RELATED-PARTY TRANSACTIONS May 2009

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INTRODUCTION RELATED-PARTY TRANSACTIONS May 2009 Spanish tax regulations governing related-party transactions state that transactions between related parties (be they persons or companies) shall be

1 INTRODUCTION RELATED-PARTY TRANSACTIONS May 2009 Spanish tax regulations governing related-party transactions state that transactions between related parties (be they persons or companies) shall be valued at their normal market value. This normal market value is defined as that which would have been agreed between two independent persons or companies under conditions of free competition. The new regulations on the matter also establish a duty to keep documentation demonstrating that these transactions have been carried out at market value, placing on written record how said value has been established. The duty to draw up this documentation affects all transactions carried out from 19 February 2009, and the authorities have the power to demand documentation and explanations at any time after the filing of the Corporate Income Tax returns for the year in which the related-party transactions were carried out. The new regulations imposes severe penalties for simply failing to have this documentation drawn up, irrespective of any tax impact on the parties should it be deemed that the related-party transactions were not carried out at market value, a tax impact which arises through the secondary adjustment (ajuste secundario) carried out by the tax authorities (the tax classification by the tax authorities of the income arising in the related parties as a result of the difference between the agreed and the market values). Given the great importance of these new regulations on related-party transactions, we have decided to publish this issue of INFORMA to comment in greater detail on the concepts and duties outlined above so that they may be better understood by taxpayers. RELATED PARTIES AND GROUPS OF COMPANIES Article 163 of Spain s Corporate Income Tax Act defines related parties as follows: - A companies and its shareholders. - A company and its directors and senior managers. - A company and the spouses or relations (up to the third degree of kinship) of shareholders, directors and senior managers. - Two companies belonging to the same group. - A company and the directors and senior managers of another company belonging to the same group. - A company and the shareholders in another company, as well as the spouse or relations (up to the third degree of kinship) of said shareholders, when both belong to same group. - A company and another company in which the former indirectly holds at least 25% of the share capital. - Two companies in which the same shareholders, members, spouses or individuals related, directly or collaterally, up to the third degree of kinship, have a direct or indirect stake in at least 25% of the share capital. - A company not resident in Spain and its permanent establishments in Spanish territory. - Companies in the same group that pay tax under Spain s groups of cooperative companies scheme. In those cases where the related-party link is defined on the basis of the shareholder-company

2 relationship, the stake must be equal to or exceeding 5% for non-listed companies or 1% in the case of listed ones. As far as groups of companies are concerned, a group is deemed to exist when a company controls or is capable of controlling one or more other companies in accordance with the criteria established in Article 42 of Spain s Commercial Code, irrespective of place of residence or the duty to draw up consolidated annual accounts. In other words, all companies belonging to the same group of companies, whether or not they have a stake in the share capital of other companies, are considered related parties. As can be seen from the above, the definition of related persons or entities is very broad. As a result, regulations governing related-party transactions affect all kinds of business: not only that between related entities, but also that with shareholders, family members, senior management, etc. RELATED-PARTY TRANSACTIONS Related-party transactions are all those between related parties (be they individuals or companies). Purely by way of example, these can include the following: a) Between related-party companies: - Property disposals - Disposals of intangible assets - Disposals of securities - Disposals of businesses - Disposals of moveable assets (be they fixed or current assets) - The provision of services (management, technical, financial, commercial, etc.) - Cost-sharing agreements (covering research and development, services, sales, etc., activities) b) Between individuals and companies: - Property and moveable asset disposals. - Disposals of shares, intangibles, businesses, etc. - Remuneration of company senior management, shareholders and family members. - Property leases (assignment of use of properties owned by shareholders or family members to companies or vice-versa) - Cash flows between companies and their shareholders or family members: loans, capital contributions, current accounts, etc. - Services provided by a shareholder or family member. NORMAL MARKET VALUE Taxpayers must value the transactions they carry out with related-party companies and persons, using one of the methods set forth in the Act and the regulations that develop it and by applying a specific methodology. Regulations contemplate different methods for arriving at and documenting the normal market value : 1. Comparable free market price: trustworthy in those cases in which an independent operator sells the same product that is sold between related parties. Used when: There is no significant difference between the transactions that may affect the market price.

3 It is possible to justify the price by means of adjustments to eliminate the impact of any differences. 2. Increased cost method: this consists in supplying documentation on the company s own profit margin or, in the absence thereof, on the margin of independent companies, obtained from industrywide studies or databases. It seeks the gross margin applied to the production cost, to then apply this margin to the related production cost to arrive at the sales price. 3. Resale price method: this consists in offering documentation on the company s own profit margin or of independent companies. It seeks the sales margin in non-related-party transactions, which is used to establish the transaction price between related parties. When, due to the complexity of the information on the transactions, the aforementioned methods cannot properly be applied, the following subsidiary methods are used: 1. The profit distribution method. 2. The overall transactions net margin method. To establish the normal market value and hence which is the right valuation method, a comparability analysis must be performed. To do this, the circumstances of the related-party transactions must be compared with those of independent persons or entities that could be considered comparable, and the comparability of said transactions must be explained, established or justified, based on the following parameters: 1. The characteristics of the goods or services. 2. The functions assumed by the parties with regard to the transactions being analysed. 3. The contractual terms and conditions, taking into account the responsibilities, risks, and benefits assumed by the contracting parties. 4. The characteristics of the markets or other factors that may have an impact. 5. Any other circumstance that may be relevant (e.g. business strategies). In the absence of usable data on comparable independent companies, or when its reliability is limited, the fact should be documented. Similarly, if any of the above circumstances are not taken into account due to their irrelevance, their exclusion must be justified. OBLIGATORY DOCUMENTATION Taxpayers must, at the request of the Spanish tax authorities, submit documentation that supports the market value used, especially that on the valuation method chosen and, as the case may be, that on way in which the comparability criteria have been applied. In this regard, a distinction must be made between: 1. Documentation on a group of companies. 2. Documentation on a taxpayer that forms part of a group of companies or that is not a small company.

4 3. Documentation for small companies or individuals who have carried out related-party transactions. No documentation shall be required (either on the group or the taxpayer) in the case of the following related-party transactions: Between entities making up a tax consolidation group. Those between Economic Interest Groupings and Joint Ventures. Those carried out within the scope of public offerings to sell or acquire securities. Documentation on the group of companies (Masterfile): For this documentation to be required, group turnover must exceed eight million euros. The group holding company may draw up and keep the documentation on the group. When it is not resident in Spain, it must nominate a Spanish-resident group company to keep this documentation. The documentation shall contain the following information: a) A general description of the group s organisational, legal and operational structure.(1) b) Identification of the group companies with which transactions are carried out. (2) c) A general description of the related-party transactions: nature, amount and flows.(1) d) A general description of the functions carried out and risks assumed. (1) e) A listing of ownership of intangible assets (patents, trademarks, trading names, etc.). (2) f) A description of group transfer pricing policy (methods for and justification of establishing prices). (1) g) A listing of cost-sharing and service agreements between group companies. (2) h) A listing of previous valuation agreements. (2) i) The group s annual financial statements or, in their absence, equivalent annual report. (1) Documentation on the taxpayer: a) The tax details of the taxpayer and of the related-party individuals or companies with which it carries out transactions, and a detailed description of their nature, characteristics and amounts. (2) b) A comparability analysis of the transactions. (1) c) Documentation justifying the choice of valuation method. (1) d) Cost sharing criteria. (1) e) Any other information supporting the valuation of related-party transactions, as well as agreements entered into with other shareholders. (1)

5 Simplified versions of the documentation in the above point required from the taxpayer: For taxpayers subject to Spain s flat-rate scheme for calculating tax (estimación objetiva) and who carry out transactions with companies in which they, their spouses, forebears or descendents are shareholders with a stake equal to or exceeding 25%: a), b), c) and e). Disposals of businesses or stakes in non-listed companies: a) and e). The disposal of property or intangible assets: a), c) and e). The provision of professional services: a). Remaining cases: a) and e). All this documentation must be available to the tax authorities from the expiration of the voluntary period for filing the Corporate Income Tax Return for the period in which the related-party transactions have occurred. THE SECONDARY ADJUSTMENT CARRIED OUT BY THE TAX AUTHORITIES The secondary adjustment is a rule for classifying the income arising from the difference between the agreed and the normal market values. general classification of the difference between the two values: greater income in one of the related parties and less income in the other one. Relates to the transaction actually carried out. individual classification: in those cases in which the related-party link is due to the shareholdercompany relationship. Relates to the movement in net assets arising as a result of the difference. In such cases, the difference will be treated as follows: Difference in favour of shareholder: When the income relates to the percentage amount of the stake: For the company: remuneration from capital and reserves (payment of dividends) For the shareholder: income due to participation in profits. When the income does not relate to the percentage amount of the stake: For the company: remuneration from capital and reserves (payment of dividends) For the shareholder: income received (income from capital) Difference in favour of the company: When the income comes from the percentage amount of the stake: For the company: contribution from the shareholder to the company s capital and reserves.

6 For the shareholder: increase in value of the stake. When the income does not relate to the percentage amount of the stake: For the company: income subject to Corporate Income Tax (if it pays non-resident income tax, the income will be deemed a capital gain) For the shareholder: non-deductible expense BREACH OF RELATED-PARTY TRANSACTION OBLIGATIONS BY THE TAXPAYER Given the above, with the coming into force on 19 February 2009 of the regulations on the documentation-related obligations regarding related-party transactions, those carrying out such transactions have the following obligations: - The obligation to value and account for the transaction at market value - The obligation to support the valuation by means of the documentation required by the regulations - The obligation to provide information in the notes to the annual accounts All this under a specific system of penalties covering the breach of the duty to keep documentation. Spain s Corporate Income Tax Act governs the tax infringements related to the documentation that related parties have a duty to keep in order to justify the market value established in transactions between said parties, and which should be made available to the tax authorities should they so require. The following are regarded as serious tax infringements: - failure to provide documentation or the provision of documentation with incomplete, inaccurate or falsified data; - when the normal market value arising from said documentation is not that declared in the tax return of the individual or company taking part in the related-party transaction. The penalties applicable to these infringements are: 1) If the tax authorities need make no correction to the value of the transaction subject to Corporate Income Tax, Personal Income Tax or Non-Residents Income Tax: a fixed monetary penalty of 1,500 for every piece of data (2) and 15,000 for every set of data (1) that is omitted, inaccurate or false, regarding every documentary obligation for the group or for each company in its capacity as taxpayer. 2) If any value correction need be made to transactions subject to Corporate Income Tax, Personal Income Tax or Non-Residents Income Tax: a proportional monetary penalty equal to 15% of the value of the amounts arising from the value corrections of each transaction, with a minimum amount of double the penalty noted in the above point. (1) (2) See the section Obligatory Documentation for what is deemed to be a set of data (marked with a (1)) and piece of data (marked with a (2))

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