Transfer Pricing A Legally Gray Area

Prime Minister Vladimir Putin's accusation of illegal transfer pricing by mining giant Mechel was met with skepticism Tuesday, as analysts and tax experts argued that the country's inadequate legislation left the practice stuck in a legal gray zone.

On Monday, Putin ratcheted up his attack on Mechel, claiming that the company had avoided taxes by selling coking coal to foreign affiliates for about one-quarter of the price it charged domestic buyers.

"It is a reduction in the tax basis inside the country. It's not paying taxes, it's creating a shortfall on the domestic market, which means an increase in the cost of metals production," Putin said.

Transfer-pricing schemes, in their most extreme form, were widespread in the lawless 1990s, as Russian companies typically evaded taxes by selling raw materials to offshore affiliates at knockdown prices, which then made a large, untaxed profit.

On Monday, Finance Minister Alexei Kudrin said long-delayed changes to tax legislation governing transfer pricing could be presented in mid-September.

"Transfer pricing is a scheme commonly used by Russian metals companies," said Olga Mitrofanova, a metals analyst at UniCredit Aton. "But after this, many companies will be afraid to use these schemes because they'll be afraid for their business, after seeing Mechel fall 50 percent in a week."

Mechel declined to comment on Putin's allegations Tuesday.

Currently, Russian law treats a difference of 20 percent or more in the price of goods sold between the domestic and export branches of a company as unlawful transfer pricing.

Proposed changes in legislation governing transfer pricing have been held up for several years. Officials have long argued that current legislation, introduced in 1999, is inadequate in coping with the complex taxation issue, leaving both tax authorities and companies trapped in a legally ambiguous situation.

Transfer prices are usually defined as prices set by a multinational group in transactions between related parties, experts said. Thus, any multinational group that has transactions with related parties is faced with the issue of transfer pricing, because of the existence of differing national tax regimes.

The biggest challenge for multinational companies in Russia is that transfer-pricing rules do not follow accepted international principles, experts said. That means that companies often lack certainty when setting pricing policies and run the risk of falling afoul of arbitrary investigations from tax authorities.

In May 2006, then-President Putin called for legislation to be tightened up, but a proposal from the Finance Ministry, slashing permissible price discrepancies and bringing Russian legislation closer to international norms, was held up.

Spokespeople for the Finance Ministry were not immediately available for comment Tuesday.

"The new amendments to the tax law will focus on the state's close scrutiny of coking coal export prices," said Nikolai Sosnovsky, a metals analyst at Sobinbank. "It is most important as the transfer-pricing schemes are based on the companies selling their goods to offshore affiliates at ridiculously low prices, in order to avoid paying taxes on profits at home."

"After the law comes into force, the companies that have used the transfer schemes will inevitably see their [earnings before interest, tax, depreciation and amortization] falling, so they will have to increase their efficiency or widen their product line," Sosnovsky said. Some companies could also switch to producing more for the domestic market, he said.

The high-profile criticism of Mechel comes as the government is launching a concerted campaign to cut down on the cost of coking coal, which is used in steel production.

In early July, Deputy Prime Minister Igor Sechin floated a plan to force coking coal producers to sell a minimum of 50 million tons of their annual production on the domestic market, Vedomosti reported. That would be the equivalent of over 90 percent of output last year.

If Putin is trying to push down the price of coking coal, then Mechel is the obvious target, said Mitrofanova, of UniCredit Aton. Mechel produces 26 percent of the country's coal, well ahead of its nearest rival, Raspadskaya, part-owned by Evraz, which controls 10 percent of the market.

"This company has a lot of influence on the Russian coal market. The company sets the price, and that's why the government has initiated the investigation against Mechel," Mitrofanova said.

Although the Kremlin has denied parallels with the attack on Yukos, accusations of transfer pricing were also deployed in the state's dismantling of Mikhail Khodorkovsky's oil empire.

But some analysts argued that Mechel was most likely not involved in illegal transfer pricing.

Marat Gabitov, another metals analyst at UniCredit Aton, said Mechel was more interested in boosting its market capitalization and mergers and acquisitions.

Illegal transfer pricing was a practice that went on several years ago when the oligarchs were looking to raise capital to buy assets, but it has been phased out now, a market source said, asking not to be identified because of the sensitivity of the issue.

Staff Writer Nadia Popova contributed to this report.