Baku, Azerbaijan, Dec. 23
Trend:
By Rashad Abbasov
Most recently the draft law introducing significant amendments to the Tax Code which also includes TP, has passed from first reading of Azerbaijani Parliament and presumably will be sent (or may be already sent) to the President to sign into law.
Although there have been some media reports on certain aspects, no exact scope of expected TP changes in the law at this stage is identified nor it is known whether these TP changes would be substitute for or complement to current market price rules. Below is a brief summary on the essence of TP, common practice and the most recent international trends in TP and also a comparison of OECD recognized TP principles with Azerbaijani market price rules. We will also address a rationale for adopting detailed TP rules in the Azerbaijan tax system.
General understanding of transfer pricing
With a rise of multinational enterprises (MNEs), a significant part of today’s global trade consists of transfer of goods and services, capital (money) and intangibles within a MNE group or controlled parties affecting several tax jurisdictions. Such transactions between controlled parties are called controlled transactions. As a general rule, whether or not parties are controlled, are analyzed based on a substance over form principle. Thus, the existence of formal ownership structure is not a prerequisite - parties are treated controlled if they are effectively controlled directly or indirectly by the same interest.
Since parties to the controlled transactions share the same economic interests as a group, there is concern that these transactions between them may not always be governed by market driven forces only. Rather, such a transaction may be structured in the best possible ways to meet specific needs of the group, for example, to minimize “tax cost” by reducing worldwide effective tax rate (“ETR”) of the group.
In order to illustrate this concern, let us consider following simple example. Suppose Company A is a tax resident of country A while Company B is a resident of country B. They both are wholly owned subsidiaries of Company C, a tax resident of country C. Corporate income tax rate in country A is 20% while the same tax rate in country B is 35%. Company B produces certain widgets and it finds a would-be buyer, Company D located in Country D. Assuming that production cost of these widgets are USD 10, Company B may make a profit of 40 should it sell these widgets directly to Company D for USD 50. Then, tax payable in Country B would be USD 14 (40 X 35%). In such a case, ETR of the group would be 28% (USD 14/USD 50). Since Company A and B are controlled by the same interest- Company C, in order to reduce the group’s ETR Company C may instruct Company B to sell widgets to Company A for USD 20 and then Company A to sell directly to the buyer for USD 50. In this scenario, profit of a Company B would be USD 10 (20-10) and Company A 30 (50-20). Converting it to a payable tax amount, it would be USD 3.5 for Company B (10 X 35%) and USD 6 (30 X 20%). Total taxes payable by the group will be USD 9.5 while it would have been USD 10 had Company B sold directly to the buyer. In terms of ETR, the group might be able to reduce its ETR down to 19% from 28%.
In the light of the above said, it is not difficult to see why it is a key priority of the governments to make sure that the right price or “transfer price” is charged in the controlled transactions between controlled parties. The “arm’s length” is widely used principle to ensure that the right price is charged in these controlled transactions. The authoritative statement of this principle is determined in paragraph 1 of Article 9 of the OECD Model Tax Convention based on which vast majority of the bilateral tax treaties signed worldwide. This principle follows the approach of treating the members of an MNE group as operating as separate entities rather than as inseparable parts of a single unified business. [1]
The cornerstone of the arm’s length principle lies in comparability analysis which focuses on the nature of the transactions between the controlled parties and compares whether conditions of these transactions differ from those that would be obtained in comparable uncontrolled transactions. In this regard, several transactional and profit TP methods are used to establish whether the conditions imposed in controlled transactions are consistent with the arm’s length principle. It has been observed that transactional methods, especially CUP (“Comparable Uncontrolled Price”), are preferred over profit methods in tax jurisdictions with relatively younger TP regimes and vice versa in the jurisdictions with mature TP regimes. Nevertheless, the best practice suggests that choice of methods should be based on a “best method” rule and no strict priority of methods shall be prescribed, and no method shall invariably be considered to be more reliable than others. That is to say, arm’s length result of a controlled transaction must be determined under the method that provides the most reliable measure of an arm’s length result given the particulars of each case.[2]
Most recent trends in international tax arena-TP documentation
Given its importance, it is not a surprise to see transfer pricing as one of the hot topics in international tax arena. In 2013, OECD and G20 countries adopted 15-point Action Plan to address base erosion and profit shifting (“BEPS”). The aim of the Action Plan is to ensure that profits are taxed in those tax jurisdictions where economic activities generating these profits are performed and where the value is created. One of the actions (Action 13) is dedicated to TP, namely Guidance on Transfer Pricing Documentation and Country-by-Country Reporting.
Action 13 replaces Chapter V (Documentation) of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. Previous Chapter V was adopted in 1995 and imposed certain compliance requirements to the MNEs in that some documents must be reasonable used or relied upon by the taxpayer to make sure that arm’s length price is charged in controlled transactions. Since it did not provide a clear guidance on a number of issues (such as the list of documents to be included in TP documentation, TP documentation process), many countries adopted their own TP documentation rules in order to address these shortcomings in the OECD TP Guidelines. This, in turn, made the TP compliance for MNEs more costly since MNEs were obliged to prepare a separate set of documentation in each tax jurisdictions.
Action 13 aims to address these shortcomings and to provide tax administration with sufficient information to perform a TP risk assessment, as well as to unify TP documentation rules over several tax jurisdictions. It identifies three objectives of TP documentation-(i) to ensure that taxpayers follows TP rules in establishing prices in controlled transactions, as well as they report income derived from such transactions; (ii) to provide the tax authorities with sufficient information so that they are able to conduct adequate TP risk assessment and (iii) to provide tax administration a starting point in performing TP audits.
In order to achieve these objectives, Action 13 adopts a unified approach to TP documentation and instructs MNEs to have the following documents in place:
Master file-provides information on legal and ownership structure and geographical location of operating entities, description of MNE’s business(es), MNE’s intangibles, MNE’s financial and tax positions. It should be reviewed annually and updated, if necessary, by the tax return due date for the ultimate parent of MNE group;
Local file-provides information of each specific controlled transaction. It is to be prepared no later than due date for the filing of the tax return for the fiscal year
Country-by-country report (“CbCR”)- provides information on global allocation of income, paid taxes and certain indicators of the location of economic activity among tax jurisdictions. The date for completion be extended to one year following the last day of the fiscal year of the ultimate parent of the MNE group.
Master file is aimed to assist tax administrations in evaluating the presence of significant TP risk while local file serves to assure that the taxpayers has complied with the arm’s length principle in their TP positions. As per CbCR, it is designed for high-level TP risk assessment purposes.
Action 13 goes on suggesting full TP documentation requirement in the local file to be applicable only those transactions meeting specific materiality thresholds, establishment of which are up to individual countries.
Action 13 includes a number of other provisions concerning penalties, language of the documentation, confidentiality and retention of the documents by the taxpayer.
Status of TP in Azerbaijan
Although Azerbaijan does not have TP rules, it does have market price rules, which may be taken as a similar concept to TP to certain extent. However, there are some fundamental differences.
The major deviation of market price rules from the TP is that while TP only targets controlled transactions between the controlled parties. Because in the controlled transactions there is a high possibility that structure of such transactions may be determined by a combination of market and group driven forces. However, the market price rules have much more extensive implications. Thus, the existence of controlled transactions is one of the conditions that may trigger market price rules along with the other four. It is very important to understand that in open market transactions, parties come up with adverse economic interests. Therefore, it is less likely that a price charged in these transactions will not be governed by market forces. Because current market price rules ignore this fact, even non-controlled transactions are exposed to the risk of being scrutinized by the tax office. In addition to compliance costs, this creates uncertainty for the businesses.
Furthermore, current market price rules specify only transactional methods and ignore the best method rule. Thus, they require comparable uncontrolled price to be applied first before utilizing other transactional methods.
The Azerbaijani market price rules also fail to address the TP compliance requirements and does not set a list of documents that the taxpayers must retain to justify that the prices charged in the controlled transactions are arm’s length. Therefore, it raises the concern whether a specific TP study produced by the taxpayer will be acceptable for the tax office.
As another shortcoming, the market price rules refer to official data sources, as well as databases of state and local executive authorities in order establish market prices of goods and services. Since these databases are not specifically tailored for TP purposes, as well as reliability and accuracy of this data may be questioned, there is a great concern that whether a produced result will always reflect “true arm’s length”.
Most recent global TP trends require Azerbaijan to have sophisticated TP rules in conformity with the internationally recognized standards for the country to become more investment friendly for MNEs. There is a number of other important reasons why Azerbaijan should have detailed TP rules. These may be summarized as follows:
- It will preclude artificially shifting profits overseas;
- It will eliminate double taxation of cross-border transactions and will ensure that Azerbaijani domestic tax rules are in compliance with the double tax agreements Azerbaijan is a party, which involves a provision similar to Article 9 (Associated Enterprises) in the OECD Model Tax Convention;
- It will result in enhancement of transparency and certainty, since there will be clear “playing rules” both for the taxpayers and the tax office;
- It will create the same playground for both MNEs and local companies running businesses in Azerbaijan.
Establishment of a TP legislative framework will have a significant impact to business environment. Given that, TP rules should be drafted based on the best practice, as well as TP experience of the countries with relatively similar (such as Russia, Kazakhstan, Ukraine, etc.) economic indicators to Azerbaijan should be taken into account.
Last but not least, great consideration must be given to the implementation of these rules. Smooth implementation of the TP rules requires tax administration to have adequate resources, in particular, existence of competent staff with specific TP knowledge. It also requires raising taxpayer's awareness of the TP rules.