30 June 2015 Global Tax Alert News from Transfer Pricing EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: http://www.ey.com/gl/en/ Services/Tax/International- Tax/Tax-alert-library#date Sri Lankan tax authorities implement transfer pricing regulations Executive summary Sri Lanka s Commissioner General of Inland Revenue has published a gazette dated 25 March 2015 but made available on the Government Printer s website on 27 May 2015, which requires the taxpayer to submit details of transactions 1 with associated parties 2 to the Inland Revenue Department (IRD) as a part of the Return under section 107 of the Inland Revenue Act (IRA). Under this gazette, taxpayers are required to specify the pricing method used to determine the arm s length price, which would mean that taxpayers must possess transfer pricing (TP) documentation as required by the regulations prior to filing the Return. The gazette also requires the approved accountant (i.e., the auditor) to certify that all transactions are carried out on an arm s length basis and that the necessary documentation has been checked by the auditor. 3 This certificate is in addition to the certificate to be submitted by the Directors as a part of the Director s Report in the published annual accounts that all transactions between associated parties are carried out on an arm s length basis. Although TP in Sri Lanka currently remains at a developmental stage, the Government has issued regulations compelling associated parties to carry out transactions between them on an arm s length basis and mandated taxpayers to report transactions with associated parties as part of their tax filing. Detailed discussion Background In August 2013, Sri Lanka s Minister of Finance published TP regulations by gazette extraordinary. With the issuance of the gazette, all transactions between associated parties were required to be conducted on an arm s length basis. Consequently, the IRD established a Transfer Pricing Regulations Unit (TPRU) for the implementation and administration of the TP regulations, providing a framework to confirm whether transactions with associated parties comply with the arm s length principle.
The implementation of these regulations has already commenced and the TPRU has now initiated a number of TP audits as part of its first audit cycle. During these audits, a significant increase in the level of scrutiny of transactions with associated parties, even in sophisticated areas such as supply chain analysis, financing and intangibles, has been observed. Since its inception, the TPRU received assistance in capacity building from foreign tax authorities and the Organisation for Economic Co-operation and Development (OECD). The TP Officers within the TPRU have also participated in extensive TP training programs both in Sri Lanka and abroad. In particular, the ongoing work at the OECD relating to the Base Erosion and Profits Shifting (BEPS) initiative has helped the TP Officers to gain further understanding of common global TP issues. Consequently, it is expected that the TPRU will continue to have a heightened interest in the TP audits focusing more on the taxpayer s business activities, supply chain operations and TP strategies than ever before. Overview of the TP regulations Gazette extraordinary no. 1823/5 issued on 12 August 2013 provides TP regulations with effect from 1 April 2013. The key features are summarized below: (a) Taxpayers are required to keep contemporaneous documentation in English evidencing that transactions with associated parties are established on an arm s length basis. Such documentation is however required only if the transaction value exceeds Rs. 100 million (approximately US$770,000) for cross-border transactions and Rs. 50 million (approximately US$385,000) for domestic transactions for any year of assessment. The regulations require taxpayers to retain documents for a period of five years. Nevertheless, as a general rule, all transactions (domestic and crossborder) with associated parties have to be carried out at arm s length and proper records should exist even if they fall below the above thresholds. (b) TP regulations do not prescribe any type or format for the TP report. Any type or format of record should be acceptable to the extent that at a minimum it includes the following: The company and group details Transaction details Pricing policies and details of assumptions and negotiations Functional, economic and market analyses, budgets, estimates and forecasts Results of comparable analysis Contract agreements The selected comparable transactions The basis of application of the selected TP methods Details of adjustments (c) The regulations recognize the methods outlined in the OECD Guidelines, which include the traditional transaction methods (Comparable Uncontrolled Price, Resale Price and Cost Plus) and profit methods (Profit Split and Transactional Net Margin). The TP regulations do not provide a hierarchy of methods but require that the process of selecting a method should be aimed at finding the most appropriate method. The profit split method is however accepted as an appropriate method in circumstances where unique intangibles or interrelated transactions exist. (d) Taxpayers can request an Advance Pricing Agreement (i.e., unilateral, bilateral or multilateral) for a fixed period of time. The applications for Advance Pricing Agreements are however allowed only for cross-border transactions with associated parties. (e) In the case of cross-border transactions with associated parties, taxpayers are required to submit a Directors Report in the manner specified in the regulations. (f) The IRA does not impute penalties targeted specifically at TP, and there are no provisions for applying penalties for a lack of TP documentation by itself. However, with the issuance of the new gazette, the IRD may refuse to accept the returns filed by taxpayers who have failed to submit appropriate audit certificates for the year of assessment 2015/2016 and forwards, which will result in the loss of time bar period and the imposition of penalties of Rs. 50,000 (approximately US$385). 2 Global Tax Alert Transfer pricing
(g) TP documentation must be available at the time the returns are filed i.e., on or before 30 November of each year. TP documentation is generally required upon request. Usually, the IRD will determine a submission deadline, which can vary greatly from case to case (e.g., from only one week to several weeks). (h) All tax underpayments in Sri Lanka (including those arising from TP related audit adjustments) may attract penalties in addition to the taxes payable. The IRA provides for an immediate penalty of 10% for the first month and, further penalties at 2% for each additional month outstanding, up to a maximum of 50% of tax payable. Mitigating the risk of TP audit Though TP audits are components of standard tax audits, they will be conducted by the TP Officers who have the TP focused skillset. TP audits generally take a longer time to close out than standard tax audits. Thus, it is important that taxpayers understand how to manage such audits efficiently to achieve effective resolution within a reasonable time frame. Taxpayers also should be aware that the Bill issued on 30 March 2015 amending the IRA contains provisions to extend the time bar period from the existing 18 months to five years in case of matters relating to the TP. This Bill has not yet passed in the Parliament but changes to the existing provision are not anticipated at the time of enactment. Given this focus on TP, it is important for companies who have transactions with associated parties to be aware of the factors that may trigger a TP audit. The questions below will help taxpayers to understand the key risk factors that prompt TP audits: (a) Are there domestic or crossborder transactions with associated parties? (b) Does the Sri Lanka entity have transactions with associated parties in low tax jurisdictions? (c) Are the transactions with associated parties large or complex? (d) Are there other dealings with associated parties that are not charged for? (e) Has there been a business restructuring recently? (f) Are there secondments of senior management to associated parties? (g) Are there local entities or permanent establishments in Sri Lanka with operating losses? (h) Does the company pay royalty fees for use of intangible assets to associated parties? (i) Was there a failure to submit the Director s Report as required by the regulations? (j) Was there a failure to prepare TP documentation for the financial year? If any of the responses to the above questions are in the affirmative, there is a higher risk of being selected for audit. Taxpayers who have not yet completed the TP documentation should take action immediately as robust TP documentation will be considered as a strong mechanism of defense. Taxpayers who have already completed the TP documentation must still ensure that they are well prepared in the event of a TP audit, through company s risk assessment and effective implementation of TP policies. The questions to be considered in such an event are as follows: (a) Are all transactions with associated parties robustly documented in the TP documentation file? (b) Is preparation of TP documentation consistent with the TP regulations? (c) Is the TP documentation consistent with documentation provided globally to other tax authorities? (d) Is supporting information adequately maintained e.g., agreements, invoices, evidence of benefits received under transactions etc.? (e) Are particular transactions that may be of high risk identified and is there adequate support for these transactions? (f) Is the respective staff fully aware of how TP policies should be implemented? Does the financial outcome match the stated policy? If not, is there a satisfactory explanation? Global Tax Alert Transfer pricing 3
Endnotes 1. Gazette extraordinary no. 1907/26 dated 25 March 2015 requires taxpayers to provide details of the following transactions with associated undertakings along with the Returns filed for the year of assessment 2015/2016 and onwards. Trading of raw materials and finished goods Assembling, processing, manufacturing of goods or articles Purchase or sale of any other moveable or immovable property or lease of such property Purchase, sale or use of intangible property such as royalty, know-how, patents, copyrights, licenses etc. Services such as financial, administrative, technical, commercial services etc. Loans and advances Mutual agreement or arrangement for the allocation or apportionment of costs Other 2. An associated party is defined based on ownership and transactions. In general, two parties shall be deemed to be associated parties, if the ownership or control over the board exceeds 50% or one person is dependent on the other for operating the business. 3. This audit certification requirement is broadly similar to the requirement in India. For additional information with respect to this Alert, please contact the following: Ernst & Young Solutions LLP, Asean Transfer Pricing Services Leader, Singapore Luis Coronado +65 6309 8826 luis.coronado@sg.ey.com Ernst & Young LLP (Sri Lanka), Colombo Duminda Hulangamuwa +94 1155 78101 duminda.hulangamuwa@lk.ey.com Sulaiman Nishtar +94 1155 78103 sulaiman.nishtar@lk.ey.com Hasitha Raddella +94 1155 78101 hasitha.raddella@lk.ey.com 4 Global Tax Alert Transfer pricing
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