10 signs you have problems with transfer pricing
Tax authorities in Ukraine have started more active and efficient control of transfer pricing (hereinafter referred to as TP). The chances are high that this trend will amplify in the nearest future (see infoletter “TP control in Ukraine: times change“).
Below we outline general signs flagging on possible problems if if your transfer pricing will be on radar of tax authorities.
1. You declare losses during several years in a row
It is difficult to imagine more glaring indicator of problems with business in general and specifically pricing than regular losses.
The provisions of the Tax Code signal importance of losses as TP risks indicator. Thus, TP rules directly forbid using in the TP analysis financial indicators of companies which report regular losses.
Simply said, if an enterprise has systematic losses, then it either buys at a price too high or sells at a price too low or both. And if such enterprise is a part of international group or cooperates with shady “independent” counterparts from other countries, then the significant attention to the transfer pricing is guaranteed.
Well, the losses according to the results of several years is not a verdict. The situations exist, when such results can be explained.
But one should prepare such explanations beforehand and ensure that the are well-grounded. And it is necessary to include such explanations into TP documentation.
2. Each year you submit a report on controlled transactions without preparing TP documentation
TP documentation is not a part of regular tax reporting. It is submitted upon request of the tax authority.
This is why often taxpayers do not prepare TP documentation and wait for the request. And this approach is practiced year after year.
However, Tax Code envisages that taxpayer is obliged to compose and keep the TP documentation. The term for submission of such documentation is only 30 calendar days.
Preparing decent TP documentation for annual transactions in 30 days is a tricky task. Yet, tax authorities will not request documentation for one year only, but, for instance, for years 2014, 2015, 2016, 2017.
And this is really challenging.
3. You annually pay huge amounts for intragroup services without ensuring their proper substantiation
The reality, economic substance and documental arrangement of transactions is not a new issue for taxpayers, that pay for intragroup services. Namely, payment of the portion of costs of the multinational company allocated to Ukraine for such centralized functions as HR, IT, financial and strategic managements etc. In the preceding years Ukrainian tax authorities actively audited such transactions. Although in recent years these issues lost their edge.
Yet, this situation is about to change soon.
Since 2019 TP rules include the priority of substance over form principle . In other words, during the TP audit tax authorities may ignore content of the agreement between the parties and ground their conclusions by their own perception of a transaction’s essence.
If an agreement contains 4-5 pages, and evidences of actual receiving of services are absent, there is a high risk of conclusion that such services are not services at all. And hence their fair price is zero.
Domestic know-how again? No. This is one of BEPS1 recommendations , already transferred to the Tax Code.
4. You sell the goods/services in controlled transactions at the prices below prices in uncontrolled transactions
The priority TP method is method of comparable uncontrolled price (CUP). And it is left behind very often shifting to more popular methods which are based on profitability. CUP method envisages the comparison of prices and is used mostly in cases, when a taxpayer sells similar goods to independent counterparts.
Obviously, logical explanations may be available why the prices in related- and unrelated – party transactions are different. Starting from the difference in terms of delivery to difference in geographical markets. However, such explanations should be well-grounded and included to the documentation. And it is clear that explanations are vulnerable for challenge by the tax authorities.
5. Your enterprise is profitable in general, but you do not trace profitability of each controlled transaction
According to TP rules taxpayers shall calculate profitability for each controlled transaction (group of transactions). That is why even steep profitability of the enterprise does not guarantee that certain transactions would not end up loss-making.
Often this may be the case when Ukrainian enterprise provides certain services to other companies of the group apart from core activity. Such services may cover IT support, market research by personnel in Ukraine, other transactions, that are not directly related to core business activity.
If the indicator of net profit for such services is calculated, such services may turn to be loss-making. This situation may result in troubles during the audit, especially if this issue is not properly addressed in the documentation.
6. You conduct foreign economic transaction through unrelated non-resident commissioner and do not report such transactions under TP rules
Such transactions are recognized as controlled by virtue of direct provision of the Tax Code. Yet, taxpayers often forget about this rule.
If value threshold for recognition of transaction as controlled is matched (annual revenue of UAH 150 mln and UAH 10 mln of turnover with commissioner), such transaction should be indicated in the TP report. Accordingly, TP documentation should be prepared for such transactions.
If this formal requirement is not met taxpayer may face penalties and other troubles with tax authority.
7. The approach to analysis in your documentation changes from year to year
Consistency is very important indicator of TP economic analysis’ reliability.
If approaches change from year to year, for example the criteria of selection of comparable persons or transactions are fine-tuned, the TP method or profitability indicator is changed, it is a signal of troubles with pricing.
8. Your documentation does not contain detailed description of the way, the profitability indicator was calculated
The Tax Code provides direct rule that TP documentation should contain the description of profitability indicator calculation, including the algorithm of allocation of costs amongst transactions. Moreover, all indicators should be confirmed by the documents.
Such requirement is often ignored in practice. Sometimes it is very difficult to understand, how the calculation was made, to say nothing of grounding the cost allocation algorithm selection.
Obviously, such situation is risky. Confirmed by practice, including court practice.
9. In TP analysis the profitability of non-resident party to the transaction is “tested” rather than your profitability
The analysis of profitability of non-resident party to the transaction is common technic of economic research in TP. Such approach is used in Ukraine very often too. However, the popularity does not mean the absence of risks.
First “alarm whistles” for such approach appeared with introduction of the requirement into the Tax Code, according to which the calculation of profitability in a controlled transaction has to be supported by documents.
From year 2019, such “whistles” transformed into actual drums. The Tax Code was supplemented with new condition regarding the selection of the party to the transaction subject to TP analysis. Namely, taxpayers should select the party to the transaction, “for which the most complete and well-documented information on financial indicators of controlled transaction is available…”.
And the final signal is provided by recent victories of tax authority on the level of the court of appeal in TP disputes. One of the key issues in such disputes was the selection of profitability of non-resident party to transaction in TP TP analysis. Detailed information is provided in our materials “Unexpected victory of the State Fiscal Service at the appeal stage in the important dispute on the TP rules: important court positions” and “The tendency, however… The State Fiscal Service again wins in the dispute on the TP rules at the level of appeal”
In other words, as of now such approach to TP analysis in documentation is a synonym of risks.
10. You import or export “exchange-traded commodities” in transactions with related parties
The mechanism of TP control over goods, which are traded at the exchange has failed to become fully operational . There are troubles with the list of exchanges, approved by the Cabinet of Ministers of Ukraine, as well as with the possibility of practical usage of relevant rules.
But it does not mean that respective provisions of the Tax Code may be simply ignored. Thus, the legislator in its efforts “to make” this rules work developed the system of provisions containing traps for taxpayers.
Thus, if taxpayer does not use the method of comparable uncontrolled price based on exchange quotes, the TP rules contain the requirement to submit information to tax authority till May 1, of the year following the reporting year. In particular, taxpayer should disclose the data on all and every related entity participating in the chain of “exchange” goods purchase-sale (up to first unrelated party) and provide indicators of profitability for such entities.
Once again – such information should be submitted not upon the request of tax authority, but as the regular reporting.
If such demand is not complied with, the Tax Code provides the tax authority with the right to define the price on their own by using CUP method. And in this case tax authority is not required to prove that taxpayer’s choice of other TP methods was wrong.
Obviously, the price, defined by tax authority, wil hardly satisfy the taxpayer.
The list may be extended further on, but we decided to stay with nice number “ten” in this material.
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The above commentary presents the general statement for information purposes only and as such may not be practically used in specific cases without professional advice.
1Base Erosion and Profit Shifting, action plan, developed under the aegis of Organization for Economic Cooperation and Development (OECD) and directed at combating base erosion and aggressive tax practices.
Starting from January 01, 2020, the List of legal forms of non-residents that do not pay profit tax and/or are not tax residents in the countries of their registration has been changed in Ukraine
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