Transfer Pricing Report

Transcription

1 Tax Management Transfer Pricing Report July 28, 2011 Reproduced with permission from Tax Management Transfer Pricing Report, Vol. 20 No. 7, 7/28/2011. Copyright 2011 by The Bureau of National Affairs, Inc. ( ) The New Russian Transfer Pricing Regulations: An Overview The author examines in detail new transfer pricing regulations designed to bring Russia more in line with Organization for Economic Cooperation and Development guidelines, noting provisions including the requirement to alert the tax authorities to related-party transactions that will increase the compliance effort required by taxpayers. BY VLADIMIR STARKOV, NERA ECONOMIC Vladimir Starkov is a senior consultant at NERA Economic Consulting in Chicago. The author wishes to thank Harlow Higinbotham for his thorough review and helpful comments. The views expressed in this article are those of the author and do not necessarily represent those of NERA. CONSULTING R ussian President Dmitry Medvedev July 18 signed legislation amending the Tax Code that significantly alters the country s transfer pricing landscape. Beginning Jan. 1, 2012, the effective date of the change, the safe harbor of 20 percent around the market price of comparable goods will no longer be sufficient to demonstrate compliance with the arm s-length standard. Instead, new amendments to the Tax Code introduce full-scope transfer pricing regulations that constitute a significant step toward adapting the framework established by the Organization for Economic Cooperation and Development transfer pricing guidelines, although practitioners will find that the regulations contain many idiosyncratic features. 1 Proper transfer pricing compliance in Russia will therefore require a thorough understanding of the newly adopted regulations. Some of the regulations features likely will increase the compliance effort for taxpayers with Russian operations. Among them: s the requirement to report controlled transactions to tax authorities on an annual basis coupled with a relatively low threshold for the volume of transactions subject to reporting requirements; s the necessity to prepare transfer pricing documentation to avoid penalties for underpayment of taxes; s limits on powers granted to tax authorities conducting transfer pricing audits to make only income adjustments that increase the Russian income taxes; s the lack of a clearly defined mechanism for corresponding income adjustments between the Russian and foreign taxpayers; and s limited availability of advance pricing agreements. This summary of the new Russian transfer pricing regulations is an attempt to chart a navigation map 1 The amendments would add Articles under Chapters , as well as other provisions. Copyright 2011 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. ISSN

2 2 through the document and does not necessarily provide exhaustive coverage of every detail. Definition of Related Parties The regulations stipulate that, for transfer pricing purposes, interdependence between parties is formed via capital participation or other relationships that allow one party to influence decisions of the other party, either directly or through other dependent parties. The regulations list the following circumstances as giving rise to such interdependent relationships: s The proportion of one party s participation in the capital of another party is 25 percent or more. The participation may be either direct or indirect that is, through other related parties. The capital participation is measured by either a proportion of voting shares or a proportion of shareholder equity. s Two or more companies for which the same shareholder holds directly or indirectly 25 percent or more capital in each company. s A party that can control appointment or election of a chief executive or at least 50 percent of the members of the board of directors in another company is considered related to that company. s Companies that share more than 50 percent of the board of directors personnel or the same chief executive are considered related. s Companies controlled by people related through the chain of hierarchy and companies controlled by relatives are considered related. Furthermore, taxpayers can choose to declare themselves to be related parties, and companies can be declared related parties by court decision. On the other hand, participation of government organizations in commercial companies does not by itself make such companies related. Definition of Controlled Transactions The following types of transactions are considered controlled: s those between related parties, as defined above; s transfers facilitated by unrelated parties acting as intermediaries among related parties when the unrelated parties do not bear significant risks or perform significant functions; 2 s export sales of goods subject to international trade in mercantile exchanges (for example, crude oil and petroleum products, ferrous and non-ferrous metals, fertilizers, gems, and precious stones); and s transactions in which at least one of the parties is a company registered, residing, or paying taxes in one of the tax havens listed under Russian law (or transactions in which a Russian company effectively forms a permanent establishment in such tax haven). Transactions among Russian taxpayers with a total volume exceeding 1 billion rubles (US$36 million) 3 are subject to transfer pricing audits unless all of such companies operate and pay taxes in the same administrative region of the Russian Federation and none of these 2 For a select group of taxpayers, such as payers of an agricultural tax and the tax on imputed income, enforcement of this clause will begin as of Jan. 1, The minimum threshold for these types of transactions is 3 billion rubles for 2012 and 2 billion rubles for companies have operating losses, including past period loss carryovers. Additionally, if the total volume of the following transactions exceeds 60 million rubles per year (US$2.1 million), such transactions among the Russian taxpayers also are subject to transfer pricing regulations when: s at least one of the parties is a payer of a mineral extraction tax and the controlled transaction involves the mineral subject to this tax; s one of the parties is a non-taxable entity while other parties are subject to income tax; or s one of the parties operates in an economic zone with a special income tax regime while other parties do not have any special tax treatment. 4 Transactions among Russian taxpayers with a minimum volume of 100 million rubles (US$3.6 million) where at least one of the parties is a payer of the agricultural tax or is subject to tax on imputed income are subject to transfer pricing regulations as well. On the other hand, transactions within the same consolidated group of taxpayers are not considered controlled (the legislation on the consolidated group of taxpayers is yet to be adopted by the parliament and enacted by the president). Transactions can be deemed controlled under other circumstances for example, by a court ruling that several transactions in the aggregate meet the criteria for controlled transaction even though each individual transaction does not. Notification of Tax Authorities Russian taxpayers will have to report to the local tax authorities all transactions defined as controlled transactions using special paper or electronic forms to be developed for such reporting. These transactions must be reported no later than May 20 of the year following the calendar year of the transaction. Taxpayers will have a right to self-correct the notifications. The penalty for failure to file such notifications or erroneous notification is 5,000 rubles (US$180). During the initial implementation period of the new transfer pricing regulations, disclosure of the relatedparty transactions is subject to the minimum thresholds (computed as annual totals of prices or costs of all related-party transactions of similar type) as follows: 100 million rubles (US$3.6 million) in 2012 and 80 million rubles (US$2.9 million) in In later years, there will be no minimum threshold for reporting controlled transactions other than the thresholds that apply to the Russian taxpayers, as discussed above. The information subject to disclosure includes: s the calendar year of the transactions; s the subject matter of the transactions (including a description of goods and services); s information about the parties to the controlled transactions, including the full name of the organization and taxpayer code (or full name of the individual entrepreneur and his or her taxpayer identification number); s the gross volume of sales or costs for the controlled transactions, including separately stated volume and costs for transactions whose prices are separately regulated under Russian law. 4 This provision will be enforced beginning Jan. 1, Copyright 2011 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN

3 3 Local tax authorities are required to forward the information about the controlled transactions to the federal tax authorities within 10 days of receipt. Transfer Pricing Audits Although conduct of transfer pricing audits is delegated exclusively to the federal tax authorities, the local tax authorities will have the right to notify the federal authorities about the controlled transactions they discover during the course of their audits. The federal tax authorities are authorized to verify the arm s-length nature of transfer pricing and propose any income adjustments. The federal tax authorities may initiate the transfer pricing audit with respect to any taxpayer no later than two years after receiving the notification about the controlled transactions. The transfer pricing auditors may review controlled transactions for the period of at most three years before the year in which the audit has begun. 5 Federal transfer pricing audits are required to be concluded within six months or, in exceptional cases, within 12 months. When the audit involves requesting information from foreign tax authorities or when an additional expert analysis or document translation are required, the audit period may be extended by an additional six months. If the foreign tax authorities do not provide responses within six months, an additional three months may be added to the audit. If the taxpayer applies one of the transfer pricing methods specified in the regulations (as described below), the federal tax authorities must apply the same method unless they determine that the method used by the taxpayer is not reliable. The federal tax authorities cannot apply methods not listed in the regulations. In conducting a transfer pricing audit, the federal tax authorities can request the transfer pricing documentation, the content of which is discussed below. The documentation must be provided within 30 days of request. If the federal tax authorities conclude that a tax adjustment is necessary, they must notify the taxpayer formally within two months of the end of the transfer pricing audit. The taxpayer has 20 days from the receipt of the notice to appeal it. The appeal may be accompanied by additional supporting evidence, and the time frame for submitting the supporting documents may be extended beyond the 20 days if the tax authorities agree to it. Correction of Taxable Income There is a presumption that the transfer prices used by the taxpayer are arm s-length unless proven otherwise. Self-correction of transfer prices by taxpayers is allowed, including the corresponding correction of the tax declarations. The correction of the tax declaration must be made within the time limit set for paying the general income tax. Self-correction, if needed, must be performed on an annual, as opposed to quarterly, basis. When a transfer pricing audit is conducted by the federal tax authorities, they are authorized to propose only pricing adjustments that do not reduce the Russian income tax liability. 5 This provision will be applied starting Jan. 1, Corresponding Income Adjustments Corresponding income adjustments can be made among the Russian taxpayers only when one of them has received an official notification of a tax adjustment (that increases its tax liability) and has, in fact, paid the additional tax. The corresponding income adjustments can be recorded in contemporaneous tax declarations of the affected parties. Given that the regulations do not allow for corresponding adjustments between the Russian and foreign taxpayers, the only feasible option to implement the income adjustment between the Russian and non-russian taxpayers outside of an APA seems to be through the use of bilateral treaties on the avoidance of double taxation (although the competent authority proceedings are not spelled out in the law). Documentation If the federal tax authorities have initiated a transfer pricing audit, the taxpayer may be asked to provide documentation. The documentation can be requested on or after June 1 of the year following the year being audited. Documentation needs to be presented within 30 days of a request. The tax authorities have the right to request documentation and other information about controlled transactions not only from the taxpayer being audited but from other parties to the transactions as well. The regulations do not provide a specific format for transfer pricing documentation, although they state that the complexity of such documentation should be commensurate with the complexity of the transaction. The information contained in the documentation is required to include: s a description of the taxpayer s business; s a list of related parties, including their countries of residence; s a description of the controlled transactions and their terms, including the transfer pricing method or methods used (if any), payment terms, and other relevant conditions; s a functional analysis of controlled parties, including risks taken and assets used by each of those parties; s a description of the method or methods used to test the arm s-length nature of transfer prices, including discussion of why a particular method was selected; s a description of the information sources used (a discussion of the information sources listed in the regulations is provided below); s a calculation of the arm s-length range including the description of the selection of the comparable transactions; s the tested party s profit and loss statement; s the profit of the tested party associated with the use of valuable intangibles obtained in a controlled transaction; s other relevant information, such as market strategy; s adjustments to the reported tax liability made by the taxpayer, if any; and s any other information confirming the arm s-length nature of transactions that the taxpayer considers relevant. The following transactions are exempt from the documentation requirements: s transactions subject to APAs; TAX MANAGEMENT TRANSFER PRICING REPORT ISSN BNA TAX

4 4 s transactions with prices regulated by government organizations; s transactions that involve widely traded financial instruments; and s those that do not involve related parties. Timely submission of transfer pricing documentation allows the taxpayer to avoid a penalty if the tax underpayment is alleged by the tax authorities. Such penalty is calculated as the greater of 40 percent of the underpaid tax or 30,000 rubles (US$1,000). 6 Advance Pricing Agreements APAs are permitted only for the largest taxpayers (as defined elsewhere in the tax law). APAs are concluded between Russian taxpayers and the federal government. Bilateral APAs are allowed with countries that have double tax avoidance treaties with Russia (this procedure is to be approved by the Russian Ministry of Finance). A single Russian taxpayer may act on behalf of a group of related Russian taxpayers in the APA process under a power of attorney provided to it by the related taxpayers. APA terms are limited to three years with a possible extension for another two years upon a taxpayer s request. The request for extension will be considered if the taxpayer has abided by the terms of the existing APA. The APA period also may cover the time elapsed between the taxpayer s application for the APA and the APA s approval. The taxpayer s APA application should be considered within six months, or, in exceptional circumstances, within nine months. A taxpayer has a right to recall its APA application. By the end of the consideration period, the tax authorities can either accept the application, ask for additional materials, or deny the application with formal explanations of the reasons for such denial. One of the reasons for denial may be the projected reduction of income taxes payable in Russia. Denial of an APA application can be appealed in court. Control over APA execution is delegated to the federal tax authorities. If the taxpayer abides by the APA conditions, the federal tax authorities cannot make upward income adjustments for transactions covered by the APA. An APA that has gone into effect can be terminated by the federal tax authorities if they conclude that the taxpayer has paid lower taxes than agreed upon under the APA. An APA can be modified based on a court decision, by mutual agreement of the parties, or to reflect changes in the tax or customs laws other than the law that regulates the APA process itself. Comparability Analysis The regulations present an extensive list of factors that should be used to consider comparability between controlled and uncontrolled transactions. These factors include: 6 Income adjustments for controlled transactions conducted in are not subject to an additional penalty. Controlled transactions conducted during are subject to the reduced penalty of 20 percent of the additional tax assessment, and controlled transactions in 2017 and thereafter are subject to the full penalty of 40 percent of the additional tax assessment. s the characteristics of goods or services; s the functions performed, risks assumed, assets (including intangible and financial) used, and responsibilities of the controlled parties; s contract terms, volume of transactions, payment terms, exchange rates, and assignment of rights among parties; s economic conditions; s market characteristics (for example, geographic location, competitive situation, relative market power of buyers and sellers, government regulations); s market strategies (such as new market penetration, and product updates); For financial transactions, additional comparability factors such as credit history of the recipient of a loan or a loan guarantee, the term of the loan (guarantee), the currency of transaction, and formulas for interest rate adjustments can be used. Sources of Information The federal tax authorities are authorized to use only the sources of information listed in the regulations when conducting transfer pricing audits. The tax authorities cannot use any non-public information not related to the taxpayer being audited in the course of the transfer pricing audit. Taxpayers can use any public information sources to support their transfer prices and prepare transfer pricing documentation. The regulations list the following primary sources of information that can be relied on by the federal tax authorities: s prices and pricing quotes of the Russian and foreign mercantile and stock exchanges, including those officially published by the Russian and foreign governments and commercial organizations; s customs statistics of the Russian Federation; s pricing databases; and s prices applied in the taxpayer s own transactions. If sufficient information cannot be obtained from the primary sources listed above, the tax authorities may consider the following additional sources: s prices and pricing quotes reported in other publicly available databases; s financial and statistical reports of companies obtained from publicly available databases or companies websites; 7 and s valuation reports prepared according to Russian or foreign valuation standards. If, during the transfer pricing audit, tax authorities determine that the taxpayer was engaged in transactions with unrelated parties that are comparable to the controlled transactions of the same taxpayer, then the tax authorities must use the prices of these uncontrolled transactions to establish the prices of the controlled transactions. Arm s-length Range The interval of arm s-length prices is calculated using the interquartile range. The interquartile range is 7 Financial data of foreign companies can be used only if financial reports of the Russian companies engaged in comparable transactions are insufficient for purposes of determining the arm s-length pricing range. Details on calculation of this range are discussed below Copyright 2011 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN

5 5 determined in the same way as described in the U.S. Treasury regulations under Section 482. Specifically, the lower end of the range is found as the lowest result derived from the range of uncontrolled prices arranged in the increasing order such that at least 25 percent of the results are at or below the value of that result. If exactly 25 percent of the results are at or below a result, then the 25th percentile is equal to the average of that result and the next higher result derived from the range of uncontrolled prices. The upper end of the range is determined analogously using the 75th percentile. Pricing Methods The transfer pricing methods that can be used to establish the arm s-length price are the comparable uncontrolled price (CUP), resale price, cost plus, comparable profits (CPM), and profit split methods. The definitions of those methods in the Russian regulations are broadly consistent with those used in the OECD guidelines and the U.S. transfer pricing regulations, although the Russian regulations differ in some details with respect to implementation of these methods. A taxpayer can use a combination of two or more methods to establish the arm s-length price. A group of similar transactions may be combined for the purposes of a transfer pricing analysis. There is a hierarchy of methods, with CUP being the priority method for all transactions and the resale price method preferred for transactions involving purchases of goods from related parties and resale to unrelated parties without substantial transformation in cases when the reseller does not own valuable intangibles. Other methods can be applied when CUP or resale price do not produce reliable results. Resale price and cost plus can be used only if financial statements of the tested party and the comparable companies apply the same accounting methods to calculate relevant costs and income, or if reliable adjustments can be made to correct for any such differences. When reliable adjustments cannot be made, CPM or the profit split method should be used. CPM and profit split do not require calculation of arm s-length prices for each tested transaction. If a transaction between related parties is an isolated transaction that involves transfer of goods or services that are not the core business of the tested party, the arm s-length price can be established using a valuation analysis. Taxpayers are not required to use the methods specified in the regulations to establish intercompany prices. The specified methods are to be used only for purposes of establishing compliance with the transfer pricing regulations. Profit Level Indicators The following profit level indicators can be used in all of the transfer pricing methods described above except CUP: s the ratio of gross profit to sales (gross margin); s ratio of gross profit to cost of goods sold; s ratio of gross profit to operating expenses; and s ratio of gross profit to total assets. Additionally, in the application of CPM, operating profit may be used instead of the gross profit in the same ratios. Other profitability ratios that reflect the relationship between the functions performed, assets used, risks taken, and profits may be used as well. The use of gross margin and the ratio of gross profit to operating expenses is recommended for transactions involving resale activities, while the ratio of gross profit to cost of goods is recommended for manufacturing activities and the provision of services. The ratio of gross profit to total assets is recommended for capitalintensive manufacturing activities. Comparables The selection of comparable companies is required to meet the following criteria: s Comparables must perform functions similar to those of the tested party (the comparability is established by examining the relevant industry codes). s Comparables must have positive net assets. s Comparables cannot have more than one year of operating losses in the multi-year analysis period. s The comparable companies cannot be more than 25 percent owned by other companies or control more than 25 percent of other companies capital (either directly or indirectly). If application of the 25 percent control criterion reduces the number of comparables to less than four, then the control threshold may be increased from 25 percent to 50 percent. The comparable companies profits can be measured using either the year of the tested transaction or three preceding years, if the latest year s data are not available. The year end for the latest comparables data cannot be later than the year end of the tested party. The measurement of the comparables profitability ratios is required to be made according to Russian generaly accepted accounting principles. If the financial data of comparables is stated using foreign GAAP, the data must be adjusted to reflect Russian GAAP. Profitability data can be adjusted to reflect differences in inventory holdings, payables, and receivables between the comparables and the tested party. Conclusion Taxpayers with Russian operations should take proactive steps to ensure compliance with the new law. This includes taking an inventory of all controlled transactions, aligning intercompany prices using available benchmarking information on arm s-length prices, and preparing transfer pricing documentation. Transfer pricing practitioners analyzing Russianrelated transactions also will need to develop a good understanding of the information sources that provide pricing data and financials for Russian companies and develop comparables screening and adjustment procedures consistent with the regulations. TAX MANAGEMENT TRANSFER PRICING REPORT ISSN BNA TAX