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Transfer Pricing: Expected Innovations
Russian tax law has applied transfer pricing rules since 1999. Law enforcement practice has, however, demonstrated that these rules are ineffective and that the tax authorities are incapable of applying them and exercising effective control over transfer pricing. The developers of the draft law have to a large extent taken into account the shortcomings and limitations of existing legislation in this area. We analysed the draft law on tax control for transfer pricing purposes to identify the underlying aspects of the proposed innovations.
1. At present tax control of the compliance of prices with market levels concerns foreign trade transactions, related party transactions, barter transactions and transactions where the price deviates by more than 20% from the transaction prices applied by the taxpayer.
The draft law removes these two grounds from tax control. This is a logical step, as court litigation practice has demonstrated that attempts to control the price set by the taxpayer have been ineffective and impractical. Barter is rare at present. Meanwhile reasonable economic substantiation unrelated to transfer pricing principles can always be found to support transactions, where prices deviate by more than 20%.
Now foreign trade transactions, material related-party transactions (for over RUB 1,000,000,000), transactions involving items subject to mineral extraction tax and transactions with companies operating under special tax regimes or registered in regions with low tax rates will be controlled.
In this list, material related-party transactions would appear to provide the most disputable grounds for exercising tax control. If none of the parties to a transaction is able to generate a tax saving from the overall result of the transaction, in view of corresponding adjustments, taxes are paid in full to the budget. The inexpediency of tax control in this case is particularly apparent if we take VAT as an example. VAT is a federal tax with all the proceeds remitted to the federal budget. As the draft law extends substantially the list of grounds for recognising the parties to a transaction as related parties, there is a risk that this problem could affect a wide range of taxpayers.
It is anticipated that adoption of the law on consolidated taxpayers will partially mitigate this problem. According to the proposed draft, however, only five or six major groups of Russian companies will meet the sub-criteria to be recognised as consolidated taxpayers. This is obviously too little to resolve the problem. We believe, however, that this problem will be resolved in time, with court practice playing a significant role.
2. At present three methods are used to calculate the market price, namely, comparable market price method, resale price method and cost-plus method. In addition, these methods must be applied in a strict sequence. The second method may only be used if it is impossible to use the first one, etc.
The draft law proposes extending substantially the list of methods to be used. In addition to the methods used today, the draft law adds the processed product sale method (a subset of the resale price method), the comparable profitability method and the profit split method. As in the past, the comparable market price method should be used first. Other methods may only be used if there have been too few market transactions and insufficient information is available about these transactions. The criterion to apply the remaining methods does not relate to the sequence of priority, but rather to their ability to reach a substantiated conclusion as to whether the transaction price complies with market prices or not.
There are no formal obstacles to the application of other methods not stipulated in the law for the same purposes, provided that they will substantiate the compliance (incompliance) of the prices used with market levels.
The taxpayer should determine in advance which of the methods, stipulated in the law or not, it finds reasonable to apply together with the comparable market price method to substantiate transaction prices, with due account of the taxpayer's specifics. Several methods can be used at the same time. If they provide similar results, this constitutes another way to support the taxpayer's position in the event of tax control in future.
3. One of the underlying provisions of effective transfer pricing legislation that create material obstacles to its application concerns the restriction on the right to use unofficial sources of information to determine the level of market prices. The tax authorities failed to overcome this restriction in courts. Here the courts managed to introduce one new positive rule: recognition of the taxpayers' right to use the services of independent appraisers to substantiate the transaction prices used.
The draft law expands substantially the list of sources of information on prices. As in the past official sources of information represent the main source of information. The data from customs statistics, international and domestic exchanges, data contained in financial statements and statistical reports, the opinions of independent appraisers and other sources of information may be used.
At the same time, however, the expansion of the list of sources of information per se does not resolve the issue of obtaining information on the prices that are suitable to solve tax issues inherent in transfer pricing transactions.
The draft law does not resolve the issue of equal access to sources of information for taxpayers and the tax authorities. Everybody knows that the state authorities have more information than taxpayers. Formally the draft law does not restrict the use of this privilege to prove that transaction prices do not comply with market levels, resulting in the additional accrual of taxes.
Legislation on information disclosure has not been developed in Russia. Naturally, this is attributable to existing restrictions that protect commercial secrets and the confidentiality of the information of commercial companies. However, this is not the only reason. To resolve the tasks of state control in the economy, including taxation, the country should have a developed and up-to-date system for collecting, processing, storing and providing information, including on the prices of goods, work and services. Russia does not have such a system in place. According to the developers of the draft law, no changes in this area are expected in the near future.
This issue is related to the quality of the existing information on prices and its applicability to protect a taxpayer's rights. It is not enough to simply obtain information on the prices of goods (work or services). It is essential that this price information is made available for transactions in comparable conditions. At the same time no information is available on standard profit margins for different industries. This makes it difficult to obtain adequate results when applying the methods for determining the market price level.
Accordingly it cannot be ruled out that taxpayers will use broadly the information provided by an independent appraiser to defend their rights. In law enforcement practice this source has already proved to be a reliable way of substantiating transaction prices. In addition, from now on the taxpayer may use information on similar transactions that it has performed, which are beyond the scope of tax control, provided that the terms of the transaction were comparable with the controlled transaction.
4. At present any tax inspectorate may check the correctness of the prices used when auditing a taxpayer registered with this inspectorate for tax purposes. Accordingly, the inefficiency of tax control for transfer pricing purposes is often attributable to the lack of inspectors with specialist knowledge on pricing and the enforcement of transfer pricing legislation.
According to the draft law, the correctness of prices used in controlled transactions will be audited by a special division of the Russian Federal Tax Service, within the scope of a special tax audit.
This announcement contains some good news. These will not be massive audits; moreover, the audits will be conducted by knowledgeable experts. As a result the number of unsubstantiated claims may fall considerably.
The draft law provides for a material increase in the burden of tax administration imposed on the taxpayer. The taxpayer will have to notify the tax authority of the controlled transactions that it performed. The taxpayer must submit a significant amount of information (on the parties to the transaction, the pricing methods used, the functional and economic specifics of the transaction, etc.). In other words, the taxpayer has to perform a significant amount of work to provide supporting documentation on the transaction price a long time before the tax audit. At the same time the taxpayer is interested in performing this work professionally, as the decision of the tax authority on whether to perform a field tax audit or not is largely dependent on the level of detail supplied by the taxpayer.
The draft law grants major taxpayers the opportunity to conclude a pricing agreement for tax purposes with the Federal Tax Service of Russia in respect of the procedure for determining the prices (methods) applicable to transfer pricing transactions. This provides an excellent opportunity to avoid disagreements with the tax authority in respect of the prices applied for tax purposes. Analysis of the practice of concluding agreements with the tax authorities in Russia (for example, on the granting of a tax credit) shows, however, that it is difficult to realise such an opportunity and to reach agreement with the tax authority. It cannot be ruled out, therefore, that the practice of concluding agreements with the Federal Tax Service of Russia will not be that popular.
The most progressive innovation of the draft law relates to the opportunity that it provides to the parties to a transaction to make corresponding adjustments to the tax base. This option should ensure that justice prevails when the transfer pricing law is enforced in practice. However, the draft law passed by the State Duma in its first reading in fact fails to provide a detailed mechanism on how to exercise the right to make a corresponding adjustment. This fact could restrict considerably use of this right in practice and lead to a material violation of the taxpayer's rights in this regard.
The draft law does not stipulate corresponding adjustments to the tax base for foreign trade transactions. The developers of the draft law adhere to the principle that this issue should be resolved within the scope of the application of double tax treaties.