Tax administrations are required to help minimize the tax risks that affect the reduction on tax revenues. On the other hand, any tax administration should seek to encourage taxpayers' voluntary compliance. This reciprocity requires a series of measures prescribed, in most cases, by tax regulations. These measures are subject to constant improvements in line with the development of the economy in general and the market as a whole and, in particular, the way in which taxpayers - entrepreneurs operate.
One of the tax risks managed by taxpayers is the risk of disclosing data that will be important for the determination of tax liabilities. If the data displayed in the tax returns and reports that taxpayers are obliged to submit, in accordance with tax and other regulations, are incorrect, the result in the majority of cases will be a reduction on tax revenues.
The increasing integration of the global economy and the growing importance of multinational companies in such an economy, lead to the fact that transfer pricing is one of the most important tax issues that multinational companies and tax administrations have to face. These issues are not only relevant to the fact that we can be dealing with significant amounts of tax involved, but also because these issues can be very complex and their resolution depend on a good understanding of the facts and the specific context of each business. Hence, resolving disputes over transfer pricing tends to be well supported by resources, both on the part of multinational companies and tax administrations.
The primary issue for the tax administration is how to provide legal certainty for taxpayers in legitimate tax compliance and avoid long-term court proceedings with uncertain results both for taxpayers and for the tax administration, i.e. the state budget, particularly because of the complexity of the transfer pricing issue.
In order to simplify the transfer pricing process and ensure legal certainty and predictability in terms of the costs related to tax obligations for group of companies, i.e. multinational companies, for certain future transactions1, many more countries use the advance transfer pricing agreements (APA).
Although not every country in the world is a member of the Organization for Economic Cooperation and Development (OECD), the fact is that, when it comes to determine prices and other contractual relations between associated enterprises, i.e. transfer pricing, profit tax regulations as well as regulations on tax procedures and separate laws in those countries may be based on OECD guidelines on transfer pricing.
In the OECD`s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations2, transfer prices are defined as the prices at which an enterprise transfers physical goods and intangible property or provides services to associated enterprises. According to OECDs Guidelines, enterprises are associated if one of the enterprises participates directly or indirectly in the management, control or capital of the other or if the same persons participate directly or indirectly in the management, control or capital of both enterprises. Since prices are established by companies within multinational companies, those prices may not always match market prices. This is a major problem for tax authorities because of the ability of multinational entities to use transfer prices for cross-border transactions for the purpose of reducing taxable profit.
The approach taken by the EU member states for estimating the price applied to transactions between associated enterprises is the arm's length principle. This principle requires that the prices used in transactions between associated enterprises correspond to the prices that would be applied between unrelated enterprises for the same transaction (market prices). Similarly, for multinational companies whose business activities take place through independent companies in multiple tax jurisdictions with different tax burdens, there is a need to ensure an adequate taxation of the profit realized in one area, while respecting the principle of avoiding double taxation. There are also different methods for determining transfer pricing such as: comparable uncontrolled price method (CUP), resale price method, costs plus method, profit split method and net margin method3.
In principle, the legislative framework, along with methods of determining transfer prices, stipulates that business relationships between associated enterprises will be recognized only if the taxpayer himself and/or at the request of the tax administration, provides information about associated enterprises and business relationships with those enterprises, method used to determine comparable market prices and the reasons for choosing specific methods.
For resident taxpayers, the comparable uncontrolled price method may also apply to associated enterprises who are residents of one country if one of the associated enterprises has a preferential tax status or it pays profit tax at rates lower than the prescribed standard rate, or it is exempt from corporate income tax4, or has the right to carry forward tax losses from previous tax periods.
When selecting the methods for determining transfer prices, it is necessary to determine the method that is the most appropriate for each given case. In principle, this means that the legislative framework does not prescribe which method has to be applied, rather depending on a case by case, that is, on the specifics of each transaction. In the selection process, advantages and disadvantages of each method should be taken into account, but also the appropriateness of the selected method regarding the nature of the controlled transaction, which is determined by functional analysis, the availability of reliable information required for the application of the selected method, as well as the degree of comparability of controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be required for the elimination of their mutual material differences.
By classical transactional methods, it can be most directly determined whether the terms of trade and financial relations of associated enterprises are consistent with the arm's length principle. Taking into account the above criteria, where the classical transactional method and the transactional profit method can be applied with the same reliability, the advantage should be given to the classical transactional method, that is, when it is possible to use the same comparable uncontrolled price method and some other method for determining transfer prices, it is preferable to use the comparable uncontrolled price method, with the emphasis being on finding the method that is most appropriate for each given case.
When selecting and applying one of the prescribed methods to determine whether a transaction is in line with the arm's length principle, the following actions should also be considered:
The global economy is a complex economy and more and more countries have become aware of the importance of transfer prices, that is, their impact on corporate income. A common issue to most countries is the lack of resources to determine transfer prices, not to mention that the process itself requires a great deal of time and a lot of people to be engaged in it. Therefore, the idea and the need for simplifying transfer prices came to light and the main reasons for the simplification are:
Certain countries have already taken some measures to simplify the entire system and the process of determining transfer prices, for example: medium and small enterprises are excluded from the process itself; a better control of the work of the department for transfer pricing audit and work on APA is introduced; the resources are used in the most risky subjects; the attention is focused on the biggest and most challenged subjects, etc. The aim was to establish a cost-effective submission and processing of the application and that, at the same time, the process becomes cost effective for taxpayers.
Simplification can also be made in the way that special legal regulations are introduced for the most important industries. It is very important to identify, before the adoption of a special regulation, which is the most significant area of business in the country, that is, the area where the highest profit lies. To begin with, understanding the business area is essential in order to understand the nature of the transaction. In this case, it is important to have robust or well-conceived provisions of domestic legislation, well-prescribed documentation rules, appropriate administrative support, and so on.
In 2010, the OECD also started a simplification project and in January 2012 published the report "Dealing Effectively with the Challenges of Transfer Pricing" on how to optimize the management of transfer pricing programs, so that the audit and control of transfer prices can be implemented efficiently and timely in favor of multinational companies and tax administrations. The report deals with practical steps which tax administrations should take to, accurately, identify cases of transfer pricing that need to be analyzed more closely, in order to reach a conclusion as soon as possible. Furthermore, transfer pricing recommendations are included in the package of measures against tax evasion, referred to as BEPS (Base Erosion and Profit Shifting), in Action 13: documentation for transfer pricing; and in Actions 8-10: adjustment of transfer pricing results with creating value.
As part of the simplification of the transfer pricing process, APA is used, and in its Transfer Pricing Guidelines for Multinational Corporations and Tax Administrations issued in 2010, the OECD has also included recommendations for APAs, based on the best practices of OECD member countries.
APA is a program designed to resolve existing or potential disputes over transfer pricing in a principled, cooperative way, as a sort of alternative to a traditional process. The APA is generally a binding agreement between the tax administration and the taxpayer through which the tax administration agrees not to seek adjustment of transfer pricing for agreed transactions if the taxpayer submits his tax return for the contracted years in accordance with the agreed methods for determining transfer prices.
APA can be unilateral, bilateral or multilateral. In principle, bilateral or multilateral APAs are used as agreement between the taxpayer, the local tax administration and two or more foreign tax administrations in order to avoid double taxation, but the taxpayer may also ask for a unilateral arrangement involving only the taxpayer and the local tax administration. In this case, the two parties agree on an appropriate methodology for determining transfer prices for tax purposes only in the country where the agreement is to be concluded. However, in the event that the taxpayer is involved in a dispute with a foreign tax administration in relation to transactions covered by the agreement, he may request the competent authority to initiate a mutual agreement procedure ("MAP"). This implies, of course, that an appropriate double taxation agreement with that other country is being applied.
One of the first APA program was introduced in Japan in 1987 and it was, then, only unilateral, being officially extended in 1999 to bilateral and multilateral. Today, more than 80% of APA requests belong to the bilateral type. Over time, the number of taxpayers' requests for APAs increased significantly from 48 requests in 2000 to 135 in 2010. APAs usually take place over a period of 5 years, but also for longer and shorter periods in special cases. The APA's effect is due to the fact that it binds an appropriate tax authority in accordance with the principle of good faith and trust, and the taxpayer is exposed to taxation risk in case he does not fulfill the conditions defined by the APA. The tax auditing and monitoring of the taxpayer is carried out through the submitted annual tax return. The average time from the receipt of the request to the conclusion of the agreement is 2 to 3 years, depending on each case.
The agreement is designed as a substitute for classical administrative, judicial and contractual mechanisms for dealing with transfer pricing problems, and is most useful when classical mechanisms are hindered or difficult to apply due to their extraordinary complexity. Special consideration has to be taken on how it will be applied and what are its key assumptions, because definite conclusions are based on predicting future events.
Although it is difficult to predict future events with certainty, forecasting reliability can be increased by using appropriate key assumptions and ranges, and as a resource, historical data on taxpayer activity can be used, as well as benchmark comparable profit rates of unrelated taxpayers, etc. It can be concluded that the reliability of forecasts depends on the facts and circumstances of each particular case, and unpredictable predictions should not be included in the APA.
The purpose of the APA is to resolve the issue of transfer prices on a partnership basis between the taxpayer and the Tax Administration, i.e. on the principles of:
The positive effect of the APA is expected to be a more rational use of the resources of the taxpayers and of the Tax Administration, which should lead to a predictable result, neutralize tax risks and achieve a better legal certainty for the taxpayer in a specific business event or a controlled transaction for which the APA will be concluded.
The APA is being concluded to determine the tax treatment of one or more transactions between associated enterprises, as a rule before the transactions have started, thus establishing a suitable set of criteria such as methods, comparators, appropriate adjustments or key and critical assumptions regarding future events of these transactions over a certain period of time. Consequently, the APA may relate to a particular transaction, several transactions, several types of permanent transactions, or any taxpayer´s cross-border transactions over a specified period of time.
The process of concluding the APA (the example of the Republic of Croatia) may include the following phases:
In a large number of countries, taxpayers bear the costs of concluding the APA, which should be reasonable and appropriate to the resources spent by the tax administration.
According to the OECD`s Guidelines the advantages of concluding the APA are:
However, apart from the above mentioned advantages, the APA also has its disadvantages, such as, for example:
From all of this and despite the outstanding disadvantages, we can conclude that the APA is one of the measures that is affecting the increase in the number of voluntary compliant taxpayers, since the APA provides legal certainty, no instruments of tax auditing are initiated, the possibility of double taxation is eliminated, the reputation of taxpayers is strengthening and, last but not the least, resources are being saved on both sides. Furthermore, by introducing the possibility of concluding an APA in the legal framework of a given state, opportunity and incentive are being given for taxpayers to be voluntarily compliant. In this course of action, it will be important to exchange information with other countries and international organizations, to educate employees, to understand business processes and business transactions and, generally, market conditions and trends in certain business sectors.
Each tax jurisdiction determines which entrepreneurs should be considered as micro, small, medium and large entrepreneurs. An often considered serious disadvantage is the inability or difficulty in applying APA to SMEs. The reason for this is the huge cost of the preparation of documentation which will require engaging authorized tax consultants, the costs of the procedure, the lack of educated personnel for the preparation of documentation, etc. However, this is reducing the value of APA as, among other advantages, it makes it impossible to have a greater impact on voluntary compliance for these taxpayers. The importance of this issue can be perceived in the fact that a very large number of SMEs influence their state's economy through their business activities.
To this end result, it is necessary and timely to regulate specific rules for applying APA to SMEs. The rules must be simple, responsive and cost-effective in terms of the cost of human resources, material costs as well as time-consuming cost. In that sense, it is necessary to make use of all available and modern technologies, such as web services etc. Some countries already have a regulated legislative framework specifically for APA applications to SMEs. However, this should not be an exception, but a rule, precisely because of the economic importance of these entrepreneurs in the economic development of each state.
Particular attention should be given to the simplification of transfer pricing documentation, for justified reasons and in the sense that SMEs will, generally, not have a lot of different transactions.
In order to increase the impact on voluntary compliance by as many taxpayers possible, irrespective of their size, this issue is one of the most important issues that deserve a legitimate focused attention on its capable and expeditious solution.
The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.
Ksenija Cipek is based in Zagreb, Croatia and she is a lecturer at the local University of Law and a Member of European Law Institute. Ksenija has over 20 years experience working at the Ministry of Finance and the Tax Administration. She is a highly respected and recognised tax expert who has been heavily involved in lawmaking. Ksenija is also an author and books writer.
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