports and other geographic areas where customs regulations are
not applicable, located either in Uruguay or abroad. Regimes of low or nil taxation
are defned as those having an effective income tax rate lower than 40% of the ITEA
rate (i.e. when such effective income tax rate is lower than 10%, equivalent to 40% of
25%). It must be noted that some of these operations are excluded from the transfer
pricing regime when they comply with certain requirements.
Operations through intermediaries
Imports and exports transactions under the intervention of an international
intermediary other than the fnal recipient of the goods are subject to transfer pricing
rules when:
There is a related party connection between the local operator and the
international intermediary, either by virtue of the general related party
assumptions established by law or of noncompliance with the certain requirements
stated by law (If these requirements are not met, the intermediary would be
considered a related party); and
There is a related party connection between the local operator and the effective
recipient of the goods (whether or not the intermediary complies with such
requirements).
In principle, these rules are applicable to commodities transactions. However, the GTB
may extend these particular rules to other goods.
Methodology
Law 18,083 adopts the best accepted international methodologies and requires use of
the most appropriate method according to the type of transaction performed.
The law foresees the application of fve methods, apart from others that may be
established in the detailed regulations:
Proft split method (PSM); and
Decree 56/009 adopts such methods and defnes them.
Tested party
When applying the methods, the analysis of comparability and justifcation of the
transfer prices can be made indistinctly on the situation of the local entity or of the
foreign entity. Should the option adopted be to analyse the position of the foreign
subject, due documentary proof will be required, which should be certifed in the
foreign subjects host country by an independent auditor of recognised reputation, duly
translated into Spanish and legalised.
Uruguay
Comparability factors
In accordance with the Decree 56/009, the comparability factors include:
Characteristics of the transactions;
Functions or activities, including assets engaged and risks assumed in the
transactions of each of the parties involved;
Economic circumstances.
The regulatory decree does not mention the business strategies as one of the factors
determining comparability. However, the elements and circumstances referred to
in the decree are not stated in a restricted sense. In this case, an in-depth analysis
isrecommended.
Exception to the best method rule
The law prescribes perceptive application of the CUP method in the following cases:
1. Imports and exports of goods with related parties for which a public and
notorious international price known in transparent markets can be determined
(commodities), in which case such prices should be used, unless there is proof to
the contrary; and
2. Imports and exports of goods through a foreign intermediary other than the fnal
recipient of the goods.
These represent transactions between related parties involving primary farming
products, and, in general, goods knowingly quoted in transparent markets
(commodities); in this case the price applied should be the value quoted in such market
at the date the goods are laden, regardless of means of transportation or the price
agreed with the intermediary. According to the law, this method will not be enforced
when the taxpayer is able to provide trustworthy evidence that the intermediary fully
complies with the following requisites:
It has a residence abroad and actual presence in the foreign territory, having a
commercial establishment in such location for managing its business activities
and complying with the legal requisites of constitution, registration and fling of
fnancial statements. The assets, risks and functions assumed by the intermediary
should be appropriate to the volume of business transactions made;
Its main activity should be different from generating passive revenue or
intermediation in the trading of goods out of or into Uruguay, or with other
members of the group economically related to the intermediary; and
Its international trade transactions with other subjects related to the importer,
or exporter in the case, should not exceed 30% of the annual revenue from
transactions made under its intervention.
However, as it was mentioned above, Decree 392/009 states that the operations
included in case (2) comprise all imports and exports transactions made under the
intervention of an international intermediary, provided any of the following situations
take place:
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Existence of a related party connection between the local operator and the
international intermediary, either by virtue of the general related party
assumptions established by law or of noncompliance with the three requirements
mentioned above; and
Existence of a related connection between the local operator and the effective
recipient of the goods as established by law, even when the intermediary complies
with the three requirements mentioned above.
The GTB may extend the application of this method to comprise other international
transactions with the participation of an intermediary other than the fnal recipient
of the goods, provided the GTB is able to produce trustworthy evidence proving that
the intermediary is not in compliance with the aforementioned requisites. For this
purpose, in the case of import transactions, the price will be the higher of the prices
quoted in a transparent market of recognised international prestige, if the price agreed
upon with the related party is still higher. In the case of export transactions, the lower
quoted price will be applied if the agreed-upon price is lower. The quoted price may
be reasonably adjusted to the value of the merchandise to the point of local market, in
respect of the insurance and freight costs involved.
According to Decree 392/009, in either case (1) or (2) above, if the contract has been
registered, the price applied should be the quoted price prevailing as of the date of the
contract. If the contract has not been registered, such quoted price will be applied as of
the date of the corresponding bill of lading.
The Uruguayan Products Mercantile Chamber is the institution appointed as the
registry offce of such contracts. This registration will be optional for the taxpayers and
will be opposable to the GTB when such registration is made within fve working days
of the month following execution of the contract.
Arms-length range
When two or more comparable transactions are identifed, the median and the
interquartile price ranges should be determined for the amount of the consideration or
the proft margins involved.
Should the price or proft margin fxed by the taxpayer fall within the interquartile
range, such price and proft margin will be deemed as having been agreed upon
between independent parties.
Otherwise, it will be deemed that the price, amount of the consideration or proft
margin that would have been applied by independent parties is the one that
corresponds to the median reduced (or plus) 5%, depending on the transactions
underanalysis.
Information required
Although the law per se does not require mandatory preparation of formal transfer
pricing documentation, it does provide that both the administration and the detailed
regulations may require additional information for purposes of control and tax audit.
The regulatory decree states that the taxpayers determined by the GTB must fle special
tax returns in the form established by this authority. The GTB may require them to fle
the vouchers and other documentary evidence supporting the transfer prices as well
as the comparison criteria utilised in order to analyse due application of the prices,
amounts of the considerations or proft margins reported in such special tax return.
Uruguay
According to Resolution 2084/009, taxpayers will be required to fle annual
information if they meet any of the following conditions:
They are included in the large taxpayers division;
Their transactions subject to transfer pricing rules are in excess of 50 million
indexed units (equivalent to approximately USD4.5 million); or
They have been notifed for fling by the GTB.
The information referred to above will have the following contents:
Informative tax return stating the details and amounts of transactions of the period
subject to the transfer pricing regime;
Copy of the fnancial statements for the fscal period, if not submitted previously in
compliance with other regulations; and
Transfer pricing study (with a minimum content).
The fling deadline for this documentation will be nine months after the closing date of
the fscal year.
Resolution 2084/009 states that taxpayers who are not required to fle the annual
information referred to above must still keep on fle the vouchers and other supporting
evidence justifying the transfer prices used and the comparison criteria applied during
the period of limitations of taxation in order to duly demonstrate and justify the correct
determination of those prices and the amounts of the considerations fxed or the profts
margin declared.
Optional regimes of notional proft assumptions
Law 18,083 empowers the Executive Power to establish special notional proft regimes
(safe harbours) considering the modus operandi of the transactions and of the type
of business activity or exploitation. Such regimes will be optional and for the purpose
of determining the income source of those transactions subject to regulations on
transferpricing.
The GTB may establish a special regime for determining notional profts derived from
import or export operations concerning goods for which a notorious international price
in a transparent market can be determined. This regime will be optional and applicable
during a period of not more than three years (counted for fscal years closing after the
date the regime becomes in force).
The rule of wholesalers price as residual criterion
In the case of import and export operations not contemplated in Chapter VII of Title
4 of the 1996 CTC in connection with transfer pricing, the Uruguayan source income
will be determined considering the FOB or CIF value of the goods being imported
orexported.
However, when no price has been fxed or when the price stated does not conform to
prices prevailing in the international market, such income will be determined in the
form to be established in the detailed regulations.
U
Such detailed regulations adopted the criteria followed to date in connection with the
wholesalers price rule. Such price will be the wholesalers price prevailing in the place
of origin of the goods (in the case of imports) or in the place of destination (in the case
of exports), plus certain comparability adjustments. Should this price not be known to
the public, or should there be doubts about its applicability to the same or to similar
goods being imported or exported, or some other reason hindering comparison, the
Uruguayan source income will be calculated taking into account proft ratios obtained
from independent enterprises engaged in identical or similar activities.
7204. Legal cases
There have been practically no transfer pricing issues submitted to administrative or
legal jurisdictions. This trend is expected to change once the transfer pricing regime is
put into practice.
To date, few verdicts of the Court on Administration Matters (CAM) concern transfer
pricing issues.
Verdict 8/982 issued in February 1982:
This verdict defnes economic group and determines the tax effects regarding this
fgure. The court refers to the concept of economic group as the union of several
legal entities dominated by one of those entities or by the same group of individuals,
which under private law will be independent taxpayers. As such group has the purpose
of transferring profts, or at least leads to this result in most cases, so as to cause the
related loss of tax revenue to the GTB, tax law regards them as one single group for
tax assessment purposes, assigning the total tax debt to any of its components or
redistributing the profts to adjust them to what each of the group members would
have obtained if they were independent entities. More recently, in Verdict 149/997
of 17 March 1997, the court ratifed the concept of economic group in terms of the
1982verdict.
Case: Philips Uruguay S.A. (Verdict issued on 19 February 2005):
The Uruguayan subsidiary had entered into a general services agreement with its
shareholder located in The Netherlands, comprising the following services: commercial
advisory; accounting advisory; and audits regarding fnancial, fscal and social matters
for a consideration computed at 1.75% on the local sales revenue. The amounts
paid for this concept had been deducted by the taxpayer in its business income tax
return. The GTB questioned such tax deduction for years 1997 and 1998, alleging
that the services lacked adequate documentation support and that they were neither
indispensable nor reasonable for generating taxable income. The CAM, however,
decided in favour of the taxpayer for various reasons. Regarding the reasonableness
of the amount deducted by the taxpayer, the court explicitly recognised the OECD
Guidelines as valid criteria for fxing the transfer prices between related parties, in the
context of regulations not providing any specifc rules on this issue.
Case: Milagro S.A. (Verdict 688 issued in October 2006):
In this case the GTB questioned the selling price of certain export transactions made by
the taxpayer during 1996 and 1997, on the basis of the wholesalers price rule among
other rules established in the aforementioned Article 19 of Decree 840/988. Applying
this rule, the GTB determined the income of the Uruguayan source on the basis of
the wholesalers price at destination (The Netherlands, in this case), overtaking the
prices stated in the custom clearance documentation by prices indicated in the listings
Uruguay
submitted by the Uruguayan Embassy in The Netherlands. Again, the CAM favoured
the taxpayer in its verdict. While the arguments used as a basis for the decision are not
clearly stated, the verdict is the frst local jurisdictional precedent of the wholesalers
price rule.
As a rule, the burden of proof lies with the tax authority (GTB) unless the operations
involve countries or regimes of low or nil taxation.
The law presumes that transactions with related parties are made at market values,
unless the GTB can provide trustworthy proof that the transactions have not been
priced at such values. Conversely, in the case of transactions with countries or regimes
of low or nil taxation (either domestic or international), the law presumes that such
transactions do not comply with the arms-length principle and therefore should
beadjusted.
However, recent changes have been introduced by the GTB regarding transfer pricing
documentation requirements. Consequently, the taxpayers should endeavour to show
that their determinations of transfer pricing are consistent with the arms-length
principle, regardless of where the burden of proof lies.
The GTB launched intense tax audit proceedings, focused within the large
taxpayersdivision.
Although the new regulations on transfer pricing were not applicable until 2007,
there were cases in which the GTB set forth its allegations questioning the structures
adopted by the taxpayers, on the basis of current regulations on economic substance.
Many of these cases were closed under mutual agreement with the GTB, with the
corresponding tax amounts being restored along with related fnes and interest
charges. In some of the cases, the administration had accepted presentation of the
documentation on transfer pricing studies as a form of justifying the pricing policy
adopted by the taxpayer in the structures used. Tax audits are carried out by the audit
department of the GTB after tax returns are fled. Tax audits are carried out on a
sampling basis; therefore, from the taxpayers perspective, they are unpredictable. Tax
audits start with a formal communication of the inspection. A request for information
setting forth a series of questions is delivered to the taxpayer.
As a general rule, the taxes are self-assessed by the taxpayer, but the GTB has far-
reaching authority for fscal investigation and verifcation. For example, the GTB may
require taxpayers to show their books and records, including documentation fles
and business correspondence, either of their own or kept for third parties; require
the taxpayers appearance at the administrations authority to provide information;
or perform tax audits of real estate and chattel properties held or occupied by
thetaxpayer.
The proceedings are in writing, both for the presentations made by the taxpayer
and the tax auditor. These are documented in minutes, which should be signed by
bothparties.
U
Regarding transfer pricing, it must be noted that the GTB may use the information
obtained in its audit as secret comparables. Expressly, the law states that the tax
secrecy rule set in force as a general principle in the tax code will not apply to the
information related to third parties that might be necessary for determining the
transfer prices, whenever the administration needs to submit such information as proof
before the court or in administrative proceedings (see Section 7209).
Once the circumstances giving rise to the tax obligation take place, the administration
makes its tax assessment through an Act of Determination, which may be appealed
by the taxpayer within a term of 10 days after the date the respective notifcation
isserved.
The resources available for the taxpayer are: the Appeal for Reversal submitted to the
GTB and the Appeal to Executive Authority submitted to the Executive Power (to which
the GTB reports).
Should the Executive Power defnitively confrm the Act of Determination appealed,
or should it fail to issue a pronouncement within a term of 200 days after the date
the appeal is presented, the taxpayer may bring an Action for Annulment at the CAM
within 60 days after confrmation (either tacit or expressed). The CAM will proceed to
confrm or annul the act impugned by means of a verdict, which is defnitive in nature.
It is worth mentioning that the CAM is an independent court written in the
Constitution of Uruguay, which is competent to judge on the legality of all the acts of
the administration.
The actions of fling, performing proceedings and resolving administrative resources
submitted to the executive authority and the action for annulment are not subject to
prior payment of taxes or related punitive charges.
With the introduction of the new rules, specifc penalty provisions for transfer pricing
have not been established, while the general rules are also applicable.
In a normal case, when a taxpayer is in default, a fne of 20% of the tax underpaid and
interest will be charged on such tax underpaid, calculated from the original due date.
In some cases, this fne can be reduced. The rates at which this interest accrues are
published, but in general they are close to, but higher than, ordinary bank rates.
Examples of more severe sanctions include tax fraud both as an infringement
(punished with a fne of between one and 15 times the amount of the fraudulent tax
omission or attempted omission) and as a criminal act (subject to an imprisonment
penalty of between six months and six years). In both cases, the behaviour subject
to punishment is confgured by deceit or deceitful concealment with the purpose of
creating an undue fscal beneft.
Any interest or penalties paid are not tax-deductible.
Uruguay
As mentioned above, the administration has broad faculties for investigation and
therefore can resort to various sources of information.
Law 18,083 introduces changes on the matter of secrecy of the administrations
proceedings. The tax code establishes that the tax administration and the staff
members reporting thereto are obliged to keep all information resulting from their
administrative or judicial proceedings confdential. The secrecy of the proceedings
may be lifted only by means of a duly founded resolution of a judge. However, Law
18,083 has changed the secrecy rule for the area of transfer pricing, adding that
the secrecy of the proceedings will not be applicable in connection with third-party
information that might be necessary for determining the transfer prices when the
administration must offer such information as evidence in cases brought to court or
administrativejurisdiction.
In conclusion, the administration may use secret comparables as a means of proof for
justifying the prices it has determined.
Following the OECD Guidelines, the use of comparable information is essential for any
analysis concerning the transfer pricing issue. Regarding local fnancial information,
the following rules should be taken into account:
1. Enterprises are obliged to fle their fnancial statements with the Registry of the
National Internal Audit Bureau only when they show total assets in excess of the
equivalent of USD 700,000 at the fnancial year-end or net operating revenue
during that year in excess of the equivalent of USD 2.2 million. While this
information is available for any interested party, its usefulness as comparables is
subject to the degree of detail of such information;
2. Large taxpayers (classifed as such in the large taxpayers division) must submit
fnancial statements accompanying their tax returns. In this case, a full audit report
is required; and
3. In the rest of the cases, fnancial statements must include a professional report
issued by an independent accountant when total assets shown are approximately in
excess of the equivalent of USD 150,000.
There are no transactions or industries that are excluded from the scope of the
transfer pricing legislation. Taking into account that if a particular industry or issue
has come to the attention of the fscal auditor, the tax authority is likely to use the
information and experience gained in dealing with one taxpayer in investigating other
similartaxpayers.
U
The Uruguayan taxation system continues adopting the source principle as the general
criteria of taxability empowerment, and therefore does not recognise taxes paid abroad
as creditable against taxes in Uruguay.
To avoid double taxation on income and on equity, Uruguay signed agreements with
Germany in 1987 and with Hungary in 1993. During 2009, Uruguay signed agreements
with Mexico, Spain and Portugal (all three not in force yet), and it is negotiating 12
additional treaties.
Aligned with the OECD Guidelines, agreements adopt the concept of related parties
and the arms-length principle. These agreements foresee the possibility of establishing
mutual agreement procedures between the competent authorities of each country in
order to avoid taxation that is not within the scope of the agreement. Notwithstanding
the open legal possibility of such agreements, there is no practical experience on
thisregard.
The GTB may execute APAs with taxpayers, which must be signed before performing
the transactions under analysis and that may not exceed the term of the three
succeeding fscal years.
The GTB will establish the conditions and formalities required for subscribing such
agreements. Up to the date, such requirements have not been issued.
Given the recent approval of the transfer pricing rules, some GTB resolutions are
expected in order to clarify how this regime will be implemented.
While the GTB resolutions are issued for internal use of its own staff, the material is
available to the public. These resolutions enable the taxpayer to gain knowledge about
the interpretation criteria of the GTB on the current tax legislation.
In a similar way, it is expected that new tax-binding consultations will be published in
the near future.
Recent experience suggests that exchange of information between GTB and the custom
authority does occur. Nevertheless, there is no prescribed approach for the use of
certain information of one area in the other area (e.g. transfer pricing analysis for
customs purposes).
Uruguay
7216. OECD issues
Uruguay is not a member of the OECD. Nevertheless, the OECD Guidelines on transfer
pricing constitute international points of reference for this subject. Their infuence in
Uruguay has been signifcant to the extent that effective from year 2005, the CAM has
considered these guidelines as valid directives for quantifying the transactions between
related parties.
Law 18,083 does not explicitly mention the adoption of the OECD Guidelines, but the
regulations in the law have conceptually followed some of them.
In theory, Law 18,083 foresees the possibility of carrying out contemporary tax audits
with foreign tax authorities, but these appear hardly probable in practice. Joint tax
audits are only contemplated for the few states having bilateral agreements signed with
Uruguay providing for sharing information between the respective fscal authorities.
Thin capitalisation is not considered the separate category by Uruguayan internal
tax legislation that it is in other legislations. Notwithstanding there are (1) specifc
regulations on liabilities and interest, (2) specifc provisions included in the bilateral
agreements; and (3) regulations on the treatment of partners accounts in partnerships
and head offce accounts in branches, which regulate the subject.
In general, tax legislation allows companies to be fnanced through equity or debt
without restrictions. However, it contains certain rules (as mentioned) that discourage
debt fnancing in some cases, by way of restraining deductible liabilities for capital tax
purposes and deductible interest for income tax purposes. Particularly, Law 18,083
states that interest paid abroad will be deductible (subject to the mentioned other
rules) provided they are taxable under the income tax on non-residents or under an
effective income taxation imposed abroad. Should they be levied under those taxes at
an overall rate of less than the Uruguayan income tax on economic activities rate (i.e.
25%), their deduction for local income tax purposes will be proportional.
Law 18,083 does not include special regulations on the treatment of management
services in the area related to transfer pricing. The methodology proposed by the law,
and then defned by the regulatory decree, should be applied to operations of any kind.
Payments abroad for the concept of management services are tax-deductible provided
they are taxable under the income tax on non-residents or under an effective income
taxation imposed abroad. Should they be levied under those taxes at an overall rate
of less than the Uruguayan income tax on economic activities rate (i.e. 25%), their
deduction will be proportional.
Uzbekistan
73.
U
Uzbekistan
7301. Introduction
Prior to 1 January 2008, tax legislation (the old tax code) contained a provision for tax
treatment of transactions between related parties.
The new edition of the Uzbek Tax Code introduced from 1 January 2008, did not
contain transfer pricing provisions.
According to recent changes to the tax code effective 1 January 2010, transfer pricing
rules were reintroduced in Uzbekistan. TP rules are established for transactions
between related parties.
Related parties are defned as legal entities that fall under one or more of the following;
they are:
Registered in Uzbekistan, and their shareholders (participants, members) are
foreign legal entities;
Of foreign states, and their shareholders (participants, members) are legal entities
registered in Uzbekistan; and
Registered in Uzbekistan and legal entities of foreign states that have the same
shareholders (participants, members).
In particular, if related parties in their operations use prices different from the prices
that would be used between unrelated entities, the tax authorities have the right to
adjust such prices.
However, the effective tax legislation does not provide any further guidance on the
application of these rules, and these rules are not yet enforced in practice.
Customs authorities usually challenge taxpayers from a transfer pricing perspective for
customs payment (customs duty, excise and VAT) purposes.
Not applicable.
Not applicable.
International Transfer Pricing 2011 Uzbekistan 823
Uzbekistan
7304. Legal cases
There are no known legal cases. Application of court practice in tax disputes is not
developed in Uzbekistan.
Not applicable.
Not applicable.
Not applicable.
Not applicable.
Not applicable.
There is very limited publicly available information on pricing, except for
consumergoods.
Not applicable.
Uzbekistan has effective double tax treaties with 44 countries. However, Uzbek tax
authorities have limited practice in the application of double tax treaties. There are no
known cases of treaty application to transfer pricing issues.
Not applicable.
There are no known or expected developments in this area.
Uzbekistan 824 www.pwc.com/internationaltp
U
The customs code contains pricing rules that allow the customs authorities to adjust
the declared import or export value of cross-border transactions for customs payment
(customs duty, excise and VAT) purposes.
These rules are well described and used in practice. More specifcally, they include
instruction for how the adjusted price can be determined for customs purposes. The
Uzbek customs authorities may use any of six methods available, including the method
of data on comparable goods and services.
7316. OECD issues
OECD interpretations are not applied in Uzbekistan because of the lack of practice on
application of OECD Guidelines by the tax authorities.
Not applicable.
Current Uzbek legislation does not provide for any thin capitalisation rules.
Because of the absence of transfer pricing practice, pricing of management services is
not normally questioned by the tax authorities. However, deductibility of such costs for
income tax purposes may be challenged if substance or documentation is questioned.
Venezuela
74.
International Transfer Pricing 2011 825 Venezuela
7401. Introduction
Venezuela experienced signifcant tax reform in 2001, especially in the area of
transfer pricing. In October 2001, the 1994 Edition Venezuelan Tax Code (COT) was
updated. The 2001 COT establishes several transfer pricing principles, including
penalties relating to noncompliance with transfer pricing regulations, specifc
rules for transfer pricing audit procedures and the introduction of advance pricing
agreements (APAs) to the Venezuelan tax system. Additionally, in December 2001,
Venezuela enacted new transfer pricing regulations under the Venezuelan Income Tax
Law. The new Venezuelan transfer pricing rules adopt the arms-length standard for
related party transactions, adhere to the OECD Guidelines, eliminate the safe harbour
regime established during 1999, impose transfer pricing documentation and fling
requirements and contain APA provisions. With these newer transfer pricing rules,
Venezuela has taken an important and positive step towards the harmonisation of its
tax system with the internationally accepted standards. Moreover, in February 2007,
Venezuela introduced thin capitalisation rules to its Income Tax Law.
The newer transfer pricing rules came into force on 28 December 2001. The provisions
are applicable to all fscal years initiated on or after 1 January 2002. The newer
transfer pricing rules are based on the internationally accepted arms-length standard,
and thus eliminate the previous safe harbour approach that specifcally aimed at two
types of transactions: importing and exporting conducted by multinationals with their
Venezuelan affliates.
Related parties are defned as parties that are directly or indirectly managed,
controlled or owned by the same party or group of parties; intermediary agents;
and any relationship between a Venezuelan taxpayer and entities located in low-
tax jurisdictions (i.e. a country included in the list of tax havens). The arms-length
standard applies to all transactions, including transfers of tangible and intangible
property, services and fnancial arrangements.
A controlled transaction meets the arms-length standard if the results of the
transaction are consistent with the results that would have been obtained
if uncontrolled taxpayers had engaged in comparable transactions under
comparablecircumstances.
V
Venezuela 826 www.pwc.com/internationaltp
A controlled transaction may be compared to an uncontrolled transaction if that
transaction complies with at least one of the following conditions:
None of the differences, if any, between compared transactions or between
companies that carry out the compared transactions will materially affect the price
or margin in the free market; and
Reasonably accurate adjustments may be made to eliminate the material effects of
these differences.
The factors required to determine the differences between controlled and uncontrolled
transactions, in accordance with the method used, are the following:
The characteristics of the transactions;
The functions or activities, including the assets used and risks assumed in the
transactions, of each of the parties involved in the transactions;
The contractual terms;
The economic circumstances; and
The business strategies, including those related to the penetration, permanence
and expansion of the market.
The transfer pricing methods specifed in the 2001 Venezuelan Income Tax Law are
basically the same as those contained in the OECD Guidelines:
Cost plus method;
In terms of selection of the method, the taxpayer is required to consider the
comparable uncontrolled price as the method of frst choice. The tax authorities will
evaluate whether the method applied by the taxpayer is the most appropriate one
given the characteristics of the transaction and the economic activity performed.
The Venezuelan tax administration (SENIAT) is entitled to make an adjustment if a
taxpayer fails to comply with the transfer pricing provisions.
Documentation
Transactions and arrangements with foreign related parties must be reported to the
tax authorities through an informative transfer pricing return, which must be fled
within six months following the end of the fscal year. This informative transfer pricing
return must illustrate the types of inter-company transactions, the dates on which the
transactions were celebrated, the amounts of each type of transaction, the transfer
pricing method applied, and the result of each transaction (i.e. proft or loss). Further
appendices require the taxpayer to disclose a related and unrelated party segmentation
of the proft and loss statement.
Moreover, the taxpayer must develop and maintain a transfer pricing study to
document the analyses of its inter-company transactions. The Venezuelan rules
also require an extensive list of transfer pricing documentation (background
documentation) that includes, among others, the following items:
International Transfer Pricing 2011 Venezuela 827
Venezuela
An analysis of fxed assets and the commercial and fnancial risks related to the
transaction, including documentation to support the acquisition and use of assets;
An organisational and functional overview of the taxpayer, including information
about the relevant departments and/or divisions, strategic associations and
distribution channels;
Information regarding the foreign related parties, including type of business, main
clients and shareholdings in group companies;
An overview of the controlled transactions, including activities carried out, dates,
prices paid or charged and the applicable currency;
Information on the main activities carried out by each of the relevant group
companies as well as data on any changes affecting the group as a whole, such as
capital increases or mergers;
Financial statements for the taxpayers fscal year, prepared according to generally
accepted accounting principles, including balance sheet, income statement,
stockholders equity statement and statement of cash fow;
Agreements, conventions or treaties entered into between the taxpayer and foreign
related parties, including agreements pertaining to distribution, sales, credits,
guarantees, licences, know-how, use of trademarks, copyrights, industrial property,
cost allocation, research and development, advertising, trusts, stock participation,
investments in securities, and other transfers of intangible assets;
The method or methods used to set the transfer prices, indicating the criteria and
objective elements considered to determine that the method used is the most
appropriate one;
Information regarding the operations of the uncontrolled comparable companies;
Specifc information as to whether foreign related parties are or were subject to a
transfer pricing audit or if they are involved in procedures by the transfer pricing
competent authority or a court. Should a resolution be issued by competent
authorities or any fnal verdict issued by the courts, a copy of the fndings must be
fled; and
Any other information that may be deemed as relevant or required by the Tax
Administration.
7403. Legal cases
No transfer pricing cases have yet been brought to the courts. Transfer pricing audits
began in February 2005 and have been expanding since then, both in the number of
audits performed and in the scope of their requirements. Initially, the SENIAT visited
several taxpayers requiring the transfer pricing support documentation detailed in
these pages, and the Tax Administration usually gave the taxpayers a three- to fve-day
period to submit the required information.
In July 2006, the SENIAT conducted the frst extensive transfer pricing audit, of a
local subsidiary of a global Japanese automotive company. The SENIAT explained that
the audit procedure was applied to control the transactions among the Venezuelan
taxpayer and its foreign related parties, to ensure that such transactions were
conducted at arms length. SENIAT, acting under the guidelines of the Zero Tax
Evasion Plan, ensured that tax collection in this matter was not reduced as a result of
illicit acts.
By the end of 2006, SENIATs tax audit manager announced the reinforcement of the
Zero Tax Evasion Plan regarding transfer pricing audits, changing its previous focus
on formal documentation compliance (whether the taxpayer has it) to a thorough
V
audit of the arms-length nature of the inter-company transactions that were detected
by SENIATs computerised system. Moreover, he stated that SENIATs transfer pricing
unit would be expanded and certain tax inspectors would be relocated from the
economic studies section to the tax audits management.
Consequently, a few weeks after that announcement, the SENIAT notifed the local
affliate of an global oil and gas foreign company that a transfer pricing adjustment of
USD 17.7 million was assessed by the transfer pricing unit using its databases, studies
and analyses. This was the frst transfer pricing adjustment in Venezuela, and it related
to certain fnancial transactions of the Venezuelan taxpayer involving its foreign related
parties. In addition, SENIATs head offcer had warned that the transfer pricing audits
were going to be reinforced and would focus on the oil and gas industry.
In April 2007, the local affliate of the oil and gas foreign company accepted part of
the transfer pricing adjustment proposed by the SENIAT and paid USD 13.7 million,
concluding the frst transfer pricing case in Venezuela.
During 2007 and 2008, the audit activity in the oil and gas business and related sectors
in Venezuela continued as part of the migration of operating agreements and strategic
associations of the Orinoco Oil Belt to mixed companies. The main issue in these audits
was the transactions carried out with related parties abroad.
Since the beginning of 2009, SENIAT has carried out several transfer pricing audits of
taxpayers from several industry sectors and concluded some audits with adjustments
to taxpayers, including the automotive, pharmaceuticals and consumer goods
companies. Transfer pricing adjustments exceeded USD 25 million in 2009; the main
issues rejected were tax deductions and the calculation of the arms-length ranges.
Other items reviewed by the Tax Authority within audits included fnancial segmented
information, supports related to services, shut-down costs, restructuring expenses,
idle capacity and selection criteria of comparable companies in the application of the
transactional net margin method.
The burden of proof lies with the taxpayer. However, a challenge by the SENIAT would
require adequate supporting evidence if such a challenge is to be accepted by the
taxcourts.
Any transaction between a Venezuelan taxpayer and an entity located in a low-tax
jurisdiction will automatically be presumed to be a transaction with a related party and
will also be considered not to take place at arms length. In such cases, the taxpayer has
the burden of proof, and it will be necessary to demonstrate either of the following:
The counterparty to the transaction was an independent third party; and
If the counterparty to the transaction is a related party, the transaction was carried
out at arms length.
Venezuela
The COT establishes specifc rules for transfer pricing audits:
When a tax objection is made by the SENIAT during a transfer pricing audit, the
taxpayer may either accept the objection and settle with the Tax Administration
or start summary proceedings to defend its position. The taxpayer has more time
to submit the defence documents and call for proofs than in a regular summary
proceeding: fve months rather than 25 days;
Within the frst 15 days of the summary proceeding, the taxpayer may name a
maximum of two representatives to evaluate the information gathered by SENIAT
regarding the related party transactions. Such representatives may be replaced
once; and
The period for furnishing proofs is the same as for a regular proceeding with
SENIAT: 30 days at the maximum. SENIAT has a two-year period to make a
decision about the transfer pricing audit once the period of negotiation and
information exchange is over.
The COT specifes three types of situations where penalties might arise:
Various noncompliance issues relating to fling and documentation requirements;
The illegitimate reduction of the taxable income because of action or omission of
the taxpayer. The penalty ranges from 25% to 200% of the tax omitted; and
Fraud on the part of the taxpayer. This attracts a jail sentence of between six
months and seven years. The sanctions established on the COT are summarised in
the table opposite.
At present, the SENIAT has a transfer pricing department and provides transfer pricing
training to its tax professionals to prepare them for the transfer pricing audits.
Comparable information is required to support the arms-length nature of related party
transactions and should be included in the taxpayers transfer pricing documentation.
However, there is very little reliable fnancial information publicly available on
Venezuelan companies. Therefore, reliance is placed on foreign comparables.
The SENIAT has the power to use third-party confdential information. The taxpayer
has limited access to this data through its two nominated representatives, who are then
personally liable to criminal prosecution if the data is disclosed.
V
Type Of Illicit
Situation Cot Article Legal Assumption
Sanction (Tu)*
Minimum Medium Maximum
Formal 103
Filing Issues
1. No ling of returns that
include the determination
of taxes.
2. No ling of other returns
or communications.
10 30 50
3. Late or incomplete ling
of returns that include the
determination of taxes.
4. Late or incomplete
ling of other returns or
communications.
5 15 25
104
Control
Obstructions
10. Not using the
methodology established in
the Venezuelan Income Tax
Law in regard to transfer
pricing.
300 400 500
105
Information
and
Appearance
Issues
1. Not submitting
information in regards to the
taxpayers own transactions
or related third parties.
10 105 200
3. Submitting false or wrong
information.
10 30 50
Last paragraph: the
revealing, divulging,
personal use, infringement
or adverse use or
information submitted by
independent third parties,
that affects or may affect
its competitive position in
transfer pricing matters,
made by any person,
without prejudice of the
disciplinary, administrative,
civil or penal responsibility.
500 1,250 2,000
Material 111
Tax Liability
Issues
Illegitimate reduction of the
taxable income because of
action or omission.
25% 200% of the omitted tax
Venezuela
Type Of Illicit
Situation Cot Article Legal Assumption
Sanction (Tu)*
Minimum Medium Maximum
Sanctioned
With Jail
Punishment
116
Tax Fraud
Inducing in error the Tax
Administration by means of
cheating, resulting an unjust
enrichment.
6 Months to 7 Years
Hiding of investments in
low-tax jurisdictions.
The aforesaid punishment
increased by 1/2 to 2/3
119 The revealing, divulging,
personal use, infringement
or adverse use of
condential information
submitted by independent
third parties, that affects or
may affect its competitive
position, made by any
person, by any means,
without prejudice of the
disciplinary, administrative,
civil or penal responsibility.
3 Months to 3 Years
*TU: tax unit (approximately USD 15)
No substantial basis yet exists for identifying any particular industry sector or type
of transaction as being especially at risk. Nevertheless, the SENIAT is conducting
investigations on some taxpayers in sectors that show high proftability or growth
such as energy, oilfeld services, automotive, pharmaceuticals, consumer goods and
fnancial services, among others.
If a relevant tax treaty exists that contains provisions for mutual agreement procedures,
it is very likely that these procedures would be used to avoid doubletaxation.
The COT enables the Tax Administration to approve or reject APAs and establishes the
formal rules governing the APA application procedure. This procedure includes a list of
the various documents that must be provided along with a taxpayers application.
The taxpayer should present a proposal to the SENIAT for the valuation of one or more
transactions, providing evidence that such transactions comply with the arms-length
standard. The proposal should be prepared by the taxpayer and should be based on an
accepted transfer pricing methodology. The SENIAT can determine the format of the
documents to be provided by the taxpayer in the proposal. The APA proposal can be
bilateral in cases involving the territories of tax treaty partners.
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The APA process must be concluded by the end of the third year after the year of
application. This period may be extended if the APA is being negotiated through a
competent authority procedure under a double tax treaty.
Either party may terminate the APA application process if commercial or operational
changes occur in the assets, functions or risks of the relevant parties.
The SENIAT may terminate the APA if it concludes that fraud was committed or false
information was provided in the APA proposal. The SENIAT may terminate an APA
in the event of noncompliance with the agreed terms and conditions. If the SENIAT
rejects an APA application, a taxpayer cannot seek any of the administrative remedies
included in the COT or other law. The only course of action available is to initiate a new
APA application.
7412. Anticipated developments in law and practise
In early 2007, the National Assembly approved an enabling law that allows the
government to legislate and speed the reform and implementation of many special
laws, including income tax law, value added tax law, fnancial administration law,
banking sector law, and insurance sector law, among others.
The SENIAT has the same level of authority as the National Customs Intendant.
In some recent customs duties audit procedures, the feld examiners requested
the taxpayers information and documentation regarding transfer pricing, and
there is an increasing coordination and information exchange between the tax and
customsauthorities.
7414. OECD issues
Venezuela is not a member of the OECD. However, the Venezuelan tax authorities have
adopted the arms-length standard and the use of the methodologies endorsed by the
OECD Guidelines.
Joint investigations with the tax authorities of tax treaty partners are possible.
Currently, Venezuela has an important network of tax treaties with countries such
as Spain, France, Italy, the UK, Germany, the Netherlands, Switzerland, Portugal,
Sweden, the Czech Republic, Trinidad and Tobago, Norway, Mexico, and the US,
among others. Most of the Venezuelan tax treaties follow the OECD model and
itsGuidelines.
On 16 February 2007, the partial reform of the Venezuelan Income Tax Law included
the Article 118 to introduce thin capitalisation rules. These rules state that the interest
paid directly or indirectly to related parties will be tax-deductible only if the amount of
Venezuela
the debts with the related parties (directly or indirectly received) plus the debts with
independent parties does not exceed the amount of the taxpayers equity. This debt-
equity ratio of 1:1 is the strictest in Latin America, where most of the countries require
a 3:1 ratio.
Moreover, to determine if a debt was received at arms-length conditions, the tax
authorities will consider (1) the level of debt of the taxpayer, (2) the possibility that
the taxpayer could have obtained the loan from an independent party without the
intervention of a related party, (3) the amount of debt that the taxpayer could have
obtained from an independent party without the intervention of a related party, (4) the
interest rate that the taxpayer would have obtained from an independent party without
the intervention of a related party; and (5) the terms and conditions of the debt that
the taxpayer would have obtained from an independent party without the intervention
of a related party.

Vietnam
75.
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Vietnam
7501. Introduction
Vietnam has been carrying out economic reforms since 1986 under the Doi Moi
(Renovation) policy, which focuses on market-oriented economic management.
This reform has included: (1) restructuring to build a multisector economy; (2)
fnancial, monetary and administrative reform; and (3) the development of external
economicrelations.
One of the most important aspects of economic reform in Vietnam has been the
encouragement of domestic and foreign private investment with the introduction of
the Law on Foreign Investment in 1987. The frst tax law was introduced in the early
1990s. Since then the tax system has been subject to various changes and amendments.
Transfer pricing issues have been addressed and dealt with in different forms (such
as setting a cap on royalty rates, interest rates, etc.). The frst proper transfer pricing
regulations were introduced at the end of 2005 and came into force in 2006.
Below is a summary of the historical evolution of transfer pricing regulations
in Vietnam, which refects not only the Vietnamese competent authorities
increasing concerns about transfer pricing issues, but also the progress of their
awarenessthereon.
On 29 December 1997, the frst Vietnamese transfer pricing regulations were
promulgated with Circular 95/1997/TT/BTC (Circular 95) by the Ministry of Finance
(MOF), which provided the guidelines for the implementation of double tax treaties.
Pursuant to related party transactions defned in Article 9 Associated Enterprises
included in double tax agreements (DTAs) concluded with other countries, Circular
95 allowed Vietnamese tax authorities to make adjustments to transfer prices of
related party transactions in order to ensure the fairness of the taxable proft under
Vietnamese jurisdiction. However, Circular 95 did not specifcally stipulate the transfer
pricing methods or the documentation requirements.
Four years later, the MOF issued Circular 13/2001/TT-BTC (Circular 13) on 8 March
2001 to provide guidelines on the implementation of the Law on Corporate Income
Tax applicable to foreign-invested enterprises. This circular specifed three traditional
transfer pricing methods applicable to the determination of the arms-length nature of
related party transactions as follows:
Cost plus method.
International Transfer Pricing 2011 Vietnam 835
Vietnam
However, Circular 13 did not provide detailed guidelines on the application of the
statutory methods or guidance on documentation requirements.
The Law on Business Income Tax (the BIT Law) issued in 2003, which came into force
on 1 January 2004, requires all transactions between related parties to be conducted at
market prices (the arms-length principle).
Pursuant to the BIT Law, the MOF issued Circular 117/2005/TT-BTC (Circular 117)
to provide guidelines on related party transactions and disclosure of documents and
information thereof. Circular 117 also specifes fve transfer pricing methods applicable
to the determination of the arms-length nature of related party transactions as follows:
Comparable proft method (CPM); and
Proft split method (PSM).
There is no preferred method. Taxpayers can select the most appropriate method for
the respective transaction.
Circular 117 came into force in 2006 and is applicable to cross-border and in-country
related party transactions. On 22 April 2010, the MOF issued Circular 66/2010/TT-BTC
(Circular 66), replacing Circular 117. Circular 66 came into force on 6 June 2010.
Similar to the Circular 117, Circular 66 retained the main compliance requirements (i.e.
requiring corporate taxpayers to comply with the arms-length principle, submission of
annual transfer pricing declaration form, and maintaining contemporaneous transfer
pricing documentation). However, Circular 66 also introduced several changes which
tightened the transfer pricing requirements. For example, the circular clarifes that the
median value of an interquartile range will be used to benchmark against companies
margins for the purposes of transfer pricing adjustments, and greater information is
required to be disclosed in the annual transfer pricing declaration form (new categories
of related party transactions, nature of related party relationships, related party
addresses and tax codes are now required).
At present, Circular 66 is considered the most comprehensive transfer pricing
regulation in Vietnam.
From a technical viewpoint, the Vietnamese transfer pricing regulations under Circular
66 are modelled on the OECD Guidelines. Indeed, Circular 66 adopts the arms-length
principle and the transfer pricing methods set out in the OECD Guidelines.
Scope of application (Part A, Article 1 and 2)
Persons covered
The provisions of Circular 66 are applicable to organisations that are subject to BIT in
Vietnam and are carrying out business partly or wholly in Vietnam with related parties.
Vietnam 836 www.pwc.com/internationaltp
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Transactions covered
Any transaction which is carried out between related parties (e.g. buying, selling,
exchanging, leasing, renting, transferring or concession of goods or services) may
come under the scope of Circular 66. However, related party transactions involving
products whose price is placed under state control are excluded from the scope of the
said circular.
The defnition of related parties in Circular 66 is much broader than that of the OECD
Model. First, the threshold of capital participation of 20%, either directly or indirectly,
is much lower than that set out in many other countries.
However, the defnition of related parties goes beyond ownership/control criteria. It
also includes signifcant business relationships between unrelated parties. For example,
when a Vietnamese companys sales or purchases of materials from an entity exceed
50% of the total sales or purchases, these transactions are regarded as related party
transactions.
The related party defnition also extends to intangible assets/intellectual property and
company fnancing. For example, parties are considered as being related when:
An enterprise uses intangible assets/intellectual property provided by another
party that accounts for more than 50% of its production costs; and
An enterprise guarantees the other enterprises loans, or makes a loan to the other
enterprise where the loans account for at least 20% of the charter capital of the
borrower and more than 50% of the total liabilities of the borrower.
The extension of the related party defnition under Circular 66 has rendered many
parties, which would otherwise be considered as unrelated, to be classifed as related
parties for Vietnam transfer pricing purposes.
Under Vietnamese transfer pricing regulations, parties with any of the following
management or business relationships would also be considered related:
One party is directly or indirectly engaged in the management, control,
contribution of capital to or investment in the other party;
The parties are directly or indirectly subject to the management, control, capital
contribution or investment in all forms by another party;
The parties directly or indirectly participate in the management, control, capital
contribution or investment in another party;
Over 50% of any single product of one party is purchased by the other party, or over
50% of the production materials of any single product of a party are provided by
the other party; and
Two parties have entered into a business cooperation agreement on a
contractualbasis.
Similar to the OECD Guidelines, Circular 66 also contains guidelines on the following
four key subjects: comparability analysis, transfer pricing methods, selection and
application of the most appropriate method, and documentation.
Vietnam
Comparability analysis
Part B, Article 4 of Circular 66 has detailed guidance with respect to the comparability
analysis. When comparing a related-party transaction against a comparable unrelated-
party transaction, a comparability analysis must be carried out and adjustments made
(if necessary) to the following four main infuential factors:
Product property/characteristics;
Operational functions;
Economic terms in which the transactions take place.
The priority given to each of the above factors in the comparability analysis varies
depending on the most appropriate transfer pricing method selected. Under the
comparability analysis, the factors that are considered to be the main infuential factors
need to be analysed in detail, while the auxiliary factors should be analysed only at a
high level.
Part B, Article 5 of Circular 66 sets out fve transfer pricing methods to be used for
determining the arms-length price. Basically, these methods are a reproduction of the
transfer pricing methods specifed in the OECD Guidelines.
Furthermore, the Vietnamese transfer pricing regulations recommend that preference
be given to the comparison of the transfer price or proft margin of transactions
with related parties against those with unrelated parties of the same taxpayer
(internalmethod).
Selection and application of the most appropriate method
CUP selected as the most appropriate method
In accordance with Circular 66, the CUP method can be considered appropriate under
either of the following two main conditions:
Where no difference in transactional conditions could have a signifcant material
impact on the price of the product; and
Where any such difference has been eliminated.
In practice, current Vietnamese transfer pricing regulations give preference to the
application of the CUP method in the following business situations:
Where transactions involve a single product in the market;
Where transactions involve a single service, copyright or loan contract; and
Where a business establishment carries out business involving the same product
with both related and unrelated parties.
RPM selected as the most appropriate method
In accordance with Circular 66, the application of the RPM can be considered
appropriate under either of the following two main conditions:
impact on the gross proft margin over the net sale; and
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In practice, current Vietnamese transfer pricing regulations give preference to
the application of the RPM where the transaction consists of a simple distribution
process of goods or merchandise; and this process involves a short business cycle
from purchase to resale; and no commercial or industrial activity is carried out to
affect/change signifcantly the product characteristics and add signifcant value to
theproduct.
CP method selected as the most appropriate method
In accordance with Circular 66, the application of the CP method can be considered
impact on the gross proft margin over the cost of goods sold (COGS); and
In practice, current Vietnamese transfer pricing regulations give preference to the
application of the CP method in the following business situations:
Where the transactions involve manufacturing, assembling, processing or
transforming goods in order to be sold to related parties;
Where the transactions between the related parties involve performance under
a partnership or business cooperation contract for manufacturing, assembling,
fabricating, processing products, or under contracts for supplying inputs for
production and purchasing outputs; and
Where the transactions involve the provision of services to related parties.
CPM selected as the most appropriate method
In accordance with Circular 66, the application of the CPM can be considered
impact on the net proft margin; and
As the CPM is considered to be an expanded version of the RPM and CP method, the
preference given to the application of the CPM is similar to those of the RPM and
CPmethod.
PSM selected as the most appropriate method
In accordance with Circular 66, the application of the PSM can be considered
appropriate where related parties (1) participate in the research and development
of new products, (2) participate in the development of intangible property to be
monopolised, or (3) are involved in any stage of the manufacturing process (from raw
materials to fnished goods) that is associated with the ownership or use of unique
intellectual property.
Documentation
Vietnamese taxpayers are required to record and maintain contemporaneous
documentation, and to submit that documentation to the tax authorities within
30 days of their request. Transfer pricing documentation under Circular 66
shouldinclude:
Vietnam
General information on the business establishment and related parties;
The business establishments transactions; and
The methods of calculation of arms-length prices.
Further, at year-end, taxpayers are required to disclose related-party transactions
on a standard form (i.e. form GCN-01/QLT), which must be attached to the annual
BITreturn.
The taxpayer is required to use data of at least three continuous fscal years
for benchmarking purposes where transfer pricing methods involve the use of
proftmargins.
In addition to Circular 66, which specifes transfer pricing for tax purposes, the
following regulations promulgated by the MOF are also relevant to transfer
pricingissues:
In December 2003 the MOF issued a number of Vietnamese Accounting Standards
(VAS) including Standard No. 26 Related-Party Disclosures which sets out general
guidelines on the accounting principles and treatment in the fnancial statements
for related-party disclosures and transactions between a reporting enterprise and its
related parties.
This accounting standard provides a defnition of related parties, outlines possible
related-party transactions and their infuences, and specifes required disclosures with
regard to related-party transactions. Standard No. 26 also provides guidelines on the
determination of price for transactions between related parties (i.e. the CUP method,
the RPM and the CP method).
On 16 March 2007, the government also issued Decision 40/2007/ND-CP which
provides guidelines on the customs valuation for import duties in the case
where buyers and suppliers are considered related parties with respect to capital
participation, management, business relationships and family relationships.
Based on this regulation, where the buyer and the supplier are considered to be related
parties, the Customs Offce uses the following methods to determine the taxable price
of goods:
Transaction value method with identical goods: Comparison with the price of
identical goods imported into Vietnam within 60 days before or after the date
ofdelivery;
Transaction value method with similar goods: Comparison with the price of similar
goods imported into Vietnam within 60 days before or after the date of delivery;
Deductive value method: Calculation of the price of imported goods based on the
resale price of similar products after the deduction of reasonable expenses;
Computed value method: Calculation of the price of imported goods based on
material costs, production expenses and profts; and
Fall-back method: Combined or modifed version of the above methods.
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7504. Legal cases
No legal cases concerning transfer pricing have been decided by the courts to date. Any
cases involving disputes on transfer pricing issues have so far been settled out of court
and the details have not been published. In order to set examples, it is anticipated that
the tax authorities could bring cases involving abuses of transfer pricing to the courts
in the future.
In accordance with prevailing regulations in relation to transfer pricing and tax
administration, the taxpayer is obliged to satisfy the burden of proof by:
Disclosing related-party transactions on a standard form accompanied by the
annual BIT return; and
Documenting and reporting information/evidence regarding related-party
transactions and the relevant related parties in a transfer pricing document
showing that the related-party transactions are consistent with the arms-length
principle set out in the transfer pricing regulations whenever requested.
The recordkeeping and documentation requirements under Circular 66 are onerous.
The taxpayer is obliged to present transfer pricing documentation within 30 days from
the date of the request. A one-time extension of another 30 days may be accepted if it is
considered reasonable.
In accordance with prevailing tax administrative regulations under Circular No.
60/2007/TT-BTC issued by the MOF on 14 June 2007, a tax audit can be conducted
at the tax offce or at the taxpayers premises. Based on the result of the tax audit at
the tax offce, the tax authorities may decide to conduct a tax audit at the taxpayers
premises and will then issue the audit decision to the relevant taxpayer.
Tax audit procedure at the tax offce (desk review)
Tax offcials examine the tax declaration dossier fled by the taxpayer to verify
whether the tax amount assessed and declared by the taxpayer is appropriate based
on a comparison with relevant data available to the tax authorities. In the case of an
abnormality in the declared tax amount or missing information which could point
to tax evasion or tax underdeclaration, the relevant taxpayer is required to provide
an explanation and additional information/evidence within 10 days from the date of
receipt of the authorities frst request. If further information is still required by the tax
authorities, the taxpayer has fve days from the date of receipt of the second request of
the tax authorities to provide information to justify his/her tax liability assessed and
declared in the tax return.
After the second request, if the taxpayer fails to justify the appropriateness of his/her
tax liability declared either with or without additional information/explanation, the
tax authorities are entitled to:
Assess the tax liability of the taxpayer in question based on the information/data
available to the tax authorities; and
Vietnam
Issue a decision to carry out a tax audit at that taxpayers premises if the
information/data available to the tax authorities is not considered adequate to
issue an assessment of the tax liability as above.
Tax audit procedure at taxpayers premises
The execution of the tax audit must be carried out within 10 working days from the
date of the issuance of the decision to perform a tax audit at the taxpayers premises.
However, the decision on such a tax audit shall be cancelled if, before the tax audit
starts, the taxpayer can justify the appropriateness of the declared tax liability or
accepts and pays the tax amount assessed by the tax authorities.
The duration of a tax audit at a taxpayers premises will not exceed fve working days. A
one-time extension of another fve days is permissible if necessary.
At the end of a tax audit, a report must be issued describing the fact fndings and
conclusions of the tax auditor team. The taxpayer has the right to make a formal
objection to the conclusion of the tax auditor team.
If the result of the tax audit raises concerns about tax evasion or fraud, the case is
reported to the head of the relevant tax authority for further investigation and/
orinspection.
Tax inspection
In practice, tax inspections are normally conducted on the basis of an annual plan
developed by the tax authorities, except where there are signs of tax evasion and/or
fraud, or for the purpose of resolving appeals, denunciations, or at the request of the
heads of tax administration bodies at all levels or by the Minister of Finance. A taxpayer
can be subject to tax inspection not more than once per year.
Where the tax law has been infringed, a tax inspection can be conducted only if the
tax authorities have evidence of tax underpayment, tax evasion, or tax fraud, but such
action is not so serious as to be considered a criminal act.
A decision on tax inspection has to be announced to the taxpayer within 15 days from
the date of issuance. The duration of a tax inspection cannot exceed 30 days. A one-
time extension of another 30 days may be permitted under certain conditions.
At the end of a tax inspection, a report must be issued to document the fndings,
including the opinion of each inspection team member. The taxpayer has the right to
make a formal objection to the inspection teams observations.
Within 15 working days from the date of receipt of the inspection report, the head of
the relevant tax authority must issue a letter specifying the result of the tax inspection.
If the taxpayer still disagrees with the conclusion of the tax authorities, he/she can fle
an appeal or suit following the procedure stipulated in the law on appeals and suits.
7507. The transfer pricing audit procedure
As there is no audit procedure set out specifcally for transfer pricing, a transfer pricing
audit could be implemented separately or in conjunction with a tax audit adopting the
said procedures.
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In the event that the taxpayer considers the administrative action taken by the tax
offcial or the decision issued by the tax authorities (e.g. in relation to tax liability, tax
reimbursement, tax exemption/reduction, including the conclusion of the tax audit or
suit) is a breach of the taxpayers rights, the taxpayer is entitled to fle a suit or appeal
against this act or decision.
The authority to resolve appeals follows the administrative hierarchical order from the
local offce to the MOF. The head of each hierarchical body is responsible for resolving
the appeal against the administrative decision issued by his/her offce and/or action
taken by his/her staff or by him/her.
The appeals procedure is the same as that of the general laws on appeals and suits.
In practice, where the taxpayer disagrees, for instance, with the conclusion of the tax
inspection of the competent authorities, including the MOF, the taxpayer can fle a suit
in the administrative court against the conclusion in question. However, there is no tax
court in Vietnam.
Currently, no specifc penalty is provided for in the transfer pricing regulations under
Circular 66. However, tax authorities have the right to assess and make appropriate
adjustment, as the case may be, to the transfer price, taxable income or tax amount
payable where they have evidence that the taxpayer has committed tax evasion or
fraud by manipulating transfer prices with related parties. In this case, the adjustment
to be made needs to refer to the arms-length range established by transfer prices or
proft margins established by unrelated parties. The value of transfer prices or proft
margins to be used for tax authorities assessment is not to be lower than the median of
the arms-length range.
Further, in accordance with the Law on Tax Administration and its implementing
guidelines, noncompliance subjects the taxpayer to the following categories of penalty:
Noncompliance with tax fling procedures and/or submission of incomplete returns
could be subject to a penalty of up to VND 5 million;
Late payment of tax is subject to interest of 0.05% per day of the outstanding
taxamount;
Underreporting of tax liabilities could be subject to a penalty of up to 10% of the
underpaid amount, regardless of whether the taxpayer keeps all related supporting
documents and presents them to the tax authorities upon request; and
Tax evasion could be subject to a penalty of up to three times the outstanding
taxliability.
Within the General Department of Taxation (GDT), a team monitors and manages
the implementation of transfer pricing regulations at the local tax authorities. This
team can conduct transfer pricing audits with assistance from local tax authorities. In
an attempt to reinforce transfer pricing audit capacity at the local level, the GDT has
recently organised transfer pricing audit training for local tax offcials.
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At the local level, each provincial tax department has a number of transfer pricing
specialists who are responsible for information gathering and reporting transfer pricing
compliance periodically to the GDT in addition to participating in transfer pricing
audits conducted by the GDT team.
With the sponsorship of international organisations, the Vietnamese tax authorities
also receive support from other tax authorities in the region, such as the Australian Tax
Offce and the Japanese Tax Administration, with respect to transfer pricing coaching.
The Vietnamese transfer pricing regulations state that only the databases recognised
formally by the government are acceptable to be used for benchmarking purposes.
However, to date no such recognised databases that are available in Vietnam are
suitable to use for benchmarking purposes. Currently in performing a comparability
search, companies rely on Asia-Pacifc regional comparable companies as a
comparative benchmark.
Over the last couple of years, the Vietnamese tax authorities have gathered information
on fnancial information of companies in order to establish its own database of
comparable information. Once it is ready, this database will be used for tax assessment
by the tax authorities.
Formally, no industry or transactions are classifed as particularly high risk from the
transfer pricing audit or investigation perspective. However, companies producing
high-value goods and having signifcant related party transactions, such as in
automobile and motorbike manufacturing and related parts manufacturing, would
likely be a high-risk industry. In practice, a company which posts continuous losses
(e.g. for three continuous years) and/or large companies with signifcant related-party
transactions are likely to be challenged by the tax authorities, in particular where the
company carries out business with related parties located in a tax haven/harbour.
Vietnam has more than 50 DTAs concluded with other countries and territorial
areas. Most DTAs contain an Associated Enterprise Article modelled on the
OECD convention. However, a large number of DTAs exclude the provision which
permits the respective tax authorities to adjust the proft of an entity where the
transaction is judged not to be at arms length (paragraph 2 of Article 9 of the OECD
convention model). On the other hand, a number of DTAs include the previously
mentioned provision but exclude the accompanying provisions in the article
requiring one contracting country to reduce the amount of tax charged to offset the
increased tax liability imposed by the other contracting country as a result of the
arms-lengthadjustment.
Under the Vietnamese transfer pricing regulations, advance pricing agreements (APAs)
are not adopted as an alternative method in dealing with transfer pricing matters.
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Subsequent to the issuance of the frst transfer pricing circular (Circular 117), the tax
authorities have become more aware of the importance of transfer pricing issues and
have attempted to improve transfer pricing compliance management by improving
transfer pricing knowledge and auditing skill of tax inspectors, and by modifying/
amending the transfer pricing regulations, such as the issuance of Circular 66 in
April2010.
In 2002 the customs authorities (the GDC) were merged into the MOF. As a result, the
cooperation between the GDT and the GDC has improved signifcantly. To date, each
taxpayer is assigned a unique tax identifcation number (TIN) which is used for both
domestic tax and customs duty declaration.
The GDT and GDC are now working to improve information exchange. The objective
of the project is for taxpayers information to be exchanged automatically on a regular
basis between the GDT and the GDC.
7517. OECD issues
While Vietnam is not a member of the OECD, the Vietnamese transfer pricing
regulations are essentially analogous to the OECD Guidelines. Indeed, the Vietnamese
transfer pricing regulations have adopted the same arms-length principle and transfer
pricing methodologies set out in the OECD Guidelines. However, the OECD Guidelines
are not formally referred to in the Vietnamese transfer pricing regulations. Also, a
transfer pricing policy that is acceptable in an OECD country will not necessarily be
accepted in Vietnam (e.g. besides the absence of APA adoption as mentioned above, the
Vietnamese transfer pricing regulations do not adopt the safe harbour/haven principle
recommended in the OECD Guidelines).
So far, no joint investigation has been implemented by the Vietnamese tax authorities
in conjunction with other tax authorities. However, in accordance with the provision
of the exchange of information of the DTAs, the GDT has actively participated in
information exchange with other tax authorities.
The arms-length principle applies to loans and interest charges. However, at present,
there are no rules dealing specifcally with thin capitalisation and no set permissible
debt-to-equity ratios.
Appendices
Functional analysis questions
Appendix 1
848 www.pwc.com/internationaltp Functional analysis questions
This appendix sets out a list of generic questions which might be used in performing
a functional analysis of a business to understand its various functions, risks and
intangibles. The list is not intended to be exhaustive and would need to be tailored to
suit the needs of specifc business entities.
Functions Analysis
Manufacturing
a. Material purchasing
1. What materials or partly fnished goods are purchased?
2. From whom are purchases made?
3. Are any purchases made from related companies?
4. Where and how are raw materials purchased?
5. Who performs the purchasing function?
6. Who plans purchasing schedules?
7. Who negotiates purchasing arrangements?
8. Who approves the vendor as being of acceptable quality?
9. Do purchasing decisions require head offce approval?
10. What are the approvals required?
11. Are any purchases made on consignment?
12. What are your major risks?
b. Inventory
1. Where is stock held?
2. Who controls the levels of inventory?
3. How are inventory levels controlled? Is there a computer system?
5. How many days of inventory are on hand?
6. Has there ever been a case, for whatever reason, where you were stuck with
excess inventory? Who bears the cost of obsolete inventory?
c. Production equipment
1. Who determines the purchasing budget?
2. Who negotiates purchasing?
3. Who maintains the plant?
4. Who has expenditure authority for capital equipment?
5. Who writes specifcations for the plant?
6. From whom is production equipment purchased?
7. Are any purchases made from related companies?
International Transfer Pricing 2011 Appendix 1: Functional analysis questions 849
Appendix 1: Functional analysis questions
8. Do you have discretion over the equipment used? Can you modify
theequipment?
9. What decisions require head offce approval?
d. Production scheduling
1. Who is responsible for production scheduling decisions? What factors enter the
decisions? When are the decisions made?
2. Is a computer system used?
6. Does your distributor always buy what you manufacture?
e. Manufacturing and process engineering
1. What products are produced?
2. Who designed the products and who owns the technology?
3. What is the manufacturing process?
4. Who developed the original process? Have any improvements been
madelocally?
5. Is it possible to compare productivity between the subsidiaries in the group?
6. Have you ever utilised a third party to produce your products?
f. Packaging and labelling
1. What packaging and labelling is done? Where is it done?
2. Who makes the decisions in relation to packaging and labelling? Have you
complete autonomy in relation to such decisions?
g. Quality control
1. What form does quality control take?
2. Who sets fnished product quality standards and procedures?
3. Who performs the quality control and who bears the cost?
4. Who provides the equipment and techniques for quality control?
5. How much product is lost because it fails quality control checks?
h. Shipping of products
1. Who pays freight charges for product in and out?
2. Who arranges shipping of products?
3. Who ships your products? To where? How?
4. Who is responsible for the selection of shippers?
5. Who is responsible for shipping deadlines?
a. What research and development do you carry out?
b. Is any research and development carried out on your behalf by
relatedcompanies?
Appendix 1: Functional analysis questions 850 www.pwc.com/internationaltp
c. Do you commission third parties to carry out research and development on
your behalf?
d. Where are products designed?
e. What input do distributors have on manufacturing, product design, or
productmodifcations?
f. How important is the development of patents in the industry?
g. What patents do you own that create unique products that competitors
cannotduplicate?
h. What unpatented technical know-how have you developed that might
differentiate your products from competitors, create important cost effciencies,
or give you an advantage in increasing your market share?
i. What decisions require corporate head offce approval?
j. What are the approvals required?
k. Who formulates the budget?
l. Are licence agreements in existence between you and related companies or
third parties?
m. Is there a cost-sharing agreement in force and if so, what are the details?
Marketing
a. Strategic
1. Do you carry out your own marketing?
2. Are market surveys performed? Do you monitor market demand?
5. Who are your competitors?
6. Who assesses demand in foreign markets?
7. What are the risks related to demand for your products?
8. Who formulates the marketing budget?
9. Does your distributor always buy what your manufacturer produces?
10. Has your manufacturer ever refused to fll an order?
11. Do related companies carry out marketing on your behalf?
12. Are third-party distributors used?
13. Who chooses, authorises and controls third-party distributors?
b. Advertising, trade shows, etc
1. What forms of marketing do you utilise?
2. What form of advertising is used? Who pays for it?
3. Are trade shows used and if so, who organises them and who pays for them?
4. Are samples provided to distributors? Who bears the costs?
5. Who produces product brochures, specifcations sheets, etc?
6. What marketing assistance do you receive?
Sales and distribution
a. Sales
1. How are sales made and who is involved?
2. Who issues the invoice to the customer?
3. Who issues the invoice to you?
4. Who formulates the projections and sets targets?
5. Where are sales orders received?
6. Who is responsible for the achievement of sales targets?
7. Who negotiates sales contracts? Do they operate autonomously?
8. Does your distributor always buy what your manufacturer produces?
9. How much is sold to related companies?
10. Are only fnished goods shipped from here?
11. Who are your competitors?
12. What are the risks related to demand for your products?
13. What decisions require corporate head offce approval?
15. Are products exported? If so, who is responsible for the export function?
16. What are the major risks in selling products in foreign countries?
b. Quality control
1. What form does quality control take?
2. Who sets fnished product quality standards and procedures?
3. Who performs quality control and who bears the cost?
4. Who provides the equipment and techniques for quality control?
5. How much product is rejected by customers as below standard?
6. Who bears the loss on defective products?
c. Freight
1. Who pays freight charges for product in and out?
2. Who arranges shipping of products?
3. Who ships your products? To where? How?
4. Who is responsible for the selection of shippers?
5. Who is responsible for shipping deadlines?
d. (d) Inventory
1. Do you actually receive the goods and hold stock?
2. Where is stock held?
3. Who controls the levels of inventory?
4. How are inventory levels controlled? Is there a computer system?
6. How many days of inventory are on hand?
7. Has there ever been a case, for whatever reason, where you were stuck with
excess inventory?
8. Who bears the cost of obsolete inventory?
e. Installation and after-sales services
1. Do you install your products?
2. Do you provide after-sales service? If so, describe the service.
3. Are product repairs carried out by any company and who bears the cost?
4. Who bears the cost of installation and after-sales service?
5. Do you provide product guarantees?
6. Who bears warranty costs?
Administration and other services
a. General administration
1. Is there a complete administration function?
2. Is any administration performed for you by related companies?
5. Who is responsible for administrative codes of practice?
b. Pricing policy
1. Who determines the product pricing?
2. What is the pricing policy for the various goods and services?
c. Accounting
1. What accounting functions are carried out? By whom?
2. Where are the fnancial reports prepared?
5. Is a bank account maintained? For what purpose?
6. Who has cheque signatory authority? What are the authority limits?
7. Do you bear the credit risk on sales to customers?
8. Who pays product liability insurance premiums?
9. Who arranges and pays for other insurance?
d. Legal
1. Who is responsible for legal matters?
e. Computer processing
1. Is computer processing and programming done here? If not, by whom?
2. Who developed the software and is any charge made for it?
3. Who has expenditure authority for capital equipment?
f. Finance/loans/credit
1. Are there any inter-company loans or long-term receivables and if so, is interest
charged?
2. What trade credit terms are received and given?
3. Is interest paid or charged if credit periods are exceeded?
4. Who is responsible for borrowing requirements?
g. Personnel
1. Are there any secondments to or from overseas affliates? What positions do
they hold in the company?
2. What training do you provide to your employees?
3. What is the length of the training period?
4. Is there on-the-job training?
5. Where is management training done?
6. What is the staff turnover rate?
7. Are all employees on your payroll?
8. Who is responsible for the employment of staff?
h. Use of property/leasing
1. Is property owned or leased from affliates?
2. Do you lease property to affliates?
3. Who is responsible for this function?
Executive
a. Does anyone report to the parent company besides the general manager?
b. Who is responsible for dealing with government agencies?
c. What are the key regulatory requirements?
d. Has the parent ever told you to use more procedures than you have developed?
e. How does manufacturing site selection occur?
f. Where does the initial impetus in relation to corporate decisions come from?
g. What decisions require head offce approval?
h. What are the approvals required?
Risk Analysis
1. Market risk
1. What are the market risks?
2. Do you bear the market risks?
3. How signifcant are the market risks?
2. Market risk
1. Does inventory become obsolete?
2. Who bears the cost of obsolete inventory?
3. Do you provide warranties in relation to fnished goods?
4. Who bears the cost of returns/repairs under warranty?
3. Credit and bad debt risk
1. What credit terms are given and received?
2. Do you bear the cost of bad debts?
3. Is this a signifcant risk?
4. Foreign exchange risk
1. Are you exposed to foreign exchange risk?
2. How signifcant is the risk?
Intangible Analysis
Manufacturing
a. Research and development
1. Have you developed your own products?
2. Have you developed manufacturing processes?
3. How important are these processes to your business? Are they unique?
b. Manufacturing processing/technological know-how
1. Do you possess technological know-how?
2. If so, what is its nature?
3. How important to your business is the know-how?
4. Is the know-how unique?
c. Trademarks/patents, etc
1. Do you own any trademarks/patents?
2. How signifcant are their existence to your business?
d. Product quality
1. Do you consider that you have a reputation for high quality?
e. Other
1. Are there any other manufacturing intangibles?
Marketing
a. Trademarks/trade names
1. Do you own any trademarks/trade names?
2. Do you pay royalties for the use of any trademarks/trade names?
3. Do you charge royalties for others to use trademarks/trade names that
youown?
4. How signifcant are they to your business?
b. Corporate reputation
1. Do you consider that you have a corporate reputation?
2. What is the nature of this reputation?
3. Is corporate reputation signifcant in your business?
c. Developed marketing organisation
1. Do you have a developed marketing organisation?
d. Ability to provide service to customers
1. Do you consider that you provide good service to customers?
e. Product quality
1. Do you consider that you have a reputation for high quality?
f. Other
1. Are there any other marketing techniques?
Examples of databases for use in identifying
comparative information
Appendix 2
855 Examples of databases for use in identifying comparative information
The range of easily accessible information is increasing at a very rapid pace, driven by
technological change. Vast quantities of data can be obtained on CD-ROM and DVD,
an example being the AMADEUS database of information on European companies.
Beyond that, the internet allows the researcher direct access to any information placed
in the public domain, either by individual companies or by commercial information
providers that make a charge for accessing their databases. These databases are
changing day by day but many are built from traditional sources, including some of
those listed below.
US
Annual Report and SEC Filings and Forms (EDGAR)
Dun and Bradstreets Hoovers (North America)
Standard and Poors Compustat North America and Global Vantage
Thomsons Financial/Disclosure SEC and Worldscope
Pan-European
Dun and Bradstreets Who Owns Whom (Europe) Europe Top 15,000
Fortune Top 500 (Non-US) Industrials Forbes Top 500 Foreign Companies Extel
Kompass Europe
Moodys International Manuals Directory
Each European country also has individual databases as an example, the major UK
databases are listed below.
UK
Companies House
Stock Exchange Offcial Year Book
Dun and Bradstreets Who Owns Whom (UK)
FT Supplement Top Companies
UKs Top 10,000 Companies
Business 1,000
McMillans Unquoted Companies
Jordans Top 4,000 Privately Owned Companies
Kompass
Extel
ICC
OneSource
Juniper
Experian Bureau van Dijk Fame
US Proposed service regulations
Appendix 3
856 www.pwc.com/internationaltp US Proposed service regulations
The fnal Treasury Regulations (Treas. Reg.) 1.482-9 were issued in 31 July, 2009.
The fnal regulations address the transfer pricing issues related to the provision of inter-
company services. The following is a summary of these regulations.
Beneft test
An activity provides a beneft if it directly results in a reasonably identifable increment
of economic or commercial value to the service recipient. The fnal services regulations
look at beneft primarily from the service recipients perspective.
The fnal service regulations permit the sharing or allocation of centralised service
activities or corporate headquarters costs only in situations in which there is an
identifable beneft to the recipients attributed to the charged-out costs. The fnal
services regulations states that activities that provide only an indirect or remote
beneft, duplicative activities, shareholder activities, and passive association are not
benefcial services for recipients. Thus, recipients are not liable for such costs under the
service regulations.
Overview of transfer pricing methods
The fnal service regulations require taxpayers to apply the arms-length standard in
establishing compensation amounts for the provision of inter-company services. Thus,
similar to other sections of the transfer pricing regulations, taxpayers involved in the
provision of inter-company services must adhere to the best method, comparability,
and the arms-length range requirements of Treas. Reg. 1.482-1. What is new is that
the fnal service regulations stipulate that taxpayers must apply one of the six specifed
transfer pricing methods or an unspecifed method in evaluating the appropriateness
of their inter-company services transactions. The six specifed transfer pricing methods
include three transactional approaches, two proft-based approaches, and a cost-
based safe harbour. The transactional approaches are the comparable uncontrolled
services price method (CUSPM), the gross services margin method (GSMM) and the
cost of services plus method (CSPM). The two proft-based approaches are the existing
comparable profts method (CPM) and the proft split method (PSM). The cost-based
safe harbour is the services cost method (SCM).
The comparable uncontrolled services price method (CUSPM)
The CUSPM is analogous to the comparable uncontrolled price (CUP) and the
comparable uncontrolled transaction (CUT). Under the CUSPM, the price charged
in a comparable uncontrolled services transactions form the basis of evaluating the
appropriateness of the controlled services transaction. Generally, the CUSPM is
applicable in situations where the related party services are similar (or have a high
degree of similarity) to the comparable uncontrolled services transactions.
International Transfer Pricing 2011 US Proposed service regulations 857
US Proposed service regulations
The gross services margin method (GSMM)
The GSMM is comparable to the resale price method (RPM) of the tangible property
transfer pricing regulations. Under this method, evaluating the appropriateness of
inter-company services pricing arrangements relies on the gross proft margins earned
in comparable uncontrolled services transactions as benchmarks. The GSMM is
appropriate in situations where a controlled taxpayer provides services (e.g. agency or
intermediary services) in connection with a related uncontrolled transaction involving
a member of the controlled group and a third party.
The cost of services plus method (CSPM)
The CSPM is analogous to the cost plus (CP) method of the tangible property transfer
pricing regulations. Like the CP method, the CSPM evaluates the appropriateness of
inter-company services transfer pricing arrangements by reference to the gross services
proft markup earned in comparable uncontrolled services transactions. The CSPM is
appropriate when the service providing entity provides the same or similar services to
both related and third parties.
The services cost method (SCM)
The services cost method evaluates whether the amount charged for certain services
is arms length by reference to the total services costs with no markup In order to
be eligible for the application of the SCM, the service should be i) a covered service,
ii) not an excluded activity, iii) not precluded from constituting a covered service
by the business judgment rule (it is concluded that the service does not contribute
signifcantly to key competitive advantages, core capabilities, or fundamental risks of
success or failure for the businesses of the group), and iv) adequate books and records
are maintained.
Global Transfer
Pricing contacts
International Transfer Pricing 2011 859 Global Transfer Pricing contacts
Global Transfer Pricing contacts
Global Leader, Transfer Pricing
Garry Stone
+1 312 298 2464
[email protected]
Argentina
Juan Carlos Ferreiro
+54 11 4850 6720
[email protected]
Australia
Lyndon James
+61 2 8266 3278
[email protected]
Austria
Herbert Greinecker
+43 1 501 88 3301
[email protected]
Belgium
Isabel Verlinden
+32 2 710 7295
[email protected]
Brazil
Cristina Medeiros
+55 11 3674 2000
[email protected]
Bulgaria
Irina Tsvetkova
+359 2 9355 100
[email protected]
Canada
Charles Theriault
+1 514 205 5001 ext 2254
[email protected]
Chile
Roberto Carlos Rivas
+56 2 940 0151
[email protected]
China (Peoples Republic of)
Spencer Chong
+86 21 2323 1135
[email protected]
Colombia
Carlos Mario Lafaurie
+57 1 634 0492
[email protected]
Croatia
Janos Kelemen
+385 1 632 8880
[email protected]
Czech Republic
David Borkovec
+420 251 152 549
[email protected]
Denmark
Erik Todbjerg
+45 3945 9583
[email protected]
Ecuador
Pablo Aguirre
+593 2 256 4142 ext. 361
[email protected]
Finland
Ray A. Grimes
+358 9 2280 1467
[email protected]
France
Pierre Escaut
+33 1 5657 4295
[email protected]
Germany
Lorenz Bernhardt
+49 30 2636 5218
[email protected]
Greece
Antonis Desipris
+30 210 6874 016
[email protected]
860 www.pwc.com/internationaltp Global Transfer Pricing contacts
Hong Kong
Charles Leung
+86 20 3819 2128
[email protected]
Hungary
Zaid Sethi
+36 1 461 9512
[email protected]
Iceland
Elin Arnadottir
+354 550 5322
[email protected]
India
Rahul K Mitra
+91 33 4400 0484
[email protected]
Indonesia
Ay Tjhing Phan
+62 21 5289 1024
[email protected]
Ireland
Gavan Ryle
+353 1 792 6425
[email protected]
Israel
Vered Kirshner
+972 3 795 4849
[email protected]
Italy
Gianni Colucci
+390 2 9160 5509
[email protected]
Japan
Akio Miyamoto
+81 3 5251 2337
[email protected]
Kazakhstan
Bob Jurik
+7 727 298 0448
[email protected]
Korea (Republic of)
Henry An
+82 2 709 0887
[email protected]
Lithuania
Nerijus Nedzinskas
+370 5 239 2352
[email protected]
Luxembourg
Wim Piot
+352 49 48 48 5773
[email protected]
Malaysia
Thanneermalai Somasundaram
+60 3 2173 1482
[email protected]
Malta
Neville Gatt
+356 2564 6711
[email protected]
Mexico
Fred Barrett
+52 55 5263 6069
[email protected]
Netherlands
Arnout van der Rest
+31 10 407 5413
[email protected]
New Zealand
Cameron B Smith
+64 9 355 8508
[email protected]
Norway
Dag Saltnes
+47 95 26 06 32
[email protected]
Philippines
Carlos Carado
+63 2 845 2728
[email protected]
International Transfer Pricing 2011 861 Global Transfer Pricing contacts
Global Transfer Pricing contacts
Poland
Mike Ahern
+48 22 5234 868
[email protected]
Portugal
Jaime Esteves
+351 225 433 212
[email protected]
Romania
Ionut Simion
+40 21 202 8708
[email protected]
Russian Federation
Evgenia Veter
+7 495 232 5438
[email protected]
Singapore
Nicole Fung
+65 6236 3646
[email protected]
Slovak Republic
Todd Bradshaw
+421 2 59 350 111
[email protected]
Slovenia
Janos Kelemen
+386 1 5836 058
[email protected]
South Africa
David Lermer
+27 21 529 2364
[email protected]
Spain
Javier Gonzalez Carcedo
+34 915 684 822
[email protected]
Sweden
Mika Myllynen
+46 8 555 344 92
[email protected]
Switzerland
Norbert Raschle
+41 58 792 42 54
[email protected]
Taiwan
Steven Go
+886 2 2729 5229
[email protected]
Thailand
Peerapat Poshyanonda
+66 2 344 1220
[email protected]
Turkey
Adnan Nas
+90 212 326 6402
[email protected]
UK
Ian Dykes
+44 121 265 5968
[email protected]
US
Horacio Pena
+1 646 471 1957
[email protected]
Venezuela
Jose G. Garcia
+58 212 7006 802
[email protected]
Vietnam
Van Dinh Thi Quynh
+84 4 3946 2246 ext 4202
[email protected]
Index
Index
Index
A
Accounting services ................. see Services
Accounting systems
policy changes .................620 p118, 624 p120
Adjustments
mutual agreement procedure ............ 313 p47,
.......................................................1007 p161
secondary ..........................................313 p47
Advisory commission
generally ....................................... 1009 p162
resolution of the problem .............. 1010 p162
Ad valorem duties and taxes . 1007 p161
Agreements cost sharing ............523 p90
...........................................................532 p96
inter-company legal agreements ........432 p73
management services .........................512 p83
Anti-dumping duties ................1008 p161
Arbitration
audits ...............................................704 p124
procedures .....................................1007 p161
fnancing transactions ........................215 p29
generally ............................ 202 p19, 302 p35
guidance ............................................302 p35
hybrid intangibles ..............................211 p24
manufacturing intangibles .................209 p22
marketing intangibles .........................210 p23
OECD Guidelines ................................301 p34
Assists
see also Intangible property valuation for
customs purposes ............................ 1010 p162
Audits
see also Tax audits
advance rulings ................................707 p126
arbitration ........................................704 p124
establishing control of process ..........702 p123
existing pricing policies, dealing with
adjustments ......................................706 p126
minimising exposure .......................703 p124
negotiation .......................................704 p124
preparation ......................................705 p125
settlements ....................................... 607 p110
B
Barriers to entry ...........................206 p21
Berry ratio ......................................311 p45
Bonus schemes ........................... 623 p119
Brokerage and commissions ...808 p130
........................................810 p131, 819 p137
Brussels defnition
of value (BDV) ..............................905 p142
Buy pin arrangements .................530 p95
Buying commissions ..................910 p144
C
Capital stock
fnancing long-term capital needs ......222 p32
Centralised support activities
restructuring techniques.....................413 p62
Comparables documentation .....434 p73
Comparable uncontrolled price 303 p36
Competent authority
procedures ............................. see chapter 10
Computer software
classifcation diffculties .....................211 p24
valuation for customs purposes ........916 p149
.........................................................920 p152
Container costs ...........................910 p144
Contract maintenance frms
restructuring techniques .......... 418 p64
Contract manufacturers
functional analysis .......................409 p58
Contract marketing
restructuring techniques ...........419 p65
Contract service providers
restructuring techniques ............415 p63
Cooperation between
tax authorities ...............................313 p47
Cost-accounting method management
fees ..................................................508 p80
Cost plus method
capacity adjustments .........................306 p40
generally ...........................................305 p38
arrangements ......... see Finance arrangements;
Credit risk .......................................406 p55
Customs duties ........................ see chapter 9

D
Debt .........................see Finance arrangements
Deep discounted loans .................224 p33
Defective products
and warranty .................................406 p55
Defnitions and meanings
arms length .......................................202 p19
control ..........................902 p141, 1005 p160
functions ...........................................405 p54
provision of services ..........................212 p25
related persons ..................................302 p35
sales of tangible property ...................203 p20
transactional net margin
method.............................................. 310 p44
transfers of intangible property ..........206 p21
Designs ... see Intangible property; Licence fees;
Royalty payments costs,
customs valuation ............................921 p152
Disclosure tax returns .............. 619 p118
Distribution companies
characterisation ...........................410 p59
Documentation
comparables .......................................434 p73
contemporaneous ...............................426 p70
fnancial analyses ...............................428 p70
functional analysis ..............................433 p73
generally ............................................427 p70
guidelines...........................................313 p47
licence arrangements .........................515 p85
management fees ............... 504 p77, 512 p83
policy changes ..................................626 p120
Double taxation relief
see Offsetting adjustments
Dumping....................................... 908 p143
E
Employees
communication of changes
to employees .................................... 622 p119
functional analysis interviews ............407 p57
transfer of..................................... 213(4) p25
End of year adjustments ........... 613 p114
Engineering risks .........................406 p55
Exchange rates .... see Foreign exchange rates
Excise duties ................................907 p143
F
Fees management ....... see Management fees
Finance arrangements
capital stock .......................................222 p32
characterisation of loans...................541 p102
cost sharing ........................................218 p31
deep discounted loans ........................224 p33
fnancial statements ......................... 621 p118
fexibility in managing
capital needs ......................................225 p33
generally ............................................215 p29
guarantees of indebtedness ..............543 p103
hybrid fnancing arrangements ..........224 p33
interest rates .................... 215 p29, 542 p103
leasing .............................. 221 p32, 544 p104
loans and advances...........................540 p102
long-term capital needs ......................219 p32
long-term inter pcompany loans ........223 p33
market penetration payments/market
maintenance ......................................217 p31
mortgages ..........................................220 p32
short-term capital needs .....................216 p30
swaps .................................................224 p33
thin capitalisation...............................215 p29
Financial analyses
evaluation ..........................................429 p72
generally ............................................428 p70
Financial goals...............................411 p60
Financial statements ...................428 p70
......................................................... 621 p118
Finished goods
sales of ...............................................205 p20
Foreign exchange rates
arms-length standard ........................534 p99
economic exposure ...........................538 p100
generally ............................................533 p99
Index
planning opportunities ..................... 539 p101
transaction exposure ........................537 p100
translation exposure .........................536 p100
types of exposure ..............................535 p100
Foreign exchange risk ..................406 p55
Fourth methods .............................307 p40
Freight costs ................910 p144, 916 p149
Fully-fedged manufacturers functional
analysis ...........................................409 p58
Functional analysis
after-sales services ..............................407 p57
business risks .....................................406 p55
centralised support activities ..............413 p62
characterisation of businesses ............408 p58
comparables search .............. 421-425 p65-69
...........................................................434 p73
contract maintenance ........................ 418 p64
contract manufacturers ......................409 p58
contract marketing .............................419 p65
contract service providers ...................415 p63
defective products ..............................406 p55
distribution functions .........................403 p52
distribution/selling companies,
characterisation .................................410 p59
documentation ...................................433 p73
environmental accidents ....................406 p55
evaluation of pricing options ..............420 p65
evidence, conclusions reached/
adjustments made etc .........................436 p73
fnancial goals ....................................411 p60
foreign exchange risk .........................406 p55
fully pfedged manufacturers ..............409 p58
functions, determination ....................405 p53
generally ............................................402 p52
income statements .............................435 p73
information/documents,
examination .......................................404 p53
intangibles .........................................407 p57
interviews ..........................................403 p52
inventory risk .....................................406 p55
manufacturing functions ....................403 p52
manufacturing opportunities ..............412 p61
marketing functions ...........................403 p52
market prices ......................................401 p51
market risk .........................................406 p55
product liability risk ...........................406 p55
research and development .. 416 p63, 417 p64
risks ...................................................406 p55
selling companies ...............................414 p62
tax havens ..........................................412 p61
warranty costs ....................................406 p55
G
Global formulary apportionment
non-arms-length approach ................312 p46
Global tax charge
active planning .................................604 p109
Goodwill ..................... see Intangible property
Guarantee fees
loans ................................................543 p103
H
Handling costs ............910 p144, 916 p149
I
Imports ............................. see Customs duties
Income statements
defensible late adjustment ................615 p115
generally ............................ 428 p70, 435 p73
retroactive price changes .................. 613 p114
.........................................................614 p115
year-end adjustments ....................... 613 p114
Insurance costs ..........910 p144, 916 p149
Intangible property
arms-length royalty rates,
determination .......................516-517 p85-87
...........................................................519 p87
assists ............ 910 p144, 916 p149, 918 p151
barriers to entry .................................206 p21
corporate reputation .......... 210 p23, 211 p24
cost sharing arrangements
ownership of intangibles ....................531 p98
customer services/training .................210 p23
customs value of imports ..................904 p142
functional analysis ..............................402 p52
Index
Index
hybrid intangibles ..............................211 p24
manufacturing intangibles .................207 p22
...........................................................209 p22
marketing intangibles ......... 207 p22, 210 p23
modes of transfer................................208 p22
ordinary intangible .............................206 p21
patents ...............................................209 p22
software .............................................211 p24
super pintangibles .............. 206 p21, 518 p87
royalty rates, valuation .......................519 p87
technical know phow ..........................209 p22
trademarks and trade names ..............210 p23
transfers ................206 p21, 513-519 p84-87
.........................................................916 p149
types of intangibles.............................207 p22
typical assets ......................................407 p57
valuation for
customs purposes ............. 916-918 p149-151
Inter-company transfers
fnancing transactions .................... see Finance
arrangements, intangibles see Intangible
property, provision of services see Services,
tangible property see Tangible property
generally ............................................201 p19
types of ..............................................201 p19
Interest
Inclusion in value of imported goods 919 p151
Inventory risk ................................406 p55
Investigations ............................. see Audits
K
Know-how ................. see Intangible property
L
Labour and material costs ........910 p144
Lease fnancing ..............................221 p32
Leasing
arms-length rental rate ....................545 p104
bona fde leases ................................544 p104
Legal agreements ..........................432 p73
Legal services............................. see Services
Licence arrangements
transferring intangible rights ..............515 p85
Licence fees
customs valuation ............. 916-918 p149-151
Litigation .........see Audits Loans see Finance
arrangements
M
Machinery and equipment
charges for construction,erection etc 910 p144
sales of ...............................................204 p20
Management compensation .......439 p74
Management fees
analysing the services .........................506 p78
arms-length service charge,
determination ....................................511 p82
central services ...................................505 p78
comparable uncontrolled price
(CUP) method ....................................506 p78
cost-accounting method .....................508 p80
cost base for service charges ...............507 p80
...........................................................509 p80
defensible late adjustments .............. 615 p116
direct costs .........................................509 p80
documentation ................... 504 p77, 512 p83
establishing facts ................................504 p77
generally ............................................502 p76
indirect costs ......................................509 p80
meaning .............................................501 p76
method for determination ..................506 p78
proft markup addition .......................510 p81
shareholder costs ................................505 p78
tax treatment......................................503 p77
Manufacturing businesses
characterisations ..........................409 p58
Market risk .....................................406 p55
Monopolies barriers to entry .....206 p21
Mortgages fnancing long-term
capital needs ..................................220 p32
Mutual agreement procedure
corresponding adjustments .......313 p47
Index
International Transfer Pricing 2011 867 Index
Index
N
Negotiation ................................... see Audits
O
Offsetting adjustments ........ see chapter 10
Organisation for Economic
Co-operation and Development (OECD)
arms-length principle ........................302 p35
cost sharing ........................................520 p89
formation ...........................................301 p34
guidelines........................... 301 p34, 313 p47
member countries ..............................313 p47
P
Patents .... see Intangible property; Licence fees;
Royaltypayments
Planning ..........................................102 p15
Plant and Machinery ............ see Machinery
and equipment
Price unbundling .........................913 p146
Pricing methods alternative .......307 p40
Berry ratio ..........................................311 p45
comparables search ..............421-424 p65-68
comparable uncontrolled price
(CUP) method .................... 303 p36, 506 p78
cost plus method ................................305 p38
capacity adjustments ..........................306 p40
determination ....................................302 p35
evaluation of options ..........................420 p65
fourth methods ..................................307 p40
proft split method (PSM) ...................309 p43
rate-of preturn method .......................308 p42
rental rates .......................................545 p104
resale price method (RPM) .................304 p38
transactional net margin method
(TNMM) ............................................ 310 p44
transactional proft methods ...............307 p40
Product liability risk ....................406 p55
Proft split method (PSM) ...........309 p43
R
Rate of return method ........................308 p42
Raw materials
Sales of ...............................................205 p20
Reproduction charges ................910 p144
Resale price method (RPM) ........304 p38
contract arrangements ....... 416 p63, 417 p64
cost sharing .......................... 520-531 p89-98
Retroactive price changes .........614 p115
Returns ................................... see Tax returns
Rights of reseller to distribute
imported goods ..........910 p144, 916 p149
Risks
business risks .....................................406 p55
cost sharing arrangements ..................527 p94
foreign exchange rates ...... see Foreign exchange
rates
generally ............................................101 p14
Royalty payments approval ...... 618 p117
customs valuation ...........910 p144, 916 p149
.........................................................917 p150
determination .................... 516 p85, 517 p87
S
Safe harbours.................................313 p47
Sales of inventory .........................205 p20
Sales taxes ...................907 p143, 910 p144
Selling companies
characterisation .................................410 p59
restructuring techniques.....................414 p62
Service charges ........... see Management fees
Services
accounting .........................................213 p25
employees, transfer of ........................213 p25
legal ...................................................213 p25
offshore affliate requiring parent
company expertise .............................213 p25
provision of, meaning .........................212 p25
shareholder ........................................214 p26
868 www.pwc.com/internationaltp Index
technical assistance, transfer of ..........213 p25
intangibles .........................................213 p25
technical in nature ..............................213 p25
types ..................................................213 p25
Set-offs
non-arms-length transactions ..........908 p143
Settlements tax
audits ............................................... 607 p110
Shareholder services ...................214 p26
Shareholder costs ........ see Management fees
Shares
fnancing long-term capital needs ......222 p32
Software ......................see Computer software
Stewardship costs ........see Management fees
Super-intangibles ..... see Intangible property
Swaps ...............................................224 p33
T
Tangible property
machinery and equipment .......... see Machinery
and Equipment
sales of .......................................203-205 p20
Tax authorities
clearances ........................................ 618 p117
Tax havens ......................................412 p61
Tax returns
disclosures ....................................... 619 p118
Technology see Licence fees; Royalty payments
Thin capitalisation .......215 p29, 216 p30
.......................................................... 223 p33
Trademarks and trade names .................
see Intangible property; Licence fees; Royalty
payments
Transfer pricing policy
audits ............................................... see Audits
customs valuation ...........909 p144, 915 p149
.........................................................922 p153
documentation ................... 426 p70, 427 p70
fnancial analyses ............... 428 p70, 429 p72
formulae for price determination ........431 p72
generally ............................................430 p72
implementation ..................................437 p74
management of policy .................. see chapter 6
monitoring .........................................438 p74
OECD Guidelines ................................301 p34
reasons for............................. 101-106 p14-17
reviewing ...........................................103 p16
theory and practice ............................104 p16
V
Valuation of imported goods
adjustments ......................................910 p144
ad valorem duties and taxes .............907 p143
alternative methods
of valuation ...................................... 914 p147
anti-dumping duties .........................908 p143
assists ...............................................910 p144
audit by an indirect tax authority ......925 p156
Brussels defnition of value (BDV) ....905 p142
computed value ................................ 914 p147
computer software ...........................920 p152
costs and payments,
exclusions/additions ........................910 p144
deductive value ................................ 914 p147
design, development, engineering
and similar charges ..........................921 p152
fxed values ......................................906 p143
(GATT) Customs Valuation Code ...... 902 p141
identical goods, value of ................... 914 p147
intangible assists ..............................918 p151
intangibles ......................904 p142, 916 p149
interest .............................................919 p151
international structure, impact .........924 p155
licence fees .......................................917 p150
pricing policy ................. 915 p149, 922 p153
relationship between customs
and tax rules.....................................903 p142
retrospective price adjustments,
impact ..............................................923 p153
royalties ...........................................917 p150
International Transfer Pricing 2011 869 Index
Index
similar goods, value of ...................... 914 p147
specifc duties ...................................906 p143
technical considerations ...................909 p144
validation of transfer price................911 p145
Value added taxes ......907 p143, 910 p144
W
Work in progress, sales of ...........205 p20
Y
Year-end adjustments ................ 613 p114
International
Transfer Pricing
at your fngertips
If you are responsible for managing
the taxes in a multinational enterprise,
you undoubtedly recognise the major
and growing challenge of complying
with the stringent transfer pricing
rules across the multiple jurisdictions
in which you operate. As these rules
frequently change, you are likely aware
of the need for a robust, consistent and
defensible policy necessary to protect
your company from fnancial penalties
exacted by fscal authorities.
International Transfer Pricing 2011,
now in its 12
th
edition is an easy to
use reference guide covering a range
of transfer pricing issues in over 60
countries worldwide. The book offers
practical advice on developing a
coherent and robust transfer pricing
policy that is responsive to todays
climate of change, at your fngertips.
Written by local PwC
1
transfer pricing
specialists in each country, the book
provides a global approach to transfer
pricing issues and a summary survey
of specifc requirements of the key
countries with transfer pricing rules.
The principal author and editor of
the 2011 edition is Nick Raby, Global
Operations leader for PwC Tax
Controversy and Dispute Resolution
network. This book is up to date (unless
otherwise stated) as of 1 March 2010.
Visit our online version
www.pwc.com/internationaltp
1
"PwC" refers to the network of member frms of PricewaterhouseCoopers International Limited
(PwCIL). Each member frm is a separate legal entity and does not act as agent of PwCIL or any
other member frm. PwCIL does not provide any services to clients. PwCIL is not responsible or
liable for the acts or omissions of any of its member frms nor can it control the exercise of their
professional judgment or bind them in any way. No member frm is responsible or liable for the
acts or omissions of any other member frm nor can it control the exercise of another member
frm's professional judgment or bind another member frm or PwCIL in any way.

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