Transfer Pricing — What Will Tomorrow Bring?

Evgenia Veter
Director, Transfer Pricing Services

In February 2010, the draft law on improving the principles of determining pricing for tax purposes was approved in its first reading by the State Duma. The second reading is scheduled for summer 2010, with the law itself planned to be in effect from Jan. 1, 2011.

The concept of amending the current transfer pricing rules has been discussed for many years. The current rules are less developed as compared with certain other countries, for example members of the Organisation for Economic Co-operation and Development. The rules provide room for various interpretations and set very high standards for tax authorities in order to question transfer pricing methods used by taxpayers, while at the same time they allow significant flexibility for taxpayers in terms of acceptable deviations from market prices. With the burden of proof in terms of transfer pricing falling on the tax authorities, in the majority of transfer pricing disputes the tax authorities lose in court. Subsequently, the government has been concerned that the budget may be losing money as a result of “aggressive” transfer pricing arrangements. The situation is going to change soon with the proposed introduction of the new transfer pricing rules.

While the draft law is likely to be amended to a certain extent before it is ready for signing, it is already clear that it represents a significant change in Russian transfer pricing rules. This change will have an impact on almost every company’s business involving intercompany transactions, as well as other transactions subject to pricing control under the draft law.

A fundamental change concerns the introduction of the “arm’s length principle,” which requires that related parties’ transactions be priced as if they were made between independent parties under comparable circumstances. Accordingly, the existing 20 percent “safe harbor,” allowing deviations of transfer prices from a market price, will be abolished, and instead an arm’s length range of prices will be introduced. Further, the scope of controlled transactions will be limited, for example, to exclude (with certain exceptions) domestic transactions that are below 1 billion rubles and transactions within a tax consolidated group. New transfer pricing methods will be introduced with a concept of a “best method” rule, whereby the choice of the method is dependent on the functional and risk profile of the tested party (as opposed to a strict hierarchy of methods prescribed by the current law). Last, but not least, advance pricing agreements (APA) may be allowed between a taxpayer and a tax authority (or between several tax authorities) starting from 2012.

The change that definitely appears to be the most burdensome for many taxpayers will be the introduction of transfer pricing documentation requirements, whereby taxpayers have to present documentary evidence supporting the arm’s length nature of the controlled transactions. Existence of such documentation is meant to serve as penalty protection in case of a transfer pricing adjustment by the tax authorities (otherwise a 40 percent penalty is proposed). As other countries’ experience shows, preparation of such documentation may involve significant resources and time, especially when this documentation is prepared for the first time. This process includes a lot of fact finding (such as documenting the actual facts, including description of the controlled transactions, functional and risk profile of the entities involved, industry analysis, etc.), as well as thorough analytical work (such as economical analysis, studies, etc.). It is not unusual to see a large multinational company having a special team within its tax department focused solely on transfer pricing.

The impact of the new rules may also result in an understanding for certain taxpayers that their pricing methods do not meet the arm’s length standard. If this happens, diligent taxpayers may have to consider major changes in their internal pricing policies, and such changes may result in a re-allocation of profits among the group entities and, thus, a potential change of effective tax rates.

The new rules should not only increase the compliance burden on taxpayers but may also bring a positive change for those who are heavily involved in cross-border transactions. Since the proposed legislation is meant to be more aligned with international transfer pricing principles as compared with current law, it should provide more certainty in terms of taxation of profits of such taxpayers and minimize double taxation. Taxpayers with an insignificant amount of related party transactions should also welcome the new rules in the sense that their transactions may fall outside the scope of transfer pricing controls if they do not exceed certain thresholds.

The new rules may appear difficult to comply with for taxpayers who currently apply “aggressive” transfer pricing practices or rely on the existing 20 percent safe harbor in terms of allowed deviation of their transfer prices from arm’s length prices. In order to comply with the new rules, these taxpayers may need to reconsider their existing practices and ensure that their intercompany transactions meet the arm’s length standard. At the same time, it is also fair to say the new rules may appear burdensome for a broader number of diligent taxpayers since they will have to prepare a substantial amount of documentation supporting the level of their intercompany prices, even though these prices may already meet the arm’s length standard. Both categories of taxpayers still have time to review their transfer pricing policies before the draft law is enacted in order to ensure their compliance with the new rules.