Introduction to transfer pricing
Narmin Aslanova, Senior Manager, Tax & Legal, Deloitte Azerbaijan
Gunel Sadiyeva, Tax Senior, Tax & Legal, Deloitte Azerbaijan
Transfer pricing is one of the most important issues in international taxation. Also it is one of the most important areas for the expected tax reforms in Azerbaijan. Discussions in the press and the business community point to the particular attention that has been paid to this subject by the Azerbaijani government. To promote the investment attractiveness of the country and ensure the continuance of Azerbaijan’s competitiveness among its neighboring countries, the government considers the reforms in this field to be crucial. This is clearly reflected in the Decree of the President of Azerbaijan of 4 August 2016 in which the introduction of transfer pricing was identified as one of the main areas of the expected tax reforms.
This article will give a brief overview of transfer pricing, its impact on the businesses and will help taxpayers to understand the upcoming new regulations.
What is a transfer pricing?
Increased globalization has driven the growth of intragroup trade. A significant volume of global trade now consists of transactions between members of multinational enterprise groups. The prices at which an enterprise transfers goods and intangible property or provides services to associated enterprises are transfer prices, i.e. prices that are charged on the transactions between two or more companies that are members of the same group.
When independent enterprises transact with each other, the conditions of their commercial and financial relations (prices, contractual terms, risks etc.) are usually influenced by market conditions. When associated enterprises transact with each other, they have the opportunity to optimize the overall tax cost of the group by way of setting prices in a way that would result in a lower tax burden. Therefore, sometimes the prices in intercompany transactions may be manipulated. Consequently, multinational groups or other parties whose relationships allow them to influence the conditions of the transaction (associated or related parties), may determine their transfer prices in a way that allocates profits to group members in a lower tax jurisdiction, reducing the group’s worldwide tax liability.
As far as taxation is concerned, transfer pricing rules exist to provide guidelines on how prices should be set for related party transactions to address potential tax avoidance within a tax jurisdiction or mismatches between profit allocation and the distribution of risks, assets and functions across the group.
For taxation purposes, transfer pricing rules require that the accurate price be established, i.e. the “transfer price”, for internal or intragroup transactions and to calculate profits as if the transactions had taken place between independent market players under similar conditions, which is known as the arm’s length principle. This is an international standard and is used by most tax administrations around the world.
It is important to note that transfer prices are used primary for taxation purposes and in this case do not affect the real terms between enterprises. However, transfer prices can be used as part of the management control system to design a suitable system for performance measurement and evaluation of the entities within a group.
Adoption of transfer pricing rules
For many developing countries, including Azerbaijan, the first challenge in implementing transfer pricing is protecting the tax base while not negatively affecting the country’s investment climate. Determining the number of multinationals operating in the country and the types of risks that are likely to arise helps the government to implement transfer pricing rules in line with its strategic needs. Governments must also establish an effective legislative framework. Recent discussions within the business community lead us to believe that the government is working on the specific provisions required for the successful implementation of transfer pricing.
Additionally, we believe that a number of extra measures should be implemented for the successful application of transfer pricing in Azerbaijan:
• Establishing an adequate, comprehensive and precise database, which contains information required for transfer pricing analysis;
• Training the tax authorities’ representatives, and exchanging experience with other countries;
• Improving the current IT infrastructure;
• Aligning the existing tax returns with the additional requirements for transfer pricing information;
• Preparing additional documentation/paperwork to be completed by taxpayers;
• Educating the business community on the importance of this new topic and getting it prepared to meet new compliance requirements.
There is a limit to what any country can achieve acting alone. Therefore, international cooperation has a crucial role in the successful implementation of transfer pricing in a particular country and double tax treaties envisaging the exchange of information should be signed with between main trading partners. So far, Azerbaijan has agreed double taxation treaties with 51 countries, which generally follow the OECD Model Income Tax Convention. Currently, 46 double taxation treaties are effective.
Transfer pricing risk management
Under the local legislation of most countries, the tax authorities can conduct “transfer pricing” audits and adjust the prices to determine the fair portion of the income subject to tax. Consequently, it is highly recommended to identify “risky” transactions and assess them in anticipation of such transfer pricing audits.
Identifying specific transactions that tax administrations are likely to examine in detail may help taxpayers be aware of such transactions and set their transfer prices at arm's length.
Here are some specific transactions and business situations that tend to attract the particular attention of the tax authorities:
• Transactions with related parties in low tax jurisdictions: the tax authorities of most countries have a list of countries that are non-cooperative in the global fight against money laundering and are usually tax havens (blacklisted countries);
• Intra-group services: these include human resources, legal and compliance, controlling and reporting, accounting, tax, IT and other services. The main issue is the ability to provide evidence that services have in fact been rendered, and that the provided services were beneficial for the recipient;
• Intercompany financing: the principal transfer pricing issue is whether the interest rate charged on the loan has been determined on an arm’s length basis;
• Business restructuring;
• Loss making: sustained losses may be evidence that the reported results have been manipulated and do not reflect the true value;
• Transfer of intangibles to related parties.
These "risky" transactions may also require more detailed explanations and documentation to be made available, which protect the taxpayer against any challenges by the tax authorities. This is part of transfer pricing risk identifying and risk assessment processes that is aimed to prevent transfer pricing disputes and to prepare the taxpayer to the transfer pricing audits conducted by the tax authorities.
Impact of transfer pricing rules on investment and business climate
We believe that introducing comprehensive transfer pricing provisions in Azerbaijan may potentially address the following issues that taxpayers face during their day-to-day business operations:
• The establishment of a unique Azerbaijani tax authority approach toward the deduction of allocated overhead expenses for profit tax purposes;
• The development of effective tax legislation that enables foreign investors to predict the amount of deductible expenses incurred on operations in Azerbaijan (royalty, administrative, inventory and other expenses, as well as interest on foreign loans);
• The subjection of a fair portion of multinationals’ profits to taxation in Azerbaijan;
• Ensuring a fair increase in the state budget inputs;
• More targeted and cost-effective use of limited resources from a tax administration’s perspective;
• Shorter timescales for audits or enquiries and for resolving disputes, which are clearly advantageous to both business and tax administration.
In summary, we believe that the introduction of transfer pricing rules in Azerbaijan could be a significant step in bringing the national tax system in line with best global practices. However, the success of adoption of transfer pricing regulations will depend on the government’s willingness to consult with the key stakeholders and draw on international experience.