Tax Messenger. TP BULLETIN A Round-up of Transfer Pricing News. In this issue: Tax Edition. 6, April, 2017

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1 6, April, 2017 Tax Messenger Tax Edition TP BULLETIN A Round-up of Transfer Pricing News In this issue: EY s Russian Tax & Law practice was named a leading Tax firm in Russia in World Tax 2017, an annual guide published by the International Tax Review. INTERNATIONAL EVENTS... 3 Automatic Exchange of Information 3 The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (BEPS) 3 Updated Version of the UN Practical Manual on Transfer Pricing 4 DRAFT LEGISLATION... 4 Revised Version of the Bill on the Automatic Exchange of Financial Account Information and Documentation Relating to International Groups of Companies 4 FEDERAL LAWS... 4 Transactions Involving the Provision of Guarantees (Surety Bonds) and Interest-Free Loans Are no Longer Classed as Controlled 4 New Type of Controlled Transaction 4 DOCUMENTS OF FEDERAL EXECUTIVE BODIES... 5 Conclusion of Pricing Agreements in Relation to Foreign Trade Transactions 5 Corresponding Adjustment for Foreign Trade Transactions 5 Main Tax Policy Objectives for 2017 and the Planning Period 2018 and

2 The Arm s-length (Fair Price) Principle in Transactions 6 Application of Corresponding Adjustments in Relation to Debt Obligations, the Assignment of Claims and Securities Transactions 6 Concept of a Group of Similar Transactions 6 Determination of the Value of a Participating Interest in the Capital of a Limited Liability Company 7 Conditions for Recognising Companies as Comparable 7 Relatedness of Companies in Which an Interest is Held by a Foreign State 7 Transactions with Residents of Priority Socio-Economic Development Areas Cannot be Considered Controlled 7 New Profits Tax Declaration Form 7 TRANSFER PRICING STATISTICS... 8 CASE LAW... 8 First Review of Supreme Court Case Law on Transfer Pricing 8 First Court Ruling on a Transfer Pricing Audit 9 Deviation from the Market Price by a Multiple Factor May Indicate the Receipt of an Unjustified Tax Benefit/Performance of an Expert Appraisal 9 Sale of Motor Vehicles at Below Purchase Price 10 Fictitious Intermediaries May be Excluded from the Supply Chain, and Transfer Pricing Rules Should Only be Applied to Genuine Transactions 11 Prices in Uncontrolled Transactions May be Reviewed Only if the Parties are Related 12 Relatedness between Parties to an Uncontrolled Transactions is Not Necessarily a Basis for Reviewing Prices 12 Court-Ordered Expert Appraisal Where Conflicting Expert Reports Are Presented by a Tax Authority and a Taxpayer 12 Charging of Additional VAT on Uncontrolled Transactions Where the Parties Receive an Unjustified Tax Benefit 12 Business Purpose in Selling Goods at a Lower Price under a Long-Term Contract Where There are Higher-Priced One-Off Contracts 12 A Taxpayer Does Not Have the Right to Petition a Court to Recognise it as a Related Party of Another Entity for Taxation Purposes 12 Use of EU Customs Statistics as a Source of Price Information/Date as at Which the Market Price is Determined under the Comparable Market Prices Method 13 Comparison of a Taxpayer s Prices with Exchange Quotations for Nonferrous Metals 13 Application of the Transfer Pricing Rules to Interest-Free Loans 13

3 INTERNATIONAL EVENTS Automatic Exchange of Information On 26 January 2017 the Federal Tax Service signed the Multilateral Competent Authority Agreement on Country-by-Country Reporting. The signing took place on the fringes of a meeting of the Inclusive Framework for the Implementation of the Action Plan on Base Erosion and Profit Shifting (BEPS). A country-by-country (CbC) report is a formal document setting out financial and tax data and functional characteristics of international groups in states (territories) where companies within those groups operate. Russia s accession to the Multilateral Agreement, in addition to the Convention on Mutual Administrative Assistance in Tax Matters which entered into force on 1 July 2015, creates an international legal framework that will enable: the Federal Tax Service to exchange country-bycountry reports with competent authorities of foreign states (territories) and use the information contained in them for pre-audit analysis; Russian taxpayers to submit CbC reports on a centralized basis, including in relation to group companies that are tax residents of foreign states (territories), without the risk of repeat requests 1. The exchange of CbC reports is to begin from More detailed information about the signing of the Agreement is presented in an EY alert. It will also be recalled that on 12 May 2016 Russia signed the Multilateral Agreement on the Exchange of Financial Account Information in the context of accession to the Standard on the Automatic Exchange of Financial Account Information. Accession to the Standard means that the Russian tax authorities will be able to obtain information from foreign tax authorities (in jurisdictions which have likewise acceded) on financial accounts held by Russian taxresident individuals and companies in the respective countries. The Russian tax authorities will be similarly obliged to provide information to their counterparts in partner jurisdictions on financial accounts held by tax residents of those jurisdictions with Russian financial institutions. The exchange will take place automatically on an annual basis. The first exchange of information with partner countries will take place in More detailed information may be found in an EY alert. In order to enable compliance with the requirements of the Agreements, a law is to be adopted on the international automatic exchange of financial account information and documentation relating to international groups of companies (see the Draft Legislation section below). The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (BEPS) On 24 November 2015, the Organization for Economic Co-operation and Development (OECD) released the text of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (BEPS) under BEPS Action 15 (the MLI). The Multilateral Convention was developed in order to enable BEPS provisions requiring the modification of existing double tax treaties to be implemented by means of the signing of a single document without the need for amendments to be made to each individual treaty. The Multilateral Convention is intended to operate alongside tax treaties, modifying their application in order to implement the BEPS measures. The elements of the BEPS Plan covered by the Multilateral Convention include: hybrid instruments (Action 2), treaty abuse (Action 6), artificial avoidance of permanent establishment status (Action 7), dispute resolution through improved use of mutual agreement procedures provided for in tax treaties (Action 14). The Multilateral Convention contains provisions enabling the implementation of the treaty-related minimum standards agreed upon as part of the BEPS package: the prevention of treaty abuse (Action 6) and dispute resolution through improved use of mutual agreement procedures provided for in tax treaties (Action 14). The minimum standards are required to be implemented by states acceding to the BEPS plan. More detailed information is given in our global alert. According to the draft of the Main Tax Policy Objectives for 2017 and the Planning Period 2018 and 2019 (see the Documents of Federal Executive Bodies section below), Russia plans to accede to the Multilateral Convention. There is, therefore, a high probability that Russia will implement the BEPS minimum standards on treaty abuse (Action 6) and improved use of mutual agreement procedures (Action 14), including in regard to transfer pricing. 1 Source: official website of the Federal Tax Service. 3

4 Updated Version of the UN Practical Manual on Transfer Pricing An updated version of the UN Practical Manual on Transfer Pricing for Developing Countries has been drafted and the final version is expected to be published in The document considers the OECD s transfer pricing recommendations under BEPS and contains chapters describing practices and approaches employed in countries such as India, Mexico, China, South Africa and Brazil. DRAFT LEGISLATION Revised Version of the Bill on the Automatic Exchange of Financial Account Information and Documentation Relating to International Groups of Companies On 6 March 2017 the Finance Ministry issued for public discussion a new version (the third to date) of a bill aimed at the introduction in Russia of documentation requirements for international groups of companies. Below is a description of the main changes that have been made to the Bill compared with the previous version published on 6 September 2016: the definitions of a parent company and an authorized member of an international group have been modified, bringing them more into line with BEPS Action 13; the time limit for submitting notifications of participation in an international group has been extended: it is now eight (rather than three) months from the end date of the parent company s last financial year. the consolidated revenue threshold used to determine whether a company has an obligation to submit country-by-country data and a notification is to be determined with account taken of the requirements of the foreign jurisdiction of the parent company, which is in keeping with the OECD recommendations; global documentation may now be requested not only from Russian tax-resident parent companies of international groups, but also from any other group members that are tax residents of Russia; the provisions concerning the preparation and contents of global documentation have changed significantly compared with the previous version of the Bill; the new draft eliminates uncertainty as to whether members of international groups will be required to prepare national documentation in addition to or instead of controlled transaction documentation provided for in the current version of Article of the Tax Code. National documentation is now viewed as the only kind of documentation (in addition to a CbC report and global documentation) that would be required from members of an international group in relation to cross-border controlled transactions; changes have been made to the provisions concerning sanctions for the non-submission or misstatement of CbC data: in particular, fines for the non-submission of (or submission of misstated) global and national documentation have been excluded and adjustments have been made to the wording of provisions regarding fines for the nonsubmission of a CbC report or the submission of a report containing false information; the law is expected to enter into force from the moment it is signed, but will apply to financial periods of international groups starting from 1 January It is also stated that the new requirements will cover transactions concluded in prior periods if amounts of income and (or) expenses relating to those transactions are recognised for tax purposes on or after 1 January More detailed information on this issue may be found in our alert. FEDERAL LAWS Transactions Involving the Provision of Guarantees (Surety Bonds) and Interest-Free Loans Are no Longer Classed as Controlled In accordance with Federal Law No. 401-FZ of 30 November 2016, as from 2017 the following transactions are no longer classed as controlled: the provision of surety bonds (guarantees) where all the parties to the transaction are Russian companies which are not banks; the provision of interest-free loans between related parties where all the parties to and beneficiaries of the transaction are registered or resident in Russia. This should put an end to disputes over whether interest income may be imputed to the provider of an interest-free loan in a controlled transaction. There is still, however, a question mark in the case of transactions that are not classed as controlled. New Type of Controlled Transaction According to Federal Law No. 475-FZ of 28 December 2016, as from 2017 a transaction between related 4

5 residents of Russia is considered controlled 2 if any of the parties is a corporate research centre such as is referred to in the Federal Law Concerning the Skolkovo Innovation Centre which exercises an exemption from the performance of obligations of a VAT payer in accordance with Article of the Tax Code. DOCUMENTS OF FEDERAL EXECUTIVE BODIES Conclusion of Pricing Agreements in Relation to Foreign Trade Transactions The Finance Ministry has published a draft order Concerning Approval of the Procedure for the Conclusion of a Pricing Agreement for Taxation Purposes in Relation to a Foreign Trade Transaction in Which at Least One Party is a Tax Resident of a Foreign State with Which There is a Double Tax Agreement (Treaty) with the Involvement of an Authorized Executive Body of That Foreign State ( the Procedure ). The development of the Procedure is provided for in clause 2 of Article of the Tax Code. The adoption of the Procedure should provide a practical framework for the conclusion of a pricing agreement with the involvement of a foreign competent authority. According to the draft order, pricing agreements in relation to foreign trade transactions would be concluded between the Federal Tax Service and a taxpayer on the basis of a mutual agreement between the Federal Tax Service and the competent authority of a foreign state. The mutual agreement must be reached by means of mutual agreement procedures conducted on the basis of a tax treaty. The Finance Ministry makes the Federal Tax Service the competent authority vested with powers to conduct mutual agreement procedures under a tax treaty for the purposes of concluding pricing agreements and to exchange information with a competent authority of a foreign state for those purposes. The Procedure sets out the following stages of the conclusion of a pricing agreement in relation to foreign trade transactions: preliminary discussion with the Federal Tax Service; submission of an application for the conclusion of a pricing agreement in relation to a foreign trade transaction; consideration of the taxpayer s application by the Federal Tax Service; negotiations between the Federal Tax Service and the foreign competent authority; implementation of the mutual agreement of the competent authorities in Russia. The use of pricing agreements in relation to foreign trade transactions is widespread in international terms, since they provide a means of ensuring the economically justified and fair apportionment of the tax base between two states and eliminating double taxation, while also eliminating uncertainty and ensuring predictability in regard to the tax treatment of foreign trade transactions, thus helping to prevent tax evasion. More detailed information on this issue may be found in an EY alert. Corresponding Adjustment for Foreign Trade Transactions According to Letter No /28673 of 10 May 2016, a foreign contract partner may use the prices based on which a Russian taxpayer made an independent adjustment 3 in the cases and in the manner provided for in the tax treaty with the foreign state of which the foreign partner is a resident. Since the issue of the application of a corresponding adjustment in a foreign jurisdiction is usually resolved between two states through mutual agreement procedures provided for in the relevant tax treaty, the letter may be an indication that the Finance Ministry is prepared to make more extensive use of those procedures. Main Tax Policy Objectives for 2017 and the Planning Period 2018 and 2019 Available on the Finance Ministry s website is the draft of the Main Tax Policy Objectives for 2017 and the Planning Period 2018 and The document contains proposals to consider: eliminating tax control over prices of transactions between persons located and operating within one region of Russia; increasing the control threshold for transactions on the domestic market with a view to removing 2 Clause 2 of Article of the Tax Code. 4 Source: official website of the Ministry of Finance. 3 Clause 6 of Article of the Tax Code. 5

6 control over transactions of minor importance for the budget. It also sets out plans: for the commencement from 2018 of the exchange of information under the Convention on Mutual Administrative Assistance in Tax Matters and the Multilateral Competent Authority Agreement on the Automatic Exchange of Financial Information; for amendments to be made to Russian tax law to provide for the exchange of financial information and documentation relating to international groups, including the creation of a mechanism for tax authorities to collect information needed for exchange with foreign competent authorities; for accession to the OECD Multilateral Convention, requiring the amendment of tax treaties between Russia and other states, as part of the strategy for combating tax evasion schemes and artificial avoidance of PE status and preventing tax violations. Work will also resume on the conclusion of new bilateral tax treaties. The Arm s-length (Fair Price) Principle in Transactions In Letter No /1/3235 of 23 January 2017, the Ministry of Finance observed that clause 1 of Article of the Tax Code establishes the globally recognised arm s-length ( fair-price ) principle. From a civil perspective, taxpayers have no obligation, when concluding transactions, to take guidance from the Tax Code (and the transfer pricing rules 5 in particular) in matters of pricing. For tax purposes, however, income (profit, revenue) accruing to a taxpayer from transactions between related persons must be determined in accordance with the transfer pricing rules. Application of Corresponding Adjustments in Relation to Debt Obligations, the Assignment of Claims and Securities Transactions In Letter No /1/63476 of 31 October 2016, the Finance Ministry raised the issue of whether corresponding adjustments may be made in relation to debt obligations, the assignment (transfer) of claims and securities transactions 6, and asserted that the matter required further examination. In our view, the problem may lie in the fact that the articles in question lay down particular rules relating to the determination of the tax base for specific types of transactions, giving rise to questions as to how adjustments should be applied (i.e. as independent or corresponding adjustments). For example, in the case of the use of interest rate threshold ranges in relation to debt obligations under Article 269 of the Tax Code, each of the parties to a transaction must independently check whether the actual interest rate is within the range and, if appropriate, make an adjustment based on its range boundary. Obviously, the fact that the party that paid interest uses the upper boundary (if the actual interest rate exceeds it) does not mean that the other party to the transaction must reduce its income accordingly, since that other party is required to recognise income in an amount that is not below the lower boundary. It must be pointed out that since it is not the provisions of clause 6 of Article of the Tax Code concerning independent adjustments that are applied for the purpose of determining the interest rate in this situation, but Article 269, the other party to the transaction does not technically have a right to a corresponding adjustment. Concept of a Group of Similar Transactions Under the transfer pricing rules, notifications of controlled transactions and related documentation may be submitted for a group of similar transactions. In addition, methods based on profit margin may be applied in relation to a group of similar transactions 7. However, the Tax Code does not provide a definition of a group of similar transactions. In Letter No /1/62279 of 26 October 2016, the Ministry of Finance reiterated its opinion that it should be understood to mean a set of transactions in which the following are the same: functions performed by the parties; the method of determining income (profit, revenue); the profit margin indicator; actual profit margin indicators for comparable companies or transactions concluded by a taxpayer with independent companies. The ministry s position makes the process of preparing notifications and documenting controlled transactions easier for taxpayers. 5 Section V.1 of the Tax Code. 6 i.e. when the provisions of Articles 269, 279 and 280 of the Tax Code are applicable for the purposes of determining price. 7 Clause 1 of Article of the Tax Code, clause 4 of Article , clause 5 of Article of the Tax Code. 6

7 Determination of the Value of a Participating Interest in the Capital of a Limited Liability Company Letter No. SD-4-3/20010 of the Federal Tax Service of 21 October 2016 addresses the issue of the determination of the value of a participating interest in the capital of a limited liability company (OOO) in the following situation. A joint stock company plans to pay dividends in kind to its sole shareholder, which is a public joint stock company. The dividends are to be paid to the shareholder in the form of a 100% participating interest held by the joint stock company in an OOO. The OOO s assets consist of cash and a block of ordinary shares in the public joint stock company. Based on the transfer pricing rules 8, the Federal Tax Service takes the view that in this situation the joint stock company may recognise income from the sale of the participating interest in the OOO s capital and the public joint stock company may determine the acquisition price of that participating interest as an amount equal to the declared dividends of the joint stock company if that price is consistent with the market value of the interest in the OOO s capital as confirmed by an independent appraisal. Conditions for Recognising Companies as Comparable Profit margins may be calculated on the basis of a company s accounting (financial) statement data subject to the condition, inter alia, that the company must not have a direct and (or) indirect interest in another company in excess of 25% (except where information is available on the consolidated financial statements of companies that are used in calculating the profit margin range) or have as a participant (shareholder) a company with a direct participating interest in excess of 25% (subsection 4 of clause 5 of Article of the Tax Code). In the opinion of the Finance Ministry, as set out in Letter No /1/58705 of 7 October 2016, the condition in question is fulfilled if one of the requirements stated in the subsection is met. This raises the question of whether a company may be considered comparable if it does not have a shareholder with a greater than 25% direct interest, but does itself hold a greater than 25% interest in another company. Relatedness of Companies in Which an Interest is Held by a Foreign State A direct and (or) indirect participating interest held by Russia, Russian regions or municipalities in Russian companies is not necessarily a basis for classing the companies concerned as related 9. According to Letter No /48517 of the Finance Ministry of 18 August 2016, there are no grounds for applying the clause in question to relations between Russian and foreign companies, including in cases where a foreign state holds a direct and (or) indirect interest in the companies concerned. Transactions with Residents of Priority Socio- Economic Development Areas Cannot be Considered Controlled A transaction between related Russian companies is considered controlled, inter alia, where any of the parties to the transaction is a resident of a special economic zone or a participant in a free economic zone with a tax regime that affords special profits tax reliefs and, in addition, the other party (parties) to the transaction is not (are not) a resident of the special economic zone or a participant of the free economic zone in question 10 and the amount of income from such transactions between the persons concerned for the calendar year exceeds 60 million roubles. In the opinion of the Ministry of Finance, as stated in Letter No /1/1541 of 17 January 2017, the status of special economic zones and priority socio-economic development areas is regulated by separate federal laws, meaning that intra-russian transactions between related parties in which one of the parties is a resident of a priority socio-economic development area cannot be considered controlled on the above-mentioned ground. New Profits Tax Declaration Form Order No. MMV-7-3/572@ of the Federal Tax Service of 19 October 2016 approved the new standard form of a profits tax declaration, the procedure for completing it and the format for submitting the declaration in electronic form. The declaration form now includes a Sheet 08 Income and Expenses of a Taxpayer Which Has Made an Independent (Corresponding, Reverse) Adjustment. Depending on the number of transactions, the taxpayer must complete an appropriate number of Sheets 08. Provision is made for adjusting both sales-related and non-sale income (expenses). 8 Clause 9 of Article of the Tax Code. 9 Clause 5 of Article of the Tax Code. 10 Subsection 5 of clause 2 of Article of the Tax Code. 7

8 TRANSFER PRICING STATISTICS The Federal Tax Service has published information on its activities for January to September 2016 on its official website, including the following statistical data relating to transfer pricing. 1. Transfer Pricing Audits (as at 1 October 2016) For 2012: all audits completed, audit reports served for 18 audits (oil products, metal products and mineral fertilizers). Total additional charges imposed in reports served 2,062 million roubles, amount of deductible loss 1,885 million roubles. The examination of audit materials relating to transactions of taxpayers that were exporters of oil and oil products resulted in 13 decisions being issued, imposing a total of 716 million roubles in additional profits tax and 16 million roubles in penalties. In the case of transactions of taxpayers which export oil products, 12 decisions were issued, imposing a total of 555 million roubles in additional profits tax and 62,000 roubles in penalties. For 2013: 7 audits carried out in relation to groups of similar transactions concluded by six taxpayers (five decisions in relation to sales of metal products, two in relation to exports of mineral fertilizers). Identification of an unjustified tax benefit through price manipulation in transactions between related parties not classed as controlled: territorial tax authorities issued 283 decisions (not contested by administrative appeals) imposing total additional tax charges of 3,058 million roubles and disallowing VAT reimbursements totalling 45 million roubles. 2. Independent Adjustments (as at 1 October 2016) In the period taxpayers made independent adjustments to the tax base amounting to 69.4 billion roubles and paid additional taxes amounting to 10.4 billion roubles. 3. Notifications of Controlled Transactions (as at 1 October 2016) Territorial tax authorities issued 5,140 decisions imposing sanctions for failure to submit a notification on time or the submission of notifications containing false information. Fines paid to the budget amounted to 20.1 million roubles. 15,059 notifications of controlled transactions were submitted in the first nine months of 2016 (13,538 of them relating to 2015). Notifications for 2015 contained details of 97,950,000 transactions. Territorial tax authorities prepared 1,615 notices to the Federal Tax Service concerning transactions identified during on-site and in-house tax audits which had not been reported in notifications of controlled transactions. 4. Pricing Agreements In the first nine months of 2016, seven pricing agreements were concluded with 13 large Russian taxpayers, including four agreements relating to sales of oil within Russia and three relating to codeshare transactions (arrangements between multiple companies on the joint commercial operation of flights). The tax authorities also monitored compliance by taxpayers with five previously concluded pricing agreements. CASE LAW First Review of Supreme Court Case Law on Transfer Pricing On 16 February 2017 the Presidium of the Supreme Court approved the Review of Court Cases Associated with the Application of Certain Provisions of Section V.1 and Article 269 of the Tax Code of the Russian Federation. The review includes the following observations: the fact that the actual price differs from the market level is not sufficient in itself to conclude that the taxpayer received an unjustified tax benefit. Where, however, the price deviates from the market level by a multiple factor, this may be considered as one indication of the receipt of an unjustified tax benefit In this case both additional profits tax and additional VAT may be charged; cases in which persons may be found by a court to be related are not limited to situations where the parties to a transaction would be recognised as affiliates, subsidiary and dependent companies, etc., in accordance with the law; influence which is exerted by reason of economic factors, such as the dominant market position of one of the parties to a transaction, should not be taken into account in declaring persons to be related; it will be recalled that a set of transactions involving the sale of goods (work and services) concluded with the participation (mediation) of non-related persons may be equated with transactions concluded between related persons if the parties to that set of transactions only perform the function of organizing the sale of goods (work and services) 11. The Supreme Court asserts that the general conditions subject to which 11 Subsection 1 of clause 1 of Article of the Tax Code. 8

9 transactions are deemed to be controlled must be met in relation to such a set of transactions. In particular, where transactions concluded within the country fall short of the relevant value threshold, they cannot be considered as controlled; courts may take account of any circumstances which are relevant to the determination of whether a transaction is priced at market level without being subject to the limitations stipulated by the general provisions of Section V.1 of the Tax Code concerning prices and taxation 12 and the rules for the application of methods of determining income (profit, revenue) 13. This provision cannot, however, serve as a basis for deviating from the rules concerning the determination of the comparability of the conditions of transactions, the selection of information to be used for that purpose 14 and the selection of the priority method 15, or for changing the established procedure for calculating income (profit, revenue) using the method in question; an expert review should not be performed in the course of judicial proceedings for the purpose of rectifying failings in a tax audit of a taxpayer; the entry of incorrect details in a notification of controlled transactions is a basis for imposing sanctions on a taxpayer only if errors made in entering those details could have impeded identification of the controlled transaction; deciding whether to impose tax sanctions for the late submission of a notification of controlled transactions (the submission of an inaccurate notification) is a matter for the tax inspectorate to which the taxpayer should have submitted the notification. More detailed information on the review may be found in our alert. First Court Ruling on a Transfer Pricing Audit The first ruling on a transfer pricing audit was the decision issued by the Moscow Arbitration Court on 27 January 2017 on Case No. A /2016. As expected, transfer pricing case law began with an examination of transactions involving the sale of global exchange-traded commodities to a foreign trader. The dispute had certain features that are not typical of existing case law. More detailed information may be found in our alert. Deviation from the Market Price by a Multiple Factor May Indicate the Receipt of an Unjustified Tax Benefit/Performance of an Expert Appraisal According to Supreme Court Determination No KG of 9 February 2017 on the case involving Lechebno-Diagnosticheskiy Tsentr Mechnikov OAO, where transactions that do not meet the criteria of controlled transactions take place between related parties and taxpayers are found to have manipulated prices, setting them at levels that deviate from market prices by a multiple factor, the fact that the taxpayer received an unjustified tax benefit is proven through on-site and in-house audits. Having established that the persons involved in the transactions were related, and considering the fact that the rent charged for the use of property (furniture, implements and medical equipment) was several times the normal amount, as well as other circumstances of the transactions, the courts rightly concurred with the inspectorate s conclusion that the company had received an unjustified tax benefit. The cassation court s ruling asserted that it was acceptable for an expert appraisal to be carried out (i.e. on the basis of valuation law rather than transfer pricing rules) in proving that the taxpayer had received an unjustified tax benefit. The case provides further confirmation that tax authorities are not limited to methods prescribed by the transfer pricing rules in proving that an unjustified tax benefit has been received. However, in Determination No. 308-KG of 1 December 2016 on the case involving Akvapark OOO, the Supreme Court concluded that the fact that the price charged by a taxpayer differs from the level of prices ordinarily charged for identical (similar) goods, work or services cannot in and of itself serve as a basis for concluding that the taxpayer received an unjustified tax benefit or has arrears to be determined on the basis of the price difference, since it is not the function of a judicial examination to assess the economic expediency of decisions made by businesses. Where, however, the tax authority challenges a reported transaction from the point of view of consistency with its true economic intent, the fact that the transaction deviates from the transaction price by a multiple factor may be considered as an indication of the receipt of an unjustified tax benefit when viewed together and in conjunction with other circumstances which cast doubt on the business 12 Chapter 14.2 of the Tax Code. 13 Chapter 14.3 of the Tax Code. 14 Articles of the Tax Code. 15 Clause 3 of Article of the Tax Code. 9

10 purpose of the transaction (the relatedness of the parties to the transaction, the fact that a company was established shortly before the conclusion of a transaction, the use of particular forms of settlements and payment schedules, etc.). The court also observed that since the purpose of the expert valuation undertaken in the context of the tax audit was to determine the market value of immovable property, only professional appraisers should have been engaged as experts. However, the self-regulatory organization of appraisers of which the appraiser engaged by the inspectorate was a member had ceased to operate, the appraiser himself did not have a higher vocational education and the information that he had received a formal qualification proved to be false. In addition, it was concluded during the hearing that the appraiser s report did not comply with federal valuation standards since he had used comparable assets that did not satisfy the criteria of identicalness (similarity) to the subject assets and comparability of the conditions of sale. Since, in view of these circumstances, the appraisal carried out during the audit was judged to be inadmissible evidence, the tax authority filed an application during the court proceedings for a courtordered price appraisal to be arranged. However, the Supreme Court asserted that it was inadmissible for a court-ordered appraisal to be arranged for the purpose of rectifying the failings of a tax audit (i.e. for a new appraisal to be carried out in place of the one judged to be admissible). The court did, however, state that a court-ordered appraisal could be carried out for the purpose of clarifying circumstances on the basis of which a taxpayer was penalized. The conditions governing the admissibility of an expert s report are also examined in the ruling of the Arbitration Court of the West Siberian District of 7 December 2016 on Case No. A /2014 involving Shakhta Zarechnaya OAO. According to that ruling, the trial court had arranged a courtordered expert appraisal to determine the market value of G -grade coal (GOST ). It was concluded on the basis of the expert s report that the taxpayer s prices did not deviate from the market level by more than 20%. The cassation court rescinded the judgments of the lower courts and ordered the case to be retried on the following grounds. The tax authority had presented a reply from the Platts price reporting agency to the effect that it had not concluded contracts for the provision of an information bulletin either with the expert or with the company for which he worked; no Platts subscribers had requested written permission to provide an information bulletin to the above-mentioned persons. Furthermore, Platts does not publish price quotations for G -grade coal with the specifications established by GOST Sale of Motor Vehicles at Below Purchase Price In Determination No. 305-KG of 26 December 2016 on the case involving Suzuki Motor Rus OOO, the Supreme Court refused to refer the taxpayer s cassation appeal for review by the Economic Disputes Panel, thereby upholding the cassation court ruling which supported the charging of additional taxes in a situation whereby motor vehicles were sold at prices below the prices at which they had been acquired. The cassation court s ruling was covered in detail in our last TP alert. The Supreme Court pointed out in its determination that the company s activities were wholly controlled by the foreign supplier of the vehicles, i.e. the parent company, which had unlimited influence over the taxpayer s activities (since it set purchase prices, resale prices and marketing policies). The taxpayer, for its part, had no power to regulate either supply prices for dealers or recommended prices for end consumers, to establish a unified marketing and bonus strategy or to set terms of business with dealers, since all conditions of operation on the Russian market were dictated by the parent company. In other words, the relationship between the company and the foreign manufacturer influenced the pricing of the vehicle import transactions. The same taxpayer did, however, win a case in which it contested similar additional charges for another tax period. It follows from the ruling of the Arbitration Court of the Moscow District of 21 December 2016 on Case No. A /2015 that, in 2011, the company imported vehicles on the basis of purchasesale contracts with Itochu Corporation. In the fourth quarter of 2011, owing to exchange rate fluctuations (vehicles were purchased for currency and sold for roubles), some cars were sold at a low margin. The cassation court concurred with the position taken by the lower courts in asserting with reference to the provisions of Article 40 of the Tax Code that the inspectorate s claims were effectively levelled not so much at the purchase price (which was the same both for vehicles sold at a loss and for those sold at a profit), but at the margin achieved on individual transactions, which was lower than for other vehicles sold. Variations in profit margins are a normal feature of business activities, since the margin on a given transaction depends on a range of separate economic factors not connected with the relationship between the company and its supplier. It was concluded that the inspectorate had failed to take into account movements in the rouble exchange rate, that the company s losses had been caused by economic factors and that the low margins on vehicle sales coupled with high amounts of transportation expenses were not attributable to the relatedness of the company and its foreign supplier. 10

11 Fictitious Intermediaries May be Excluded from the Supply Chain, and Transfer Pricing Rules Should Only be Applied to Genuine Transactions According to the ruling of the Ninth Arbitration Appeal Court of 7 September 2016 on Case No. A /14 involving Vinokonyachny Zavod Alyans OOO (upheld by a ruling of the Arbitration Court of the Moscow District of 13 January 2017), the taxpayer concerned imported cognac spirits into Russia. The tax inspectorate reduced the amount of VAT reclaimed on imports of the goods in question after recalculating the price at which they had been acquired (without, however, adjusting the customs value of the goods). The taxpayer had purchased the spirits from related intermediaries, which had in turn bought them directly from the manufacturer. The inspectorate contended that the intermediaries had been introduced into the company s business arrangements for the purpose of obtaining an unjustified tax benefit, given that the prices for the spirits increased two or three times as they passed through the intermediaries. The evidence pointed to in the rulings as proof that the operations were fictitious included the fact that the intermediaries did not have any intermediary trade functions of their own and the terms of the contracts concluded between the manufacturer and the intermediary were the same as those between the intermediary and the purchaser. The only difference in the terms of the contracts was the inclusion (or non-inclusion) of transportation charges in the cost of the goods, but the appellate court concluded that the intermediary s mark-up could not be attributed to transportation expenses. Furthermore, the view that the intermediaries had no business functions was corroborated by information from the French tax authorities to the effect that the taxpayer and the manufacturer of the spirits had corresponded with each other directly regarding orders, approval of documents, payments and price negotiations. It is stated in the ruling that the approach that should be taken where there is evidence that a taxpayer has acted with the intention of obtaining an unjustified tax benefit is not to test prices according to the rules prescribed by clauses 4 to 11 of Article 40 of the Tax Code, but to apply clause 1 of Article 252 of the Tax Code, which requires expenses to be economically justified. In other words, all costs over and above the price at which spirits were purchased from the manufacturer and the cost of transportation may be deducted from the taxpayer s expenses. In calculating the taxpayer s obligations, the inspectorate took the prices of similar transactions between another large cognac product manufacturer and a cognac importer Moskovskiy Vino-Konyachny Zavod KiN OAO as market prices. Since its purchase prices were marginally higher than the supply prices of the manufacturer of spirits purchased by the taxpayer, the courts concluded that the inspectorate had acted favourably towards the taxpayer in calculating its tax obligations. In the course of the audit the tax authority commissioned a number of expert reviews, which concluded that supply prices for cognac products made by other foreign manufacturers and sold in Russia did not differ substantially from the supply prices of the manufacturer in question; the spirits sold by the taxpayer and by Moskovskiy Vino- Konyachny Zavod KiN OAO were of the same kind. Notably, the tax authority compared not only raw materials (spirits), but also the respective finished products of the taxpayer and Moskovskiy Vino- Konyachny Zavod KiN OAO: according to a reply from Torgovy Dom Perekryostok ZAO, the finished products of the two manufacturers were within the same price segment. Also considered in the course of the proceedings was a reply from the French tax authorities in which it was stated that transactions between the spirit manufacturer and the intermediaries were priced at market level. The appellate court also found that the validity of the additional charges was corroborated by the application of the comparable market prices method on the basis of Article 40 of the Tax Code: tax obligations had been adjusted on the basis of the difference between the actual price and the market price, which had been established following an expert review to determine the market price for the products in question based on the comparable prices method, taking into account appropriate adjustments and evidence collected. A particular feature of the case was that the actual value of the cognac spirit was known even without applying the methods prescribed by Article 40; the cost to the taxpayer of acquiring the raw materials was made up of the manufacturer s price and transportation expenses, and the remaining amount was fictitious. Similar conclusions were drawn in the ruling of the Arbitration Court of the Urals District of 22 December 2016 on Case No. A /2015 involving Metallurgicheskiy Zavod Kamastal OOO. The taxpayer underwent an audit for the period Additional charges were imposed on the basis of the inspectorate s conclusions that the taxpayer had obtained an unjustified tax benefit by creating fictitious paperwork aimed at disguising the actual nature of arrangements for the purchase of goods (ferroalloys and metal products) and artificially introducing intermediaries into those arrangements. The inspectorate identified the actual suppliers of the products concerned. 11

12 During the court case in which it attempted to challenge the results of the audit, the taxpayer argued, among other things, that the tax authority had not applied the provisions of Section V.1 of the Tax Code in relation to dealings with the contract partners in question in The courts supported the additional charges imposed by the tax authority, stating that the provisions of Article 40 concerning the examination of prices for taxation purposes were applicable where a transaction was genuine and had been recorded in accordance with its true economic intent. It had been established in the course of the hearing, however, that the petitioner s transactions with nominal partners were not of a genuine nature and involved artificial intermediaries which were introduced by means of fictitious paperwork. It is fair to say that the tax authorities have in recent times begun to pay more attention to intermediaries and to exclude them from the supply chain if they are found not to have business functions of their own, thereby reducing the expenses of the end purchasers. Prices in Uncontrolled Transactions May be Reviewed Only if the Parties are Related In its ruling of 18 January 2017 on Case No. A /2016 involving A1 Nedvizhimost OOO, the Arbitration Court of the Volga District rejected the inspectorate s contention that the taxpayer had received an unjustified tax benefit, supported by reference to an expert appraisal of the value of properties and the finding that that their value had been overstated in order to increase the amount of VAT reclaimed, on the grounds that the tax authority had examined pricing and arranged an expert appraisal to determine the value of the properties without having evidence that the taxpayer and its contract partner were related persons. It follows that the prices of transactions that are not deemed controlled may be investigated by tax authorities only if the transactions are between related parties. Relatedness between Parties to an Uncontrolled Transactions is Not Necessarily a Basis for Reviewing Prices In its ruling of 7 December 2016 on Case No. A55-979/2016 involving Tekhnokeramika OOO, the Arbitration Court of the Volga District supported the stance of the lower courts in rejecting the tax authority s contention that it had the power to adjust the taxable base after finding that transactions had been concluded between related parties. This fact indicated, in the inspectorate s view, that the taxpayer had received an unjustified tax benefit. The courts asserted that the tax authority, after discovering in the course of the on-site tax audit that the parties were related, had limited itself to stating that fact, without establishing any evidence of collusion between the related parties for the purpose of obtaining an unjustified tax benefit. Court-Ordered Expert Appraisal Where Conflicting Expert Reports Are Presented by a Tax Authority and a Taxpayer In the opinion of the Arbitration Court of the North- Western District, as set out in the ruling of 29 September 2016 on Case No. A /2015 involving Tekhsnab OOO, given that there was a dispute between the parties regarding the market value of non-residential premises and they presented different independently commissioned expert reports as evidence, the courts should have arranged for a court-ordered appraisal to be carried out in order to address the contradictions between the experts conclusions. Charging of Additional VAT on Uncontrolled Transactions Where the Parties Receive an Unjustified Tax Benefit The Arbitration Court of the North Caucasus District concluded in its ruling of 16 January 2017 on Case No. A /2015 involving Merkuriy OOO that the tax authority had grounds to conclude that the interests of the budget had been violated by the taxpayer s actions in selling services at prices which deviated substantially from the market level, and therefore to apply the provisions of clause 1 of Article 154 of the Tax Code in determining value added tax arrears as well as profits tax arrears. Business Purpose in Selling Goods at a Lower Price under a Long-Term Contract Where There are Higher-Priced One-Off Contracts In its ruling of 15 November 2016 on Case No. A /2015 involving ARTI-Zavod OAO, the Arbitration Court of the Central District supported the stance taken by the lower courts in asserting that the fact that goods were sold to third parties under oneoff contracts at a higher price does not mean that there was no reasonable business purpose in the disputed transactions in which goods had been sold at a lower price but on a regular basis and in larger quantities. A Taxpayer Does Not Have the Right to Petition a Court to Recognise it as a Related Party of Another Entity for Taxation Purposes According to the ruling of the Arbitration Court of the Central District of 8 November 2016 on Case No. A /2015 involving Jurchi OOO, the company in question filed a petition against Krymgazseti GUP RK with the Arbitration Court of the Republic of Crimea requesting that Krymgazseti GUP RK and Jurchi OOO be recognised as related parties for tax purposes. The district court concluded that nothing in the Tax Code gave Jurchi OOO the right to petition a 12