Tax Flash Report. New Russian transfer pricing draft law is available. Tax services. Background in brief. Key points

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1 Tax services Tax Flash Report Russia, New Russian transfer pricing draft law is available Background in brief On 30 October 2009, the Russian Ministry of Finance made public the revised draft law on new Russian transfer pricing rules (hereinafter the Draft Law) which was agreed with the Ministry of Economic Development. It is expected that the Draft Law will be considered by the Russian Government in November 2009 and then submitted to State Duma. The Draft Law refers to 1 January 2011 as the date of entry into force, although we understand that 1 July 2010 is being discussed as an alternative. Key points Generally, the provisions of the Draft Law follow the Framework of the Draft Law On Improving the Principles of Determining Pricing for Tax Purposes published by the Russian Ministry of Finance in April 2009.[1] Compared to the drafts which were available previously, the new Draft Law appears to be more technically elaborate and to a certain extent better aligned with international transfer pricing principles developed by the Organisation for Economic Cooperation and Development (OECD). Key points are the follows: Significant reduction of the list of transactions where the Russian tax authorities may control prices for tax purposes; Expansion of the list of related parties; Burden of proof that prices of controlled transactions do not correspond to market will rest with the tax authorities; Introduction of the arm s length principle as the fundamental principle of Russian transfer pricing rules; Abolishment of the present safe harbour provision (the allowable 20 per cent fluctuation of prices of controlled transactions from market prices); Expansion of the list of information sources for determining market prices; Formally introducing a functional analysis as one of the comparability factors; Introduction of new methods for determining market prices. Changes to the existing pricing methods to make them more in line with internationally accepted transfer pricing principles; Introduction of correlative adjustments for controllable transactions within Russia; Introduction of reporting and transfer pricing documentation requirements; Introduction of special transfer pricing audits to be performed by federal tax authorities; Introduction of penalties for non-compliance with reporting requirements; as well as a penalty for failure to prepare transfer pricing documentation provided a transfer pricing adjustment is made by tax authorities; Introduction of unilateral and multilateral Advance Pricing Agreements (APAs) for companies registered as large taxpayers (but not earlier than 2012). Below we provide a summary of the key provisions contained in the Draft Law related to the new Russian transfer pricing rules. New Russian transfer pricing rules Controlled transactions 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: 1. Domestic transactions between related parties (see below) if they meet one of the following criteria: a. The transaction amount exceeds RUB 1 billion (approx. USD 30 million) per calendar year. Transactions between Russian companies forming a consolidated taxpayer group will not come under the pricing control. The draft law on consolidated taxpayer group is being developed in line with the Framework established in April 2009[2]. The revised draft is not yet publically available; b. One of the parties to a transaction is subject to mineral extraction tax (MRET) calculated as a percentage of the value of minerals extracted; c. One of the parties to a transaction is subject to taxation under the unified tax on imputed income or unified agricultural tax; d. One of the parties to a transaction is located within a special economic zone in Russia. [1] For more details on the Framework of the Draft Law, please refer to our Flash Report Issue No. 1 (199) of April [2] For more details on the Framework of the Tax Consolidation law, please refer to our Flash Report Issue No. 3 (201) of May , PricewaterhouseCoopers. All rights reserved 1

2 2. Cross-border transactions between related parties; 3. Cross-border transactions with certain types of commodities, including: (1) oil and oil products, (2) ferrous and non-ferrous metals, and (3) precious metals and stones. The list of commodities is to be established by the Russian Ministry of Economic Development. 4. 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 application of dividend participation exemption. It includes, among others, such jurisdictions as the British Virgin Islands, Cyprus, Hong Kong, Gibraltar, Liechtenstein and certain other territories. Also, the Russian tax authorities will be able to control transactions with a foreign entity whose beneficial owners are located in one of the jurisdictions and territories included in the list. If prices are regulated by the Russian authorities or established in accordance with the Russian anti-monopoly law, the Russian tax authorities will accept such prices for tax purposes. 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, the authorities have in effect incorporated certain elements of antiavoidance rules in the new Russian transfer pricing rules by proposing controlling cross-border transactions involving certain types of commodities and transactions with residents of low-tax jurisdictions. Related parties The new Framework Paper 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: 1. Parties, where one entity (the entity and its related parties) or individual (the individual and his/her related parties) has more than a 20% direct or indirect participation in another entity; 2. Entities, where one party (the party and its related parties) has more than a 20% direct or indirect participation in these entities; 3. An entity and a member of its board of directors/other collegial management body or an individual/entity acting as the sole executive body; 4. Entities, where the same individual/entity acts as the sole executive body; 5. Entities or individuals if the direct participation share of each preceding entity in each succeeding entity exceeds 50%; 6. Individuals, if one of them is subordinate to the other in terms of their employment position; 7. Individuals who have a marital, kinship, affinity, adoptive/adopted, trustee, or ward relationship. 8. Settler of fiduciary management (a trust, a trust fund created under non-russian law), trustee and beneficial owner, as well as trustee and entities managed by trustee. Courts will retain the right to recognise parties related for reasons other than those stipulated above if the relationship between the parties may have an impact on the conditions and outcome of a transaction performed by the other entity (entities represented by it) or the results of its economic activity. Arm s length principle The Draft Law formally introduces the arm s length principle with respect to transactions between related parties. In case conditions and /or financial results of controllable transactions between related parties differ from those which would take place between independent parties, then any income (profit, sale proceeds) which would have accrued to one of the parties to the controllable transaction, but, by reason of those conditions, have not been so accrued, should be taken into account for taxation purposes. Functional analysis The Draft Law introduces a concept of a functional analysis and highlights its importance for the choice of the transfer pricing method. It is stated that the transfer pricing analysis requires consideration of functions performed, commercial (economic) risks assumed and assets employed in a controlled transaction. The Draft Law outlines a list of functions, commercial (economic) risks and assets to be analysed (such list is open ). Market price (profitability) range It is proposed that the present safe harbour provision, i.e. the allowable 20 per cent fluctuation of prices from market prices, will be abolished. The Draft Law introduces the concept of a market price (profitability) range. For the purposes of determining the market price (profitability) range, at least four comparable transactions between independent parties (or four comparable independent companies) should be taken into account. In order to arrive at the market price range against which a tested transaction price (profitability) will be benchmarked the tax authorities should apply certain statistical methods to narrow down the full market price range so that it represents an inter-quartile range. The Draft Law explains how the range is to be determined. The 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 (profitability). When determining the market profitability range on the basis of financial data of comparable independent companies, the Draft Law establishes a number of criteria to be followed for selection of such comparable companies. There is a requirement to use financial data available as of 31 December of the year when a controlled transaction takes place or financial data for the three years preceding the calendar year of a controlled transaction. 2009, PricewaterhouseCoopers. All rights reserved 2

3 Methods for determining market prices The Russian Tax Code provides for three traditional transfer pricing methods and establishes a strict hierarchy for their application: (i) the comparable uncontrolled price (CUP) method, (ii) the resale price method and (iii) the cost plus method. These methods do not fully comply with OECD Transfer Pricing Guidelines. The Draft Law anticipates the introduction of the following three new methods: the secondary product method the transactional net margin method (TNMM) the profit split method which may be based on either comparative or residual profit split analysis The CUP method, the resale price method and the cost plus method are revised to be in line with internationally accepted transfer pricing principles. The strict hierarchy of applying the transfer pricing methods will be replaced by the best method rule coupled with certain hierarchy of the methods application, in particular: The CUP method will remain the primary transfer pricing method, provided at least four proper comparables are available. It also requires the high level comparability of the subject of a transaction and terms of a controlled transaction with the subject and terms of comparable transactions which prices are used as a benchmark. If it is not possible to apply the CUP method, taxpayers will be able to choose an appropriate method from the remaining four methods, i.e. the resale price method, the cost plus method, the secondary product method or the TNMM. The resale price method, the cost plus method and the secondary product method provide for analysis of gross margins. Thus, these methods could be applied only if it is possible to ensure financial data comparability in a controlled transaction and comparable transactions used to determine the market profitability range. TNMM anticipates the analysis of operating profit margin of one of the parties to a controlled transaction. The profit split method should only be applied as a last resort. It should apply when parties to a controlled transaction employ unique intangible assets having a material effect on profitability in the supply chain. It is envisaged by the Draft Law that the profit split method will apply, among other transactions, with respect to transactions involving investment management services, broker and dealer activity. The Russian Ministry of Finance will develop methodological recommendations on the application of the transfer pricing rules. The methodological recommendations will be binding for tax authorities, but not for taxpayers. Sources of information Current Russian transfer pricing legislation requires the use of official sources of information ; however, the Tax Code does not provide a definition of the term official sources of information. A detailed list of sources of information to be used to determine market prices has been suggested in the Draft Law, these include: Commodity exchange quotations; Russian customs authorities statistical data; Pricing information of authorised state government bodies; Publicly available information systems; Data from companies accounting and statistics statements; Appraisal reports (only if the transfer pricing methods established by the Draft Law cannot be applied). The list of information sources is an open one. The taxpayers and tax authorities may use for determining market prices information from other sources not specifically listed by the law. Reporting requirements and transfer pricing documentation Taxpayers will be required to submit information on controlled transactions: Such reporting requirements apply provided 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 be gradually decreased to RUB 10 million (approx. USD 0,33 million) by By decreasing the threshold, the authorities anticipate to cover a wider range of transactions by reporting requirements. Information on controlled transactions should be provided no later than 20 May of a calendar year following the year when a controlled transaction was performed. Taxpayers will be also required to prepare transfer pricing documentation supporting the arm s length nature of prices applied and transfer pricing methods used in controlled transactions. Under the current wording of the Draft Law, transfer pricing documentation should be prepared for controlled transactions with the same entity if their income and expenses exceed the threshold of RUB 10 million. The list of transfer pricing documentation for transactions between related parties is more extensive compared to other controlled transactions. The tax authorities may request transfer pricing documentation during a tax audit, but not earlier than 1 April of a 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 during 10 working days upon receipt of a tax authority s request. 2009, PricewaterhouseCoopers. All rights reserved 3

4 Correlative adjustments The Framework Paper introduces a mechanism of correlative adjustments 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 within the Draft Law refers to correlative adjustments relating to Russian domestic transactions only. Advance Pricing Agreements (APAs) The new Russian transfer pricing rules will provide for the possibility to conclude unilateral and multilateral APAs. Multilateral APAs will be allowed only in case there is a double tax treaty between Russia and another jurisdiction where the counterparty of a controlled transaction is tax resident. Only companies registered as largest taxpayers will be eligible for an APA. The corresponding APA provisions will become effective from Burden of proof, transfer pricing audits and penalties The burden of proof that prices of controlled transactions do not correspond to market prices will rest with the Russian tax authorities. Compared to previous versions, the new Draft Law suggests introduction of special transfer pricing audits which will be performed by federal tax authorities. Such audits may last up to six months (unless extended to one year in an exceptional case) and cover not more than three calendar years preceding the year of a tax audit. Transfer Pricing Specialists Svetlana Stroykova Director, PwC Russia Evgenia Veter Director, PwC Russia Penalties of up to 40% of the transfer pricing adjustment, but not less than RUB 30,000 are proposed for underpayment of tax liability as a result of application of prices which do not comply with the arm s length principle in case of nonsubmission or submission of incomplete, untimely or inaccurate transfer pricing documentation. Untimely submission of transfer pricing reporting forms or their inaccurate completion may result in a penalty of RUB 5,000. In case of non-compliance with APA provisions, the tax authorities will be able to terminate the APA and impose penalties up to RUB 1,500,000 (approx. USD 50k). Action steps As advised before, the introduction of new Russian transfer pricing rules will require that companies doing business in Russia perform a revision of their transfer pricing policies. As seen from the Draft Law, it provides certain clarity with respect to application of transfer pricing rules. At the same time, the Draft Law introduces significant changes (reporting and transfer pricing documentation requirements, new methods, penalties). Thus, unless your company has already started some preparatory actions, it is recommendable to start preparing for the changes as soon as practically possible. If you would like to discuss this or any other transfer pricing matter, please contact one of our dedicated transfer pricing specialists listed below or your regular PricewaterhouseCoopers contact. Ilarion Lemetyuynen Tax Manager, PwC Russia svetlana.stroykova@ru.pwc.com evgenia.veter@ru.pwc.com ilarion.lemetyuynen@ru.pwc.com 2009, PricewaterhouseCoopers. All rights reserved 4

5 Contacts in Russia Bill Henry Leader, Tax and Legal Services Alina Lavrentieva Consumer Industrial Products Ekaterina Lazorina Financial Services Peter Solyonov Energy, Utilities and Mining Natalia Milchakova Technology InfoCom Entertainment Yana Zoloeva Legal Services Cherie Ford Mergers and Acquisitions Tax Services Vladimir Konstantinov, Indirect Tax Services and Customs William Schofield, International Assignments and HR Services Alexei Ryabov Director Global Compliance Services Veronica Misiutina International Tax Structuring PricewaterhouseCoopers Russia BV Kosmodamianskaya Nab.52, Bld Moscow, Russia Tel.: Fax: The Tax Flash Report is issued in Russian and English to keep PricewaterhouseCoopers clients abreast of changes in Russian legislation which may be of special interest. The information presented does not constitute professional advice provided by our specialists solely on individual basis PricewaterhouseCoopers Russia B.V. All rights reserved. PricewaterhouseCoopers refers to PricewaterhouseCoopers Russia B.V. or, as the context requires, other member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. 2009, PricewaterhouseCoopers. All rights reserved 5