Received a request on providing transfer pricing documentation: what to do?
Tips from attorneys, specializing in transfer pricing (hereinafter – TP) disputes
Ukraine sees intensification of TP control. And compliance with the “arm’s length” principle is the current primary target of tax authorities, instead of procedural violations during reporting that were in the primary focus of tax control before.
For example, this July in Toronto at the 3rd Ukraine Reform Conference, Minister of Finance of Ukraine Ms. Markarova reported on 12 large-scale cases of TP violations, which are currently being worked out jointly with international partners and will be presented to the public soon. According to Ms. Markarova a truly effective department of TP control is already established and operating.
This is evidenced by the practice, namely by the quantity of court disputes over TP adjustments. At the same time, according to the statistics efficient protection from the TP-related charges turns out to be more difficult task as compared to other types tax disputes. Examples of such cases are described 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”, “The tendency, however… The State Fiscal Service again wins in the dispute on the TP rules at the level of appeal”, “TP control in Ukraine: times changе“.
In most cases, TP control starts with a request of TP documentation. This is the first interaction between the specialized department of the fiscal authority with the taxpayer and the result of such interaction may determine further turn of events.
In this article, we share our tips for taxpayers who have been requested to provide TP documentation. We make these recommendations based on our experience of assisting taxpayers in preparing responses to such requests, as well as supporting audits, and court defense in disputes regarding TP adjustments.
1. Since when the tax authority has the right to request TP documentation and for which periods?
According to subpara. 39.4.5 of Article 39 of the Tax Code of Ukraine, the fiscal authority may send request not earlier than 01 October of the year following the year of the controlled transaction. For the same date the deadline for submitting TP report is set by the law. Therefore, immediately after the deadline for filing of report on controlled transactions, they have the right to request TP documentation.
The number of annual periods for which the documentation could be requested is not limited by law. Thus, the documentation could be requested for all the years during which the controlled transactions were reported.
2. What does it mean to get request on providing TP documentation?
TP control system according to Article 39 of the Tax Code of Ukraine consists of:
1) monitoring of controlled transactions,
2) questioning regarding TP issues and
3) auditing on compliance with the “arm’s length” principle.
During the monitoring, the tax authority analyzes the available information about the transactions and financial results of the taxpayers. In particular, tax authority scrutinizes the information from the reports on controlled transactions, tax returns, financial statements etc. The purpose of monitoring is to identify the range of transactions that are at risk of breaching the “arm’s length” principle and, hence, to define the taxpayers which are worth scrutinizing more thoroughly.
The filing of the request for TP documentation is the final phase of the monitoring process. So, if the taxpayer receives a request for documentation, it means that the specialists of tax authority that conducted the monitoring saw the risk of violation of TP rules by such taxpayer.
In other words, it is likely that such a request is not a “shot in the dark” but rather a deliberate step made with preliminary understanding of possible violation of TP rules made for defining if it is worth to start a comprehensive TP audit.
3. Should we provide documentation upon request?
According to Article 39 of the Tax Code of Ukraine, an audit of compliance with the “arm’s length” principle can be carried out both in the case of providing documentation on request, and in the case of failure to provide it.
This means that regardless of the taxpayer’s decision, the tax authority will have a legitimate right to initiate an audit. And it is clear that most likely the decision not to provide documentation will increase the chances of initiating the audit.
Moreover, the Tax Code of Ukraine provides for penalties for failure to provide documentation, which can be very significant. Learn more about penalties for TP reporting in our material “Transfer pricing penalties 2019: onwards and upwards“.
Therefore, if controlled transactions were carried out and reported, it is worth to provide documentation. At least, taxpayer will not be penalized for non-provision of documentation.
4. What if the documentation was not prepared?
The Tax Code of Ukraine gives the taxpayer 30 calendar days from the date of receipt of the request for submission of the documentation.
These 30 calendar days may be used for preparing the documentation.
If the complete documentation is not prepared within this timeframe – never mind. It is worth to submit what you have.
Typically, in a such case, the tax inspectors follow the subpara. 39.4.8 of the Tax Code of Ukraine and send an additional request, with demand for additional provision of the missing information (based on the requirements to the content of the documentation) and / or justification of compliance of the controlled transactions with the “arm’s length” principle.
Thus, there would be an additional 30 calendar days during which the TP documentation should be completed.
It should be emphasized that we do not recommend to prepare TP documentation in such a great haste.
Such behavior increases the likelihood of documentation quality problems as well as eliminates other options of more efficient utilizing the period allocated by the law for submitting the documentation. We will talk about such options below.
5. What will be an efficient way of using the period available for submission of TP documentation if it is prepared in advance?
As we noted, request on TP documentation is a signal that the tax inspectors identified the risk of violating TP rules. And this signal should not be ignored.
It is recommended to review the register of court decisions on the availability of TP disputes in similar situations. This may help identifying the risky areas and anticipate possible approaches of the tax authority, and thus to get prepared for them properly.
According to our experience the most effective way to use this time period is to provide TP documentation for third party opinion in other words for review of TP professionals other than those who helped to prepare it. Most likely, a “fresh” look at the documentation will help in identifying weaknesses in the TP documentation, which would likely draw also tax officer’s attention. In the result, the documentation may be further elaborated if deemed necessary.
By the way, in our practice we have faced situations when more complete disclosure of certain points in the documentation (for example, calculation of profitability indicator) or timely correction of mistakes in accounting would most likely help in avoiding the TP dispute.
Of course, this third-party review can be done at any other stage, but it will be the most efficient before submitting the documentation for the first tax request. After that it is more difficult to change the key approaches that will probably be captured in the provided documentation.
Well, it should not be forgotten that at this stage it is still possible to adjust tax reports on the initiative of taxpayer if the result of this alternative review concludes that there are significant risks that the terms of transactions do not comply with “arm’s length” principle. And this, in turn, may allow minimizing financial losses due to the rules on more favorable TP adjustment if done by taxpayer in comparison to the adjustments by tax office. Once the audit starts the taxpayer will no longer have the right to make self TP adjustment.
6. Are there any benefits of not submitting a complete set of documentation upon the first request?
In practice, there are different approaches to this issue. In many case consultants recommend not to provide all the calculations that led to the conclusions of the analysis. We understand that the reason behind such recommendation is to win the time and wait for request for additional information.
In our opinion, provision of all the calculations, which are mostly stored in Excel format, really makes no sense. At least upon first request. But it is important that abridgement of the documentation does not make it not clear why and how respective conclusions were drawn. Such a reduction can do more harm than good.
In any case, if there are questions to justification of compliance with the arm’s length principle, then the tax authority will most likely request additional information / justifications.
7. What are the peculiarities of preparing response to the request for additional information?
The fiscal authority requests additional information and / or justifications if the documentation submitted for the first request does not contain (1) all information required by the Tax Code of Ukraine and / or (2) sufficient justification proving that conditions of the transaction are in compliance with the “arm’s length” principle.
For responding on the additional request a taxpayer has 30 calendar days.
In practice, request for additional information usually contains specific questions and requirements to provide specific explanations / documents that directly or indirectly relate to the TP.
So, it is not a certain “routine” request. If the taxpayer receives such a request, it means that the tax authority has already “invested” time and efforts in reviewing the documentation and there are some specific points information about which is lacking.
The “justification” questions reveal the points which, in the opinion of the fiscal authority, are weak and which they plan to use to justify the TP adjustment should a decision is made to carry out the audit. Therefore, it is worth paying special attention to the questions related to the justification of compliance with TP rules.
From experience, TP professionals usually can understand from the questions raised by the fiscal authority their plans for future audit.
And, as the practice shows, almost all TP audits end up in TP adjustments. Thus, a response to a request for additional information may be the first expression of the taxpayer’s position on the key disputable points of justification of TP rules that will be further considered in the court.
Therefore it is highly advisable to prepare the answer having firstly identified principal legal positions that may be used in defending taxpayer against possible TP adjustment. The change of position may later be used by the tax authority in the dispute against the taxpayer.
In the request for additional information the tax authority may demand specific documents related to the controlled transaction, the taxpayer’s business, etc. It is worth remembering that the fiscal authority does not have the right of requesting any information and data at its discretion. The Tax Code of Ukraine contains clear list of information that should be included in the documentation and documents that should be added. If the Tax Code of Ukraine does not require to add any documents to the documentation, mentioned in the request, then the taxpayer is not obliged to submit them.
Therefore, it is important to carefully analyze if taxpayer is obliged to provide the requested documents and whether their provision will be in the interests of the taxpayer, taking into account the content of the request.
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Thus, receiving of request on TP documentation is already a serious signal to the taxpayer. It is important to take this signal seriously and use the legislative deadlines to assess risks and identify ways to mitigate them.
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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.
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