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Court disputes on the net margin method: the first battle in Ukraine won by taxpayers

20 December, 2017 Blog

Ivan Shynkarenko_

Ivan Shynkarenko

Partner at KM Partners

Last week our team has succeeded in the first Ukrainian court dispute regarding revision by the fiscal authority of the results of the transfer pricing (TP) net margin method (TNMM).

To briefly recap the merits of the case: the fiscal authority has challenged the TP analysis of our client, outlined in the TP documentation, drafted with assistance of the auditors firm, conducted alternative analysis using the TNMM and came into conclusion that TP adjustment was necessary. The fiscal authority argued that taxpayer has wrongly computed the profit indicator and dismissed the taxpayer’s market profitability range.

We expected this case to be not an “easy walk”, since any TP practitioner understands how strongly the fourth TP method is linked to the economic, statistic and accounting aspects. The claimant has to explain all this economic, statistic and accounting aspects to the Court. On the legal side, almost annual amendments to Ukrainian TP rules harm legal certainty and make the task even trickier. We are thankful to the Court for readiness to hear the numerous explanations on the merits and desire to understand the underlying substance of the dispute.

In the dispute, every important aspect of TP methodology was considered, including the rules on computation of the profit indicator of controlled transaction (what elements of costs should be included and what should not), necessity to ensure comparability, year of financial data on comparable companies that may be used, necessity of TP adjustments to raise comparability. In addition to that, we raised the number of important legal aspects, including the limits of the fiscal authorities’ power to conduct TP audits given that the TP audit has been conducted under seriously revised version of TP rules as compared to the period which was audited.

Now we are waiting for the written text of the entire judgement on the case. Yet, already at this stage, we are quite sure to argue that this dispute will make some important precedents not only with respect to TNMM but also to the general principles of interaction between the fiscal authority and taxpayer in TP sphere.

If to follow the thought on the principles of interaction, for me personally, the approach of the fiscal authority proved to be an unpleasant surprise. On the stage neither of pre-court appeal, nor in the court we have not seen an open discussion regarding the fair level of the price or assessment of the additional evidences and additional calculations that we provided with the client.

The fiscal authority built its defense exclusively on pedantic arguments and picking on technical nuances not clearly addressed by the tax law.

Just to cite few examples.

The elements of operating expenses that were clearly not related to controlled transactions according to the authorities had to be included into calculation just because taxpayer has not amended its accounting before the audit. In defending this position, the fiscal authority referred to various technical issues regarding the procedure of such amendment of accounting even though they could not have been applied in the case in hand. It seems that the only aim of such “explanations” was to muddle up the case.

Another example, in computing the market profitability range for 2014 the fiscal authority in some cases used financial data reported for 2013 (although not disclosing clearly this fact in the act of tax audit). It is not necessary to be an economist to conclude that specifically for Ukraine 2013 and 2014 (the year of Russian intervention in eastern regions, economic and financial crisis that followed) are not comparable at all. In this respect, our opponents were humdrum to argue that the wording of the Tax Code in respective version allowed for such possibility. In providing such explanations, the fiscal authority kept silence on the requirement to ensure comparability.

In my opinion, the modern tax system aimed at development the economy cannot tolerate such approaches. It is especially important to keep in mind in applying TP instruments. In case of free interpretation by fiscal authorities, TP control may become the mighty instrument of filling the budget but at cost of discrimination of the taxpayers, since it will be possible to think out to any enterprise any payable amount of profit tax depending on the will of fiscal authority. This is not only our imagination but the conclusion from the fact that the TP is not an exact science and is heavily reliant on expert judgements, as acknowledged in OECD TP Guidelines. If all such judgements of the fiscal authorities are one-sided, the result is clear.

We will pay maximum efforts not to allow the TP mechanism’s transformation in Ukraine into yet another way of filling the budget by way of suppression of law-abiding business.

As a conclusion, I would like to cite the wording that I have come across when studying Indian TP court practice1 and which is in line with my vision of the TP rules and desired way of their implementation in Ukraine:

“20. Let us not forget the fundamental fact that transfer pricing, by itself, is not, and should not be viewed as, a source of revenue; it is an anti –abuse measure in character and all it does is to ensure that the transactions are not so artificially priced, with the benefit of inter se relationship between associated enterprises, so as to deprive a tax jurisdiction of its due share of taxes. Our transfer pricing legislation as also transfer pricing jurisprudence duly recognize this fundamental fact and ensure that such pedantic and unresolved procedural issues … are not allowed to come in the way of substantive justice…”.


1Income tax appellate tribunal No. 5025/Del/10 Case Toll Global Forwarding India Pvt Ltd Vs. Deputy Commissioner of Income Tax Circle 2 (1)

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