Recommendations of the Russian Federal Tax Service for drafting and filing documents for the purposes of tax control over transfer pricing

To implement the provisions of article 105.15 of the Russian Tax Code, the Russian Federal Tax Service (FTS) has published its Letter No. OA-4-13/14433@ dated 30 August 2012 On taxpayers preparing and filing documents for the purposes of tax control over transfer pricing (the “Letter”). The Letter contains recommendations for taxpayers drafting and filing documents for the purposes of tax control over transfer pricing. These include recommendations for content (Appendix 1) and the stages of preparation (Appendix 2).

As well as covering issues that are organisational in nature, the Letter sheds light on aspects of applying transfer pricing rules.

Definition of a transaction for the purposes of applying section V.1 of the Tax Code

The FTS takes the view that a “transaction for the purposes of applying section V.1 of the Code is regarded as each separate operation (transaction) (for example, a shipment of goods, performance of work, provision of services, or completion of operations with another item to which civil rights attach) which is aimed at establishing, amending or terminating civil rights and obligations”. Thus, a contract is not necessarily treated as a transaction and it may comprise several transactions.

The time at which a transaction is completed for taxation purposes is not defined in the Letter. However, it is recommended that taxpayers monitor prices in controlled transactions and prepare documents in particular areas (for example, calculating the margins of market prices) at the time when a controlled transaction is being undertaken or when a price is being set in a controlled transaction. 

The FTS confirmed in the Letter the stance it had previously affirmed to the effect that in determining the amount of income for transactions across a calendar year, the total amount of income for each counterparty under such transactions should be determined. 

An exception is when the amount of income is being determined from transactions in a calendar year and transactions with several related parties need to be taken into account: for example, if more than two parties have taken part in a transaction or if a court has held that a transaction is controlled under the regime in article 105.14(10) of the Tax Code (according to this rule, upon the application of the FTS a court may treat a transaction as controlled if there are sufficient grounds to believe that this transaction is part of a group of homogenous transactions undertaken in order to create conditions whereby such a transaction would not meet the criteria for a controlled transaction).

The FTS draws particular attention to the requirement for detail in the information supplied by a taxpayer about controlled transactions. It stresses two aspects.

Firstly, the documentation supplied is intended to serve as grounds on which the FTS will carry out a pre-check analysis to assess whether it is prudent to institute tax control measures.

PG comments. The wording put forward by the FTS in the Letter assumes that an analysis will be conducted of the taxpayer’s documentation regarding the controlled transaction before a check is carried out according to the regime in article 105.17 of the Tax Code, which means that documentation will be demanded outside the scope of a specific check. However, the tax authority may not in any event demand such documentation earlier than 1 June in the year following the calendar year in which the controlled transactions were undertaken (article 105.15(3) of the Tax Code).

Secondly, the FTS stresses that applying article 129.3(2) of the Tax Code to a taxpayer (this provision stipulates an exemption from liability under article 129.3(1) of the Tax Code in relation to supplying documentation confirming that prices in controlled transactions are in line with  market prices) is possible only if, when the documentation was prepared, the 105.15(6) of the Tax Code were complied with. Under this provision, the detail and thoroughness of documentation provided to the FTS should be commensurate with the complexity of the transaction and the formation of its price (the profitability of the parties to the transaction).

PG comments. Tax legislation does not define the methodology for assessing the detail of information provided by the taxpayer. This provides the tax authorities with wide scope for discretion in resolving the question of whether the detail and thoroughness of the documentation is commensurate with the complexity of the transaction.

In view of this, we recommend that documentation in relation to complex transactions be drafted with qualified legal support.

Taking account of the requirement for detail in information provided to the extent  of a description of the activity of the taxpayer undertaking the controlled transaction,  the FTS considers that the documents provided must contain information about the ownership structure of the group of companies (a diagram, indicating equity holdings, functions performed, and states and territories of which they are tax residents) or of the part of such structure including the persons that influence pricing in the controlled transaction.

PG comments. The rules of the Tax Code regarding transfer pricing contain no such requirement to disclose information about ownership structure. In view of this, the issue of disclosure of information should be resolved case by case, taking account of the specific circumstances.

Referring to the lack of any right for the FTS to apply, when it undertakes tax control, methods not provided for in section V.1 of the Tax Code, the FTS also recommended that taxpayers, when they establish prices for transactions, use the methods stipulated in 105.7(1) of the Tax Code.

Other methods (which, for the FTS, also includes combinations of methods) may, in the view of the FTS, be used by taxpayers if the provisions of the Code which govern calculation and payment of particular taxes specify other rules for determining the price of goods (work or services) for tax purposes (for example, in relation to determining the tax based for operations with securities and fixed term financial instruments).

The Letter contains no recommendations regarding the application of specific methods of determining prices. However, in characterising the carrying out of functional analysis, the FTS drew attention to the importance of accounting for differences in the level and type of expenses when the cost-plus method is applied: operating and non-operating, including expenses on financial activity that are related to functions performed and risks assumed. 

The accounting for these differences is as follows:

• if the expenses reflect a functional distinction (taking account of the assets used and risks assumed) which was not taken into account in the method applied, there may be a requirement to adjust the seller’s mark-up indicator when the cost-plus method is applied;

• if the expenses reflect additional functions which differ from the seller’s functions as analysed by the relevant method, additional payment to the seller may be required for the functions it has performed;

• if the difference in the expenses of the parties that have been analysed reflect only the effectiveness or ineffectiveness of the companies, which is typical for general and administrative costs, additional gross margin adjustments are not required.

Determining the commercial and/or financial conditions of a transaction that is being analysed and the functional analysis is carried out based on the provisions referred to in the agreement (contract) and or arising from the agreement (contract) within the scope of which the transaction is being undertaken.  However, as the FTS stressed in the  Letter, it is necessary to take account of which of the parties is performing (not performing) the terms of the agreement and which of the terms do not reflect the actual relationship of the parties and the genuine financial and economic results of their activity.

For the purposes of accurately determining the functions of the parties to a transaction that is being analysed and allocating the risks when the analysis is carried out, the FTS has recommended that the parties be classified as the companies assuming the main functions or bearing the key risks, and the companies performing ‘routine’ functions, i.e. they do not have significant intangible assets and do not assume material risks. 

Companies performing ‘routine’ functions, in the FTS’s view, are marked out by receiving a stable and small income (profit) in view of the fact that the services they perform are mandatory for the performance of the principal activity of the related parties that are in a single group. Such services are provided on an ongoing basis. In relation to them, the search for comparable independent companies is less complex and does not require substantive adjustments to be made.

In relation to the assets used when transactions are undertaken, the FTS recommended that an analysis be conducted, beginning with the most important, the use of which makes the biggest contribution to the amount of income (profit) received or profitability obtained. Account should also be taken of the fact that the specific nature of assets increases the risks of them being used.

Deadline and procedure for drafting and filing documents further to a demand of the FTS

In the Letter, the FTS stressed that the deadline for filing documents demanded by the FTS in relation a controlled transaction is 30 days from the day on which the demand was received. No provision is made by the Tax Code for this to be extended.

In addition, the FTS noted that the documents should be provided by the person to whom the demand was addressed; however, such documents may also be prepared by persons who are counterparties under the controlled transaction. 

The total time period for storing documentation relating to transfer pricing has been set by the FTS, based on article 23(1)(8) of the Tax Code, at four years. 

To avoid negative consequences of discrepancies when documentation is downloaded over different periods of time (when research is conducted and when an inspection is carried out), the FTS points to the need for a taxpayer to preserve the initially downloaded documents while it carries out a search for comparable prices (companies).

In relation to the procedure for updating documentation, the FTS stresses in the Letter the requirement that it be reviewed annually. To this end, the FTS points out the need to review the results of economic analysis both based on updated statistical data from previously selected comparable organisations, and on the basis of a new search of comparable organisations on the market.

Documentation relating to long-term contracts (over 1 year) is an exception to the procedure for updating documentation. For this, the FTS has provided for the possibility of preparing one set of documentation without it being updated annually if the material terms of such transactions are the same throughout the life of the contract, and if, to implement such transactions, among other things financing has been attracted subject to a condition that the interest rate shall be preserved as long as the terms of the contract are complied with.

Account needs to be taken of the position of the FTS that is set out in the Letter, as well as the obligations on the tax authority stipulated in the Tax Code to apply the methods used by a taxpayer when the authorities check prices. It is therefore prudent for companies that undertake controlled transactions and that have not entered into a pricing agreement to select a defined method for ensuring that the prices actually applied in such transactions correspond to market prices.

Determining the grounds for a particular method to be applied will require extensive and detailed research to be carried out. This research will ensure that a taxpayer can provide a reliable justification of its choice of method. It will also ensure that the taxpayer may come up with and describe the mechanism for applying that method for each specific transaction (group of homogenous transactions).

Similarly, in relation to each specific transaction and taking account of the specific factors of the taxpayer’s business, contentious issues need to be resolved which may arise when the transfer pricing rules are applied to the taxpayer’s transactions. Among these issues are whether it is possible to apply other price control methods (or combinations of methods), disclosing information about the ownership structure, and the content and detail of documentation.

The experts in Pepeliaev Group’s tax practice stand ready to assess the tax risks of a company’s activity in the light of the new transfer pricing rules. We will devise a model for applying such rules, including in terms of selecting price control methods and arranging monitoring of price control methodology to check compliance with the methods stipulated by the Tax Code.