Muranov, Chernyakov & Partners: Transfer Pricing

The Ministry of Finance of the Russian Federation and the Russian Union of Industrialists and Entrepreneurs have agreed on a new version of the amendments to the Tax Code of the Russian Federation regarding transfer pricing. Nikolay Stepanov, partner in Muranov, Chernyakov & Partners, shares his views on the new law.

Nikolay Stepanov

Muranov, Chernyakov & Partners
+7 495 783-74-50

Transfer pricing, selling goods or services within a group of interconnected companies at prices different from market, is one of commonest ways of international tax planning. Its purpose is the relocation of profits within the group, i.e. to jurisdictions with favourable tax regimes.

In the context of globalization, the need for regulation in Russia is obvious. Though the issue has been discussed since the early 2000s, but it was only in 2010 that a bill was prepared to streamline control over the payment of taxes in transfer pricing transactions. However, the draft law was so raw, underdeveloped and sometimes even aggressive in terms of government intervention that it did not pass a second hearing in Parliament.

The new version of the bill is a result of a compromise between business and the government. The new law, nevertheless, has a touch of pro-state bias since taxation of transfer pricing is a tool to promote the fiscal interests of the state.

Its essence is the mechanisms of fiscal control over transactions not at market prices between persons who are not independent from each other. Articles 20 and 40 of the Tax Code will be abolished, and a new Part V will be introduced which will define the following issues: interdependent entities, pricing and taxation, tax control of prices (rate of return) in transactions, agreements on pricing.

It is expected that in 2012 control over transactions of interdependent companies will affect companies with an annual turnover exceeding 3bn roubles, in 2013 – companies with an annual turnover in excess of 2bn roubles, and only in 2014 - companies with a turnover of 1bn roubles. Also during the first two years, the tax service will not control the transactions of residents in special economic zones and / or those who use special tax regimes.

The phased introduction of transfer pricing control should reduce risks for business and give it time to change. Pricing mechanisms will probably be revised (primarily by oil companies, which have the greatest experience of transfer pricing); the appropriate staffing and equipping of the tax authorities will be made.

We should specifically highlight some novelties in the law.

The law clarifies and expands the concept of interdependent entities (in particular, companies may be recognized as interdependent by a court decision on grounds other than those specified in the law), the concept of controlled transactions (focusing on the established ‘arm’s length’ principle). The lawmaker walks away from the assumption of "market" prices in transactions between related companies and, therefore, the burden of proving the reasonableness of pricing and conformity to the market has been shifted from the tax authorities on to the taxpayer.

The law also departs from the 20% limit of deviation from the market price and instead sets guidelines for determining the range of market prices for tax purposes. The procedure for determining this range varies.

Transfer pricing methods expand in line with international practice as well as the sources of information to be used by tax authorities; preliminary approval of controlled transactions by the tax authorities and agreements between taxpayers and tax authorities on pricing will be introduced in order to harmonize the methods of control, so that a company observing these methods can be protected from additional taxation.

The new law is mostly based on the OECD Guidelines which brings together and promotes the convergence of Russian legislation with international law and the law of most developed countries.

At the same time, the law has a number of distinctive features and shortcomings.

One of the negative aspects of the law is introduction of penalties for taxpayers who use non-market prices for controlled transactions. Article 40 of the Tax Code excludes such a possibility, but the bill seeks to add article 129.3 on liability for non-payment or incomplete payment of tax as a result of price (rate of return) which does not match market prices (rate of return). According to this norm, non-payment of tax is subject to a fine of 40% of unpaid tax. The taxpayer will be exempt from liability if he or she submits some documentary evidence to the tax authorities confirming the level of market prices applied (rate of return) for controlled transactions.

Such an approach can hardly be called reasonable. In many countries penalties don’t apply in such cases; and that would have been appropriate for Russia too. Otherwise, the rule would entail numerous disputes between taxpayers and tax authorities. Today, just as a decade ago, the taxmen tend to challenge in court even pretty simple and standard documents justifying, for example, the right to apply a zero rate of VAT.

Ideal methods for determining the market price do not exist. The results of any method are relative and depend on many factors, including the quality of market data possessed by the taxpayer or the tax authority. Thus, when a 40% fine is at stake disputes over justification of price are unavoidable.

We, therefore, agree with our colleagues on the need to delete article 129.3.

However, even with all its flaws, the new law is a necessary step in the process of improving Russian tax legislation and its convergence with international standards.

Given the scale of the proposed innovations and complexity of implementation of new methods of control, their effectiveness will depend on the law enforcers, primarily from the tax authorities on their ability and desire to apply new tools professionally and conscientiously.

Muranov, Chernyakov & Partners