The new system of control in transfer pricing: what is known today?
The Law of Ukraine “On Amendments to the Tax Code of Ukraine on transfer pricing” of July 4, 2013 under the № 408-VII (hereinafter “the Law”) was finally signed by the President and was published in “Holos Ukrainy” newspaper no. 145 dated 07.08.2013.
Thus, the official text of the law is available, and we can draw conclusions on what kind of rules will become effective on September 1, 2013.
Let’s start from the definitions.
The Law amends sub-para. 14.1.71 of the Tax Code (hereinafter the “TC”), which contains the definition of the arm’s length (fair market) price.
First, similarly to previous rules, it is stated that the price, determined by the parties of the agreement, is the arm’s length price. Unless proven otherwise, it is deemed that such arm’s length (fair market) price corresponds to the market prices’ level.
The definition is supplemented with a number of provisions that may be of interest:
- in respect of goods (works, services), price (margin) on which is regulated by law, the arm’s length price is determined in accordance with rules of this regulation. Therefore, there should be less troubles with new transfer pricing rules at least for companies that operate in the fields with regulated pricing;
- if a transaction involves a mandatory evaluation, the result of this evaluation may be recognized to be an arm’s length price only if it is impossible to use methods for the determination of prices in controlled transactions;
- also the price set upon the auction results should be deemed to be an arm’s length price, but only in cases when such auction is mandatory according to the law;
- if the supply of goods (works, services) is made on the basis of a forward or futures contract, an arm’s length price shall be the price that corresponds to the market price on the date of concluding the contract. This rule actually deprives the tax authorities of any reasons to use prices that existed at the time of handing over of the goods in forward/ futures transactions. Earlier such precedents appeared in practice. However, this provision could have been clearer. Namely, it would be useful to envisage that the special conditions of forward and futures transactions may influence the price, which may differ from the spot prices existing at the time of contract concluding.
In addition to that new definition of related parties is provided and unclear wording of this definition has already been actively discussed by experts
The important question is which transactions are considered to be controlled, i.e. transactions, tax consequences of which may be determined by application of arm’s length prices:
- transactions with related parties-non-residents;
- transactions with related parties-residents who:
- declared negative object of taxation for the previous tax year;
- apply special tax regimes as of the beginning of the year;
- pay profit tax and/ or VAT at the rate different from the basic one;
- were not profit tax or VAT payers as of the beginning of the reporting year.
- transactions with non-residents registered in a low tax states (areas) (with the tax rate which is less than the rate existing in Ukraine for 5 % or more). The list must be approved by the Cabinet of Ministers of Ukraine.
It should be noted that the final wording of the law resolves the issue regarding the value of transactions with a contractor resulting in recognition of transactions to be controlled. The value of the transactions in any of the following cases must be equal to or exceed UAH 50 million per year with each of the counteragents taken separately.
Let us remind that the wording of the draft law submitted for the second reading, led to the question whether the threshold will be applied to all cases or only to transactions with counteragents that are registered in jurisdictions with low tax burden.
It is worth mentioning that changes were made in the rules regarding VAT. Namely, the arm’s length prices should be applied to determine the tax base only in transactions that are considered to be controlled. Previously for determining the VAT base the arm’s length prices were taking into account in all cases.
List of methods for the determination of prices compared to the previous version of Article 39 of the TC has not changed, which is understandable taking into account that the methods are set forth in line with the OECD Transfer Pricing Guidelines. In particular, the methods include:
- comparable uncontrolled price (analogues sales);
- resale price;
- cost plus;
- net margin;
- profit split.
As regards the choice of the methods for the determination of prices in controlled transactions, according to the new version of paragraph 39.3 of the TC, taxpayer uses any method that he reasonably deems to be the most appropriate. However, if it is possible to use either the method of the comparative uncontrolled price or any other method, the method of comparative uncontrolled price should be applied.
In other words, method of comparable uncontrolled price is considered to be the basic method.
In general, the new rules in detail (although a bit muddled) describe the peculiarities of the methods’ application, comparability of transactions determination etc. In addition to that new concepts of market price range and market range of profitability are introduced, which are probably intended to provide flexibility in order to determine regular price in the absence of previously permitted 20 % variation.
Methods for determining the prices in controlled transactions are mostly translated from OECD guidelines on transfer pricing.
An important novelty, which remains unresolved directly by TC, concerns the sources of information used for the purposes of transfer pricing.
Prices (rates of profitability) used as a base for comparison, are very important. In recent years, probably, most of Ukrainian importers have felt it, since the customs value of the imported goods have been increased by the customs authorities sometimes in two or even in three times with reference to a mythical price base of the customs service.
Unfortunately, the issue of sources of price information that can be used in transfer pricing is not properly addressed in the Law. Thus, sub-para. 39.5.3 of the TC states that during the fiscal control over transfer pricing officially recognized sources of information on market prices are used, the list of which should be established by the Cabinet of Ministers of Ukraine.
What kind of sources it would be? Today we can only guess.
Directly in the TC only the list of information that can be used in the absence of such information in these “official” sources is provided.
Moving forward by the way of simplification of tax administration, the authors of the Law established new requirements for submitting special reports and documentation on transfer pricing (paragraph 39.4).
Thus, the taxpayers which have carried out the controlled transactions during the reporting period are required to submit a report to the Ministry of incomes and fees of Ukraine on controlled transactions by May 1 of the year following the reporting year. Report shall be submitted in electronic form and its form should be established by the Ministry.
In case the local office of the Ministry identifies the facts of the controlled transactions that were not reported, the notification on these facts should be sent to the Ministry. The taxpayer shall also be informed in this respect.
According to the analysis of the report or receiving information about the presence of non-reported transactions, the Ministry has the right to request submission of the documentation regarding controlled operations (not earlier than May 1 of the year following the reporting year).
In case of request:
- taxpayers (except large taxpayers) during the month are required to submit primary documents on controlled transactions specified in the request, and other documents (a set of documents or a single document, drafted in any form) that can prove compliance of the contractual prices of the controlled transaction with the level of arm’s length prices;
- large taxpayers within two months are required to submit documentation on controlled transactions specified in the request (a set of documents or a single document, drafted in any form), which should contain the following information:
- information on related parties;
- information on group (set of entities that are deemed to be related parties), including group structure, description of activities, and transfer pricing policy of the group;
- description of the transaction, the conditions of its accomplishing (cost, terms, and other requirements of the agreements (contracts) according to the legislation of Ukraine);
- description of goods (works, services), including physical characteristics, quality and reputation on the market, the country of origin and the manufacturer, the presence of a trade mark, and other information related to the quality characteristics of goods (works, services);
- terms and conditions of the settlements;
- factors that influence the pricing;
- information about the functions of related parties who are parties in the controlled transaction, information on the assets used by them, that are associated with this controlled transactions, and economic (commercial) risks which such parties took into consideration during the controlled transaction (functional analysis and risk analysis);
- economic analysis (including methods that are used to determine the price of controlled transaction and explanation of the reasons for selecting the respective method, the amount of earned income (profits) and/ or the amount of expenses (losses) incurred in the result of the controlled transaction, the level of profitability, the calculation of the market price range (profitability) in respect of a controlled transaction including description of the approach to the selection of comparable transactions, the sources of information used to determine the price of controlled transactions);
- results of a comparative analysis of commercial and financial conditions of transactions;
- information on the proportional adjustment of the tax base and tax amounts made by the taxpayer (in case of its accomplishing).
It will not be easy to prepare this information in the required terms and therefore we recommend getting prepared to such request beforehand. At least, it is advisable for the large taxpayers to prepare the general information on the group.
Failure to submit the documentation within the set terms is the basis for a tax audit, and may result in a considerable fine of 100 minimum wages.
What might be really very expensive is a failure to report on controlled transactions since this breach leads to penalty in the amount of 5 % of the total amount of controlled transactions.
In addition to the abovementioned, among novelties it is worth mentioning the right of the taxpayer to conduct self-adjustment – adjustment of the price for controlled transaction by the taxpayer, which result in use for the tax purposes of the price, assed according to the arm’s length price, even if it differs from the actual price, established during the controlled transaction.
Such mechanism as a proportional adjustment has been also foreseen – adjustment of tax liabilities by the other party of controlled transaction (related party) based on the level of the arm’s length price specified by tax audit or the taxpayer.
For large taxpayers also the possibility of advance agreement of prices in controlled transactions is envisaged.
The Law provides for two ways of implementation of the transfer pricing control:
- monitoring prices in controlled transactions through observation of the prices applied by the parties of transactions and by analysis of documentation on controlled transactions;
- specialized audit of controlled transactions on the matters of compliance with transfer pricing rules.
In other words, unfortunately, any previously stated intention to reduce the number of tax audits is not observed in practice.
To conclude we note that in general the new transfer pricing system has positive features, such as limiting the number of controlled transactions. However, there are disadvantages, which may indicate that in practical application of these rules the taxpayer is likely to expect at least a considerable additional administrative burden to comply with the new requirements and rules. Therefore, it is necessary to get prepared beforehand to the application of the new rules, taking into account the fact that the approach to coming into force of the law may indicate the intention to extend the new rules (at least as regards submission of the report) to the whole 2013.
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.
Transfer pricing penalties: general overview
The list of legal forms of non-residents who do not pay income tax (corporate tax), including tax on income received outside the state of such non-residents’ registration, and /or are not tax residents of the state in which they are registered as legal entities