Worldwide: The Arm´s Length Standard

The information in this article has been prepared by professionals in the member firms of Deloitte Touche Tohmatsu.

Originally published April 2005

Italy’s Ministry of Economy and Finance on February 2 issued a resolution in response to a ruling request filed by an Italian commissionaire regarding the tax treatment of transactions carried out with its Swiss principal.

The questions submitted involved the application of article 110, paragraph 10 of the Italian Tax Code, which states that costs arising from transactions with companies domiciled in non-EU countries with a "privileged" tax regime¹ are presumed to be nondeductible, unless the taxpayer:

• Demonstrates that the foreign companies are engaged in actual commercial activity; or
• Shows that the transactions are carried out pursuant to a sound business purpose.

The newly issued Ministerial Resolution n. 12/E clarifies some doubts regarding the actual application of article 110, paragraph 10 and provides some indications regarding others.

Although the resolution was issued by the Central Revenue Agency at the Ministry of Economy and Finance, it refers only to a specific case, and therefore it has neither the universal validity of ministerial instructions nor the force of law. Still, the fact that it was published (publication is not mandatory for this kind of resolution) clearly indicates the agency’s intent to let taxpayers and tax auditors be aware of the principles discussed therein.

The Italian company that filed the ruling request distributes software products in the Italian market under a commissionaire agreement with a Swiss principal (that is, in its own name and on behalf of the Swiss principal). The Swiss principal is located in Switzerland’s Geneva canton, and benefits from a tax regime that enables it to pay reduced federal and municipal taxes. For this reason, it is considered to be resident in a "privileged tax regime country" for Italian tax purposes.

The Italian commissionaire receives a commission from its Swiss principal for the commissionaire services rendered to the latter.

The Italian commissionaire requested a ruling asking whether the commissionaire or its clients must provide evidence that the exception to article 110, paragraph 10 applies.

In the commissionaire’s opinion, neither it nor its clients should be subject to the presumption of nondeductibility in article 110, paragraph 10. The commissionaire argued that, based on Italian generally accepted accounting principles, it shall account in its P&L for revenues just for the commissions earned and for the operating costs relevant to its commissionaire activity.

The amounts invoiced by the Swiss principal (which would represent the cost of goods sold for an ordinary distributor, and are equal to the goods sale price applied to the final customers, net of the commission owed to the commissionaire) are instead booked by the commissionaire just for VAT purposes and, as such, should not have any relevance for corporate income tax purposes.

The commissionaire also argued that the ultimate clients deal exclusively with the Italian commissionaire, and may not even be aware of the existence of the Swiss principal. Thus, they may well ignore that they are buying from a principal located in a "privileged tax regime" country.

The ministry’s response accepted the taxpayer’s arguments only partially, agreeing that no burden of proof should be placed on the customers to prove the deductibility of costs incurred with reference to the goods sold by the Swiss principal. However, the ruling clearly states that the burden will fall on the Italian commissionaire.

The ministry’s position completely overturns the Regional Revenue Agency of Piemonte’s November 2002 interpretation of the same issue, which identified the ultimate customers as the parties obligated to prove the tax deductibility of their purchase costs. The Regional Revenue Agency’s position was vigorously questioned by tax practitioners and never supported by the National Agency (even though it was not explicitly criticized either). However, the position now adopted by the latter will raise numerous objections and concerns among both practitioners and taxpayers.

The ministerial resolution argues that the fact that the sole commission is booked in the commissionaire’s P&L (as required by International Accounting Standard n.18 and deemed correct by the same Ministry of Economy and Finance in its Resolution n. 377/E of December 2, 2002), rather than both the revenues invoiced to clients and the "costs" invoiced by the principal (a procedure that indeed appears incorrect from an accounting viewpoint, as it does not reflect the economic substance of the principal-commissionaire scheme) does not prevent article 110, paragraph 10, from being applicable in theory.

In fact, said the Ministry of Finance, the commissionaire’s tax return will in any case provide evidence of the "costs" of the "goods sold" on transactions carried out with the Swiss principal (that is, of the amounts invoiced by the principal to the commissionaire)², regardless of whether they are included in the commissionaire’s P&L account for statutory purposes.

In practical terms, the recording in the Italian commissionaire’s tax return of costs that in the first instance should qualify as nondeductible under article 110, paragraph 10, would imply that sooner or later the commissionaire would very likely be asked by the Italian tax authorities to provide evidence to overcome the presumption of nondeductibility of such costs. The deadline for providing such evidence would be 90 days from the request. Once the 90-day period expires, the tax authorities would be free to challenge the deductibility of the costs.

The only alternative for the commissionaire would be to file an advanced ruling request with the Revenue Agency to obtain its opinion on the tax deductibility of the amounts that will be invoiced to it by the tax-privileged Swiss principal. Such a request of course would have to be supported by documentation showing that at least one of the two conditions mentioned above is met.

Footnotes

^{1 Generally, those countries in which the level of taxation is appreciably lower than in Italy, or with which there is no adequate exchange of information agreement.}

2 The tax return model "Unico" requires that taxpayers fill in, in specific row, the amount of costs that would not be deductible under article 110, paragraph 10, then indicate in a subsequent row the portion of those costs the taxpayer deems deductible under paragraph 11 of the same article, according to which costs are deductible regardless of whether the Italian taxpayer is able to prove the exception to article 110 applies to it.

The Internal Revenue Service on March 31, 2005, released Announcement 2005-27, its Advance Pricing Agreement (APA) annual report covering the activities of the APA program during calendar year 2004. The annual report is issued under §521 (b) of Pub.L. 106-170, the Ticket to Work and Work Incentives Improvement Act of 1999, which requires the Secretary of the Treasury to report annually to the public on APAs and the APA program.

The annual report provides a statistical snapshot of the APA program’s activities during 2004. By comparing the 2004 annual report with prior reports, and based on knowledge Deloitte’s APA team has obtained through its large number of APA cases, significant trends and highlights of the APA program may be summarized:

• Completed APAs -- The IRS executed 65 APAs (27 unilateral, 37 bilateral, and one multilateral) and amended four APAs (four unilateral) in 2004, an increase from the 58 APAs executed in 2003.
• Small Business Taxpayer APAs -- Nine small business taxpayer APAs were executed in 2004, down from 12 in 2003. On average, these took longer to complete in 2004.
• Months to complete APAs -- In 2004, the median time to complete a unilateral APA was 18.4 months, and 43 months for a bilateral APA. This represents a fairly significant increase in negotiating time from 2003 (when the median time to complete a unilateral APA was 9.2 months and a bilateral APA 39.4 months). Deloitte’s bilateral APA cases have been completed in shorter periods of time.
• Requests for APAs -- The IRS received 80 APA applications (35 unilateral and 45 bilateral) in 2004, down from 90 in 2003.
• Inbound v Outbound -- Continuing the trend established in previous years, inbound cases accounted for the majority of the APA program’s caseload in 2004, with 62 percent of the APAs executed involving foreign multinationals with U.S. subsidiaries. This number has increased from 53 percent in 2003 and 58 percent in 2002.
• Boilerplate and Balance Sheet Adjustments -- The annual report also includes the latest versions of the APA program’s boilerplate APA agreement and formulas for balance sheet adjustments.

The year 2004 was eventful for the APA program, with the launch on December 22, 2003, of the Senate Finance Committee inquiry into the APA Program and the release on July 1 of Rev. Proc. 2004-40 (2004-29 I.R.B. 1), the long-awaited revenue procedure providing updated guidance regarding the APA program. Even with these distractions, the statistics evidence that 2004 proved to be another successful year for the APA program.

In January 2005, the IRS for the first time in over 10 years provided public comments on the interpretation of the commensurate with income standard and the requirement to make periodic adjustments. The IRS apparently has been considering the need for further guidance in this area as part of the expanding project to propose amendments to the cost sharing regulations. The comments, if included in regulations, could substantially limit a taxpayer’s ability to affirmatively use the commensurate with income standard and periodic adjustments in many situations. However, they could also provide welcome clarification of a taxpayer’s ability to shift risk without running afoul of the periodic adjustment rules.

At the January 2005 American Bar Association meeting in San Diego, IRS Deputy Associate Chief Counsel (International) Steven Musher stated that taxpayers are free to structure their license arrangements in a manner consistent with economic substance and the arm’s length standard. Taxpayers can enter into an arrangement in which the royalty payments are contingent on the profit attributable to intangibles, or they can enter into lump sum or long-term agreements in which the consideration is fixed. If the parties enter into a lump sum or long-term fixed agreement, Musher stated, they should not be able to use the periodic adjustment rules to undo the economic bargain they struck. In those circumstances, only the IRS should be able to apply the commensurate with income standard and the periodic adjustment rules to change the consideration.

The IRS comments appear to be a response to the fact that the IRS views itself as at a disadvantage, in part because taxpayers have affirmatively applied the commensurate with income standard and the periodic adjustment rules far more frequently than the IRS. Apparently, the IRS is concerned that taxpayers have used the commensurate with income standard and the periodic adjustment rules to negate economic bargains they agreed to with related parties. For example, assume a taxpayer enters into a related-party license of intangible property for a fixed royalty for 10 years and agrees to shift a certain amount of the risk with respect to the success of the intangible to the related party. If, after three years, the intangible does not generate sufficient profits to support the agreed upon royalty, the IRS is considering not allowing the taxpayer to apply the periodic adjustment rules to reduce the amount of the agreed upon royalty without the compensation that arm’s length parties would require. In this situation, the IRS would argue the taxpayer could have entered into an agreement in which the royalty was reviewed periodically, but instead chose to enter into a fixed royalty agreement. In a fixed royalty agreement, the parties agree to a certain amount of risk shifting. In the IRS’s view, the parties should not be able to retroactively change their risk-sharing bargain.

Implicit in and, we would argue, a necessary consequence of the IRS comments is that a carefully structured and well documented license agreement can shift risk between the licensor and the licensee beyond a mechanical application of the current safe harbors in Treas. Reg. §1.482-4(f)(2)(ii).

Treas. Reg. §1.482-4(f)(2)(i) provides that if an intangible is transferred for a period of more than one year, the consideration in each taxable year may be adjusted to ensure it is commensurate with the income attributable to the intangible. However, the adjustment must be consistent with the arm’s length standard and the provisions of Treas. Reg. §1.482-1. The regulations further provide three exceptions, the most widely used of which is that the periodic adjustment rule does not apply, if among other requirements, the profits or cost savings attributable to the transferred intangible are within 80% to 120% of the expected profits from the intangibles. The regulations do not provide any additional guidance on the profit or cost savings risk that could be shifted beyond that permitted by the exceptions. Some taxpayers have wondered if the regulations permit any profit or cost-savings risk shifting beyond that permitted by the exceptions.

The regulations state that a periodic adjustment under Treas. Reg. §1.482-4(f)(2)(i) must be consistent with the arm’s length standard and the provisions of Treas. Reg. §1.482-1. Treas. Reg. §1.482-1(d)(3)(iii)(B) states, in part, that an allocation of risk specified or implied by the taxpayer’s contractual terms will be respected if it is consistent with economic substance. The regulations provide three factors that are relevant in determining economic substance: conduct over time, financial capacity to bear the risk and managerial or operational control over the risk-bearing activities.

The interaction between the ability to shift risk under Treas. Reg. §1.482-1(d)(3)(iii)(B), the commensurate with income standard and the periodic adjustments rules has always been unclear. The IRS comments that focus on the economic substance of the license agreement suggest that taxpayers can shift a substantial amount of profit and cost-savings risk in a carefully documented and structured license agreement as long as it is consistent with economic substance and the arm’s length standard. We suggest that such an interpretation is correct and the fair result, especially if the IRS is not going to permit taxpayers to adjust their lump sum or long-term fixed compensation agreements by using the periodic adjustment rules. Hopefully, if the proposed regulations limit taxpayers’ ability to apply the commensurate with income and the periodic adjustment rules, they will also clarify with additional language or examples that taxpayers can shift profit and cost-savings risk provided it is consistent with economic substance.

The IRS focus on economic substance is consistent with the statements in numerous Treasury tax treaty technical explanations that implementation of the commensurate with income standard in the section 482 regulations is in accordance with the arm’s length standard as interpreted by paragraphs 6.28 through 6.35 of the OECD Transfer Pricing Guidelines (see, for example, the Treasury Department Technical Explanation to Article 9 of the U.S.-Japan income tax treaty). In general, those paragraphs adopt the position that hindsight should not be used, but that tax administrators should look to what independent parties would have done in light of the uncertainty of the potential outcomes from using the intangible property.

Arguably, the IRS position that only the IRS can make periodic adjustments to fixed license agreements is consistent with U.S. and foreign documentation requirements and the taxpayer’s ability to make transfer pricing adjustments under Treas. Reg. §1.482-1(a)(3). U.S. and, in many cases, foreign documentation requirements require that taxpayers reasonably adopt and apply an arm’s length transfer pricing method. Treas. Reg. §1.482-1(a)(3) permits taxpayers to adjust non-arm’s-length related-party transactions. Before filing their income tax return, taxpayers are permitted to make both positive and negative adjustments. After the return is filed, taxpayers are only permitted to make positive adjustments. If the IRS adopts the position that licensees and licensors are free to shift profit and cost-savings risk as long as the risk shifting is consistent with economic substance, taxpayers should be able to meet their documentation requirements by showing that the risk of the outcome in the current year was shifted to the licensee, and that the compensation in the year the license was entered into was arm’s length based on the facts that existed during that year, and not with hindsight. Similarly, taxpayers would be free to adjust the compensation under the license agreement in the year the license agreement was entered into under Treas. Reg. §1.482-1(a)(3), but could only increase the consideration in subsequent years.

As a practical matter, if the IRS adopts the position that only the IRS can make periodic adjustments to fixed license agreements, taxpayers will be more likely to include periodic adjustment clauses in their license agreements. Taxpayers that decide not to incorporate periodic adjustment clauses into their license agreements may face substantially increased documentation requirements. Taxpayers that wish to shift profit or cost-savings risk as part of their license agreement may be required to prepare sophisticated risk-weighted projections to demonstrate that the potential outcomes were contemplated and that the parties considered those outcomes in establishing the arm’s length royalty to satisfy the IRS that their license arrangements properly allocated profit and cost-savings risks and, therefore, should not be subject to periodic adjustments. In addition, taxpayers may be required to show economic circumstances surrounding the license and that the license transaction had economic substance within the meaning of Treas. Reg. §1.482-1(d)(3)(iii)(B). Finally, although not explicitly required by the U.S. rules, it may be helpful, consistent with OECD requirements, to document industry standards for the class of licensed intangibles. For many taxpayers, this may be more documentation than they typically prepare at the time they enter into a license agreement.

The IRS position that only the IRS can make periodic adjustments to lump sum or long-term fixed license agreements could have a number of additional consequences. Clearly, taxpayers will need to consider the terms of their license agreements more carefully. Uninformed taxpayers that enter into lump sum or long-term fixed compensation agreements could find themselves in difficulty if they are unable to adjust the compensation to reflect the actual profit potential or cost savings achieved by the licensee. In these situations, the IRS position could be a trap for the unwary.

Finally, the IRS may have failed to fully consider that most license agreements are with related parties located in treaty countries and that most of those countries also have documentation requirements. If the IRS adopts this position, some taxpayers could be faced with an unappealing choice of which countries’ transfer pricing law to violate. As a practical matter, those taxpayers may have few alternatives that would keep them in compliance with both countries’ transfer pricing rules other than obtaining a bilateral advance pricing agreement. As a result, the IRS should consider whether the contemplated position will increase taxpayer compliance or force some taxpayers to adopt unrealistic positions in their U.S. or foreign country documentation.

Recent comments by the IRS suggest that the "to be proposed" cost sharing regulations will not be limited to pure cost sharing issues. Those regulations could substantially limit taxpayers’ ability to use the periodic adjustment rules to modify their license agreements. In that case, we would also hope that the IRS clarifies with additional language or examples that taxpayers are free to shift profit or cost savings risk in an intangible license agreement, as long as the risk shifting is consistent with economic substance. If the IRS limits taxpayers’ ability to use the periodic adjustment rules, many more taxpayers will likely be forced to enter into contingent royalty arrangements or licenses with a shorter term to avoid being caught with an uneconomic arrangement. However, for those taxpayers concerned that the periodic adjustment rules did not permit shifting profit or cost-savings risk that routinely occurs in arm’s length agreements, the "to be proposed" regulations will hopefully provide the additional guidance that will clarify that risk can be shifted as long as it is consistent with economic substance and the arm’s length standard.

Venezuela’s National Tax Administration Services (SENIAT) recently began transfer pricing audits of several multinational corporations, resulting in sanctions for those that failed to comply with transfer pricing documentation requirements. The audits, part of SENIAT’s "Zero Tax Evasion" policy, resulted in fines and suspension of operations for 48 hours for violators.

Transfer pricing provisions in Venezuela’s Income Tax Law (ITL) require taxpayers to submit an annual statement (Form PT-99) listing controlled transactions carried out with foreign related entities to document the arm’s length nature of foreign related-party operations under valuation methods specified in 2001´s Venezuelan Income Tax Law. The obligation to submit Form PT-99 was enacted in 2002 for fiscal years ending in 2001. In February 2005, SENIAT started reviewing taxpayers’ compliance with obligations for open years. Under a special audit program, the tax administration plans to visit 70 multinational corporations to request additional information on PT-99. Specifically, the tax authorities will verify compliance with formal duties and transfer pricing documentation for fiscal years 2001, 2002, and 2003. Enterprises must respond to the request within three to four days of receipt. In early March, five enterprises were sanctioned on the basis of transfer pricing and value added tax infractions. The companies forced to close were engaged in the food, pharmaceutical, and consumer products sectors.

Failure to provide the information requested within the stated period is considered a failure to comply with a formal obligation and is subject to penalties, as well as the possibility of closure. The penalties range from 10 to 50 Tax Units (UTs) (each UT is equal to approximately US $11.50), for a possible maximum of US $683. Penalties for inaccurate valuation or data inconsistencies range from 300 to 500 UTs, or a maximum of US $6837. SENIAT’s recent actions have focused on taxpayers designated by the Administration as "special." SENIAT categorizes some taxpayers as "special" when their gross income exceeds a specified amount. Special taxpayers are required to comply with different obligations aimed at keeping closer supervision over them.

So far, SENIAT has reviewed and penalized few enterprises; nonetheless, this development is certain to be a first step regarding transfer pricing audits.

SENIAT has also been involved in unprecedented activities whereby it has requested from enterprises in-depth information on technical assistance, trademarks, and intangibles contracts to ensure their accuracy. The tax authority is evaluating the substance of transactions involving the transfer of intangible property, specifically, technical assistance services, know-how, and royalty agreements. In this regard, SENIAT has requested information such as financial studies that justify the need for the technical services provided, and detailed explanations of activities and hours of service, studies showing the need for and impact of these services on the overall enterprise activity, and documents that support the services rendered.

In November 2004 a large oil services multinational was subject to an investigation encouraged by the National Securities Commission based on Item No. 8 (Related-Party Transactions) of their 1999 audited financial statements. This confirms that government agencies other than the tax administration, including the Banking System Regulatory office (SUDEBAN), the National Securities Commission (CNV), the Foreign Investment Regulatory office (SIEX), and the Currency Exchange Administration (CADIVI) have been actively monitoring transfer pricing Issues through currency requirements, contracts undersigning and other publicly available information.

Since its inception in October 1999, Venezuela’s transfer pricing legislation has been modified to conform more closely to the OECD Guidelines. SENIAT has created a special unit to "supervise, coordinate and analyze resolutions [in regards to transfer pricing]," implemented the Form PT-99 requirement, and started to request that taxpayers provide further information in connection with these informative statements. Specifically, the data sought is necessary to validate the information provided in Form PT-99, and to review possible inconsistencies between different appendices to the statement. SENIAT has also requested resubmission of appendices when the financial information had not been properly segmented between controlled and uncontrolled operations; details on cost structure, particularly in the case of service providers; and the appropriate selection of an arm’s length pricing method.

During 2004, two months after taking office, Venezuela’s National Tax Commissioner announced SENIAT’s "Zero Evasion Plan," an intensive audit program intended to "persuade taxpayers about the need to comply with fiscal obligations…" Given the high levels of tax evasion in the country, the tax administration has clearly adopted a more aggressive posture toward infractions. In the commissioner’s words, "We are going to initiate proceedings against any taxpayer evading taxes." Also as part of this initiative, the administration plans to share information with tax administrations and other official organizations abroad in order to audit, among others, individual’s foreign bank accounts and imports and exports declared.

Denmark’s minister of taxation on March 2, 2005, introduced legislation that would tighten Danish transfer pricing rules. Bill No. 120 was introduced because an earlier bill -- Bill No. 140 of December 8, 2004 – had been repealed because of the general election on February 8, 2005. The new bill would exempt controlled transactions that are deemed insignificant (based on volume and frequency) from the documentation requirement. Moreover, taxpayers would not be obligated to justify the pricing of controlled transactions on the basis of database searches unless specifically required by the tax authorities. Finallly, shipping companies that elect to be subject to tonnage taxation would be exempt from tax return information requirement and documentation requirement for cross-border transactions. Once finalized, the new rules will apply to fiscal years beginning on 1 January 2005 and thereafter.

The bill contains the following elements, discussed below.

Intercompany transactions between Danish resident companies would be covered by the transfer pricing documentation requirement and the tax return information requirement. The reasoning behind this expansion of the transfer pricing legislation is the minister’s belief that the current rules may be in conflict with the nondiscrimination ban contained in the EU treaty, because the current transfer pricing rules apply only to cross-border transactions.

Small and medium-sized enterprises (SMEs) will be relieved from the obligation to prepare transfer pricing documentation. However, the exemption does not apply to intercompany transactions with companies and permanent establishments in states outside the European Union and the European Economic Area that have not concluded a tax treaty with Denmark.

An SME is defined as a company that: 1) has less than an average of 250 full-time employees during the year, and 2) total assets of less than DKK 125 million (USD 22 million) or net sales of less than DKK 250 million (USD 44 million). The test should be applied on the basis of the companies’ financial statements. The test must be made on a consolidated basis including all Danish and foreign parent companies, subsidiaries and sister companies. This applies to both Danish and foreign multinationals. Intercompany transactions and intercompany loans and debt between the affiliated companies should be elimintated. SMEs will still be required to comply with the transfer pricing tax return information requirement. If a company is eligible for SME status, it should check a box to that effect in the annual tax return information requirement form.

The tax authorities may impose penalties on companies for not preparing their transfer pricing documentation and for filing incorrect information regarding eligibility for SME status. The minimum penalty would amount to twice the cost saved by not preparing the documentation. If proper documentation is prepared subsequently, the minimum penalty would be reduced by half to an amount equal to the cost saved. Thus, taxpayers would get a second chance to improve their documentation if the tax authorities deem it insuffcient. In addition, if the outcome of the audit is a transfer pricing adjustment, the penalty will be increased by an amount equal to 10 percent of the adjustment.

The quality of a taxpayer’s transfer pricing documentation should meet the standards set by the Danish transfer pricing regulations issued by the Central Customs and Tax Administration in December 2002. Under the regulations, transfer pricing documentation should include the following:

• A description of the company;
• A description of the controlled transactions;
• A functions and risk analysis;
• A description of economic issues;
• A comparability analysis;
• The transfer pricing method selected; and
• Any relevant written agreements.

Taxpayers will be under an obligation to prepare a database search for comparable uncontrolled transactions only if specifically required by the tax authorities. If the tax authorities request a database search, the taxpayer should be given a deadline of at least 60 days to comply with the request. Moreover, the taxpayer is not required to prepare documentation for controlled transactions that are considered de minimis, based on volume and frequency. If the documentation is incomplete, the Danish tax authorities are entitled to estimate the tax due.

Danish taxpayers are entitled to receive a refund from the government for costs incurred for professional advice during an appeal of a tax case. The refund will no longer be available for costs incurred to prepare transfer pricing documentation during an appeal.

Tonnage Taxation

Shipping companies that elect to be subject to tonnage taxation will be exempt from the tax return information requirement and from documentation requirements for cross-border transactions.

Ecuador enacted tax reform measures on December 31, 2004, including an amendment to the Regulation for Application of the Tax Law that introduced standards to regulate transfer pricing. The new measures are effective January 1, 2005.

In 1999 the country adopted article 91 of the Tax Code, which allowed the Ecuadorian Internal Revenue Service (SRI) to establish standards to regulate transfer pricing of goods and services for tax purposes. Regulations enacted under this article were of limited application, because the tax administration was allowed to make adjustments to transactions only in specific cases: when sales were conducted at or below cost, or imports and exports were above international market prices.

The main purposes behind the reform are to ensure the fair and equitable collection of tax revenues, to establish clear transfer pricing rules, and to establish the correct determination of income tax, eliminating various mechanisms used in international tax law to transfer benefits covertly by manipulating prices.

Under the new rules, Ecuadorian resident taxpayers must apply the transfer pricing rules to transactions with related parties. The term "related party" is defined to include entities, whether or not domiciled in Ecuador, when one entity participates, either directly or indirectly, in the management, administration, control, or capital of the other; or a third party, either an individual or legal entity, whether or not domiciled in Ecuador, that participates either directly or indirectly in the management, administration, control, or capital of the related parties.

Taxpayers also are deemed related parties when undertaking transactions with entities located in low-tax jurisdictions or tax havens.

The tax administration is expected to issue a general resolution on tax havens for purposes of applying transfer pricing standards. The resolution is expected to be based on the OECD Guidelines and Ecuador’s Financial Action Task Force.

The tax administration also may determine whether two entities are related parties by presumption when transactions between the two parties do not adhere to the arm’s length standard.

To establish a relationship or connection, the tax administration will base its decision on the following factors:

• Stockholdings;
• Effective management of the business;
• Distribution of earnings;
• Proportion of transactions; and
• Mechanisms to establish prices.

Ecuador’s new rules permit the following six transfer pricing methods to determine transfer prices in transactions between related parties:

• Comparable uncontrolled price;
• Resale price;
• Cost plus;
• Profit split;
• Residual profits split; and
• Transactional net margin method

No method prevails over another. Taxpayers must apply the method or methods that best reflects application of the arm’s length principle. This is a very important feature of the rules, because taxpayers are entitled to apply any of the indicated methods, without being obligated to demonstrate the impossibility of applying the other methods.

The regulation expressly provides that the OECD Transfer Pricing Guidelines will be used as a technical reference for those aspects not covered by the Ecuadorian legislation on transfer pricing.

Taxpayers subject to the transfer pricing regime must submit an appendix to their income tax return listing all transactions with related parties conducted during the tax year. In addition, taxpayers must file in October of the following tax year an "integral transfer pricing report." The appendix and report must be prepared using a form and content to be established by the SRI in a forthcoming General Resolution, expected to be issued momentarily.

The appendix summarizes transactions performed with related parties. The report, on the other hand, substantiates:

• That transactions with related parties have been performed applying the arm’s length standard;
• The adjustments made by taxpayers, if any, to calculate their income tax liability; and
• The methodology used.

The tax administration is considering the possibility of establishing minimum reporting requirements to determine whether an entity is obligated to submit transfer pricing reports, to avoid the need for taxpayers involved in de minimis transactions to provide appendices and a transfer pricing report. The SRI would then be able to focus on taxpayers that engage in significant transactions with related parties.

Operations are comparable when no differences exist between the relevant economic characteristics of the operations that significantly affect the price or value of the payment or the profit margin. Any existing differences may be eliminated through technical adjustments.

To determine whether operations are comparable or whether significant differences exist, the following operational elements will be considered, depending on the application of the arm’s length principle:

• Characteristics of the goods or services, such as:
• Physical characteristics of the goods -- qualities and reliability, as well as availability and volume;
• Nature of the service, whether it involves experience and technical knowledge;
• Type of license concession or sale; type of asset (for instance, patent, brand, or know-how). Duration and level of protection and anticipated benefits to be derived from use of the asset;
• Updated book capital of the entity issuing shares, the equity, current value of earnings or forecast cash flows or the stock market price recorded at the last transaction completed with these shares; and
• Principal value, period, guarantees, debtor’s solvency, interest rate and economic essence of the financing operation, rather than the form.
• Analysis of the function or activities performed, assets used, and risks assumed;
• Contractual terms;
• Economic or market circumstances, such as geographic location, market size, market level, retail or wholesale, level of competition within the market, competitive position of purchasers and vendors, availability of substitute goods and services, offer and demand levels in the market, consumers’ purchasing power, governmental regulations, production costs, transportation costs, and date and time of operation; and
• Business strategies, including penetration, permanence, and market extension.

The current legislation does not address several major tax issues. For instance, the legislation does not provide a mechanism for advance pricing agreements.

Moreover, the transfer pricing rules do not deal with certain legal and tax dispositions that govern revenues or expenses for tax purposes. For example:

• Interest on foreign loans duly registered with the Central Bank of Ecuador (BCE) and not exceeding maximum interest rates established by the Bank at the loan registry date is a deductible expense. The effect of transfer pricing standards on determining interest rates at market prices has yet to be defined. We believe the BCE should take this standard into account when establishing referential interest rates for tax purposes.
• For tax purposes, companies engaged in hydrocarbon exploration and exploitation activities under a participation contract must establish their income for the sale of hydrocarbons at the actual sale price. Under no circumstances may such price be less than the referential price. The referential price is the average weighted price of prior month external sales of crude petroleum, as performed by PETROECUADOR. So, while these companies have been paying taxes based on their income at market price, current transfer pricing standards do not mention whether these companies must comply with current standards governing transfer pricing.

The Canada Revenue Agency (CRA) on March 18 issued a Special Release to IC94-4R to introduce small business taxpayer advance pricing agreements (APAs). The special release provides procedures for small business taxpayers to improve access to the APA program.

The Canadian APA Program was introduced in July 1993, and has been perceived as essentially geared to large multinational corporations. The need to make the program accessible to a broader taxpayer group while reducing onerous requirements for smaller taxpayers led to the special release.

Canadian tax authorities have been seen as one of the more aggressive administrations in terms of audit coverage and compliance. Taxpayers are seeing an increase in audit activity, the issuance of transfer pricing documentation request letters, and the levying of penalties, regardless of the size or complexity of the organization. This aggressive enforcement environment will be a factor on the strategic decision making of small taxpayers in assessing whether this initiative is appropriate for seeking transfer pricing certainty.

The key elements of the Small Business APA Program can be summarized as follows:

• The CRA’s Competent Authority Services Division (CASD) will administer the program;
• The program will have a fixed nonrefundable administrative fee of $5,000;
• The Canadian entity must have gross revenues of less than C $50 million or a proposed covered transaction of less than C $10 million to be considered for the program;
• The program will cover only transactions of tangible goods (that have not been bundled with nonroutine intangibles) and routine services;
• Site visits will not be performed. Taxpayers need only submit a functional analysis (rather than a functional and an economic analysis, as would be required under the traditional APA program);
• Only requests for a unilateral APA, without rollback, will be accepted into the program; and
• Annual reporting under the program will be limited to stating, in writing, whether the critical assumptions have or have not been breached. Conversely, under the traditional APA program, taxpayers must file an annual report describing compliance with the terms of the APA.

On the surface, this new initiative appears to provide welcome relief to smaller taxpayers seeking to comply with domestic transfer pricing requirements. No doubt for a sector of small taxpayers, the initiative will provide some advantages. The following are examples of when the Small Business APA Program has some appeal:

• Taxpayers with relatively straightforward transactions and a history of compliance might consider this route to reduce overall compliance costs;
• Canadian subsidiaries of parent companies resident in nontreaty countries;
• Canadian NSULC subsidiaries of U.S. companies;
• Canadian subsidiaries of foreign companies that have large NOLs in foreign jurisdictions that might expire; and
• Taxpayers that intend to do a documentation study but want to avoid the cost of updates.

The attractiveness and cost-effectiveness of the program must be balanced by a consideration of some interesting risk management and business management concerns. Time will tell if the perceived benefits of the Program are sufficient to attract small taxpayers in light of the initiative’s potential drawbacks and limitations. The lack of rollback and the unilateral nature of the process may well outweigh the short-term benefits of a small business APA, particularly in light of the newly introduced Canadian accelerated competent authority procedure (ACAP) recently announced in IC 71-17R5. Also, enticing taxpayers into the program by limiting the necessary submissions to "functional analysis"-type information may create a false sense of compliance for uninformed taxpayers.

Clearly, taxpayers are always best served by advocating their position and supporting it with their own economic analysis. Nothing prevents taxpayers from doing this, and in general, taxpayers should be very cautious about allowing the CRA to perform the economic analysis and dictate a result. Taxpayers should almost always perform their own economic analysis; otherwise, they may then lack the ability to effectively negotiate or influence the results or findings of the CRA. Furthermore, in the context of bilateral transfer pricing compliance, taxpayers must satisfy documentation rules for multiple countries in any event. The reality is that a Canadian taxpayer is normally ill advised to think only in terms of a one-sided Canadian solution, especially when the CRA’s conclusion may be seen as aggressive by other taxing authorities.

No doubt the simplicity of the small business APA program has an unquestionable allure for some taxpayers, and we would highly recommend it for that sector of the taxpayer community that has the right profile to benefit from it the most. But following this path could turn into a costly endeavor if taxpayers are not aware of the pitfalls and risks. Thus taxpayers or potential buyers of the small taxpayer APA are encouraged to seek guidance in assessing all the appropriate options for managing their transfer pricing compliance.

Colombia’s tax authorities recently issued the country’s first transfer pricing rules, effective January 1, 2005. Decree 4349 of 2004 details specific transfer pricing requirements, including an annual informative return and supporting documentation, and describes the new advance pricing agreement program.

Taxpayers Subject to Transfer Pricing Regime

Taxpayers engaged in transactions with foreign related parties or with companies located in tax havens and who exceed the following thresholds (for 2004) are subject to the transfer pricing regime:

Taxpayers subject to the regime are not required to prepare supporting documentation for transactions during tax year 2004 that do not exceed the following amount:

Transactional Transfer Pricing Regime

Colombia’s transfer pricing regime requires an operational analysis, which implies that the taxpayer’s transactions with foreign related parties must be analyzed jointly only when there are no significant differences regarding activities performed, assets used, and risks assumed by the taxpayer.

Considering the foregoing, it is necessary to determine the amount accumulated during the tax year, of the following types of operations:

Likewise, there is a requirement to present the movement and balance of the following asset and liability accounts, which flows are contained in the operation types mentioned in the preceding table.

The informative return designed by the tax authorities must be filed annually by taxpayers subject to the transfer pricing regime, and must include the following information regarding the taxpayer’s transactions with its foreign related parties:

• Information necessary for the identification and location of taxpayer;
• Information necessary for the identification of related parties abroad, and/or individuals or entities domiciled or resident in tax havens with whom the taxpayer engaged in transactions;
• Information on the methodology used and other factors necessary to determine prices or profit margins;
• Information necessary to determine the assumptions of economic relationship;
• Assessment of penalties whenever applicable; and
• Signature of the person who is complying with the formal duty to declare.

The information requirements of the supporting documentation are divided into general and specific information.

Regarding the specific information requested regarding the taxpayer subject to the transfer pricing obligation, the decree establishes the following:

• Description of each type of operation carried out in the taxable period subject of the study.
• Parts involved in the operation, object, term and value of contracts, agreements, or covenants entered into between the taxpayer and related parties domiciled or resident abroad and/or in tax havens.
• Functional analysis by type of operation, detailing the functions carried out by the parties, classification of assets used, and risks inherent to the type of operation.
• General information on commercial strategies.
• Information of the industry, sector or economic activity where each type of taxpayer’s operations is carried out, and description of substitute goods or services.
• Political changes, modifications to regulations, or other institutional factors that affect the types of operation.
• Method used to determine the prices, amounts of consideration, or profit margins, indicating the criterion and objective elements considered to conclude that the method used is the most appropriate.
• Selection of the profitability indicator in accordance with the type of activity and other facts and circumstances (gross margin, operating margin, margin over costs and expenses, return on assets, return on equity and Berry Ratio, among others).
• Document whereby, based on the functional analysis, the taxpayer and his operations are compared to comparable companies or operations.
• Description of technical, economic, or accounting adjustments made to the types of comparable operations or companies selected.
• Detailed conclusions on the conformity or inconformity of the prices, consideration or profit margin amounts, of the types of operations, with the rules that regulate the transfer pricing regime.

In addition to the foregoing, the decree requires attachment of the financial statements as of December 31 of the year under analysis, both of a general purpose², and of special purpose³; copy of all the contracts, agreements, or covenants entered into between the company subject to the transfer pricing regulations and the related parties with whom it carried out operations during the period; and the remaining agreements in effect during the periods related to the transfer of shares, capital increases or reductions, reacquisition of shares, merger, spin off and other corporate changes, during the year subject to the transfer pricing regime.

Dates of Compliance: Informative Return and Supporting Documentation

Decree 4345 of 2004 establishes the deadlines for filing the informative return and the supporting documentation of taxpayers subject to the transfer pricing regime.

The law provides that the informative return must be delivered to the tax authority at the times provided in the following table, in accordance with the last digit of the tax identification number (TIN) in effect in Colombia:

However, the supporting documentation must be prepared and made available to the tax authorities at the latest on June 30 of the year immediately following the tax period subject to the transfer pricing regime. If the tax authorities require the supporting documentation, the latter must be delivered within a 15 days following the notice of the request.

Once the supporting documentation has been prepared, it must be kept for a period of at least five years, counting from January 1 of the year following the taxable period referred to in the mentioned supporting documentation.

Decree 4349 states that an APA is an agreement "…entered into between the National Tax and Customs Direction and the taxpayer who requests it, whereby it is determined, for income and complementary tax purposes, a set of criteria and a methodology for fixing prices, amounts of consideration, or profit margins applicable during certain tax periods to the operations carried out with related parties abroad."

Requests for APAs must be made within the first three months of the taxable year to the National Tax and Customs Direction (DIAN). The APA application must include identification of the requesting taxpayer, obligations of the parties involved, assumptions, description and currency of the operations, methodology, taxable periods in effect, loopholes, and causes for termination. These requirements are described in detail in Regulatory Decree 4349 of 2004.

Upon receipt of the APA application, the DIAN has nine months to decide whether to accept or reject the same. If the application is accepted, the APA will be in effect during the taxable period in which it is applied for, and up to three following taxable periods.

It is important to emphasize that should there be any significant variations in the assumptions considered at the time the APA is signed, the same may be modified at the initiative of the taxpayer or the DIAN.

APAs may be executed only as of the 2006 tax period.

Footnotes

^{1 Minimum monthly legal wage in effect.}

2 Balance sheet, income statement, statement of changes in the equity, statement of changes in the financial condition and cash flow statement.

3 Balance sheet, income statement, product cost statement, cost of sale statement for goods and services, segmented by type of operation and adjusted for inflation if necessary

Taiwan’s Ministry of Finance (MOF) officially promulgated its Transfer Pricing Assessment Guidelines on December 28, 2004. Although the guidelines became effective on the same day, the MOF believes the transfer pricing investigation may apply to any of the taxpayer’s open tax years. More important, the provisions regarding transfer pricing documentation and penalties entered into effect as of January 1, 2005. However, the transfer pricing return with respect to 2004 transactions must be filed by May 31, 2005.

The official guidelines retain many elements of the MOF’s October 8 draft guidelines. Nevertheless, the official guidelines expand the recognition and definition of related parties, introduce less-stringent guidance in applying the arm’s length principle, and modify documentation requirements. The amended final rules and significant changes are discussed below.

Recognition of Related Parties

Control Over the Board of Directors -- The majority (50 percent or more) directors of a profit-seeking enterprise are appointed by another profit-seeking enterprise and its 50 percent subsidiary. (Article 3, subparagraph 5 of paragraph 1)

20 Percent Common Ownership -- 20 percent or more of the total number of issued shares or capital stock of two or more profit-seeking enterprises is controlled directly or indirectly by the same individual. (Article 3, subparagraph 2 of paragraph 1)

10 Percent Major Shareholder -- Any profit-seeking enterprise that holds the highest percentage of the total number of issued shares or capital stock of another profit-seeking enterprise, if the percentage of ownership is 10 percent or more. (Article 3, subparagraph 3 of paragraph 1)

Branch Offices -- The foreign headquarters and its Taiwan branches, or Taiwan branches of the foreign headquarters and its foreign branches, and the Taiwan headquarters or branches and its foreign branches. (Article 3, subparagraph 7 of paragraph 1)

Control Over Personnel, Finance, or Operations -- When the amount of loan or guarantee of a nonfinancial profit-seeking enterprise to another profit-seeking enterprise is more than one third of the total assets of another profit-seeking enterprise. (Article 3, item 2 of subparagraph 8 of paragraph 1)

Definition of Related Parties

Common Chairman, President, or CEO -- The directors, supervisors, president, or any individual that holds an equivalent or higher position, vice-president, senior manager, and other departmental managers directly managed by the president of a profit-seeking enterprise. (Article 4, subparagraph 2 of paragraph 2)

Relatives of Chairman, President, or CEO -- The brothers, sisters, lineal descendants, and relatives of the chairman, president, or any individual that holds an equivalent or a higher position of a profit-seeking enterprise. (Article 4, subparagraph 4 of paragraph 2)

Guidance for Applying Arm’s Length Principles

• When examining the results of the taxpayer’s related party transactions, the tax office must use the same and consistent years of data that the taxpayer has used for its economic analysis. (Article 7, item 3 of subparagraph 4 of paragraph 1)
• Taxpayers may now use the reliable internal CUP to avoid from using profit-based methods to go through an entire economic analysis. (Article 7, item 4 of subparagraph 5 of paragraph 1)
• The results of a controlled transaction shall be compared with the data of uncontrolled transactions that occurred in the taxable year under review. However, if one of the following situations occurs, the results of a controlled transaction compared with the data of uncontrolled transactions from the taxable year under review or more consecutive years before may be used instead:

1. The industry of the profit-seeking enterprise is influenced by business cycles;
2. The tangible, intangible properties and services are influenced by the product’s life cycles;
3. Profit-seeking enterprises adopt market penetration strategy;
4. Profit-seeking enterprises adopt profit-based methods to determine arm’s length price; and
5. Other situations stipulated by the MOF. (Article 7, item 1 of subparagraph 4 of paragraph 1)

If the amount of a taxpayer’s related party transaction is below the threshold amount to be set by the MOF, a taxpayer’s transfer pricing documentation requirements may be waived and instead taxpayers may use other documents to support its transfer pricing methodology. (Article 22, paragraph 3)

This provision refers to the OECD Transfer Pricing Guidelines and adopts the concepts of the "Safe Harbors" rules. (Chapter 4, paragraph 4.94 to paragraph 4.100) The reasoning behind this modification is to relieve small to mid-sized companies from the obligation to prepare transfer pricing documentation due to the high cost associated with preparing transfer pricing documentation. The amount of threshold is yet to be set by the MOF. However, exempted taxpayers will still be required to comply with the transfer pricing tax return information requirement.

According to the Guidelines, contemporaneous documentation requirement will be effective as of January 1, 2005. Although documentation should be submitted to the tax authority within one month of their request, companies may have to state if they have had documentation ready when filing their annual corporate income tax returns. Thus, companies will therefore be expected to have prepared documentation before they file their 2005 corporate income tax returns in May 2006 for the companies adopting calendar year.

Taxpayers must file a four-page long "related-party transactions" disclosure form when they file their corporate income tax returns for 2004. Detailed information must be provided on this form regarding transactions with related parties that involve the transfer of tangible and intangible property, the provision of services, and financing arrangements. Detailed information includes the names of related parties, tax identification number, nationality, business scope, shareholding percentage, relationship to the taxpayer, the amount of the controlled transaction, and the percentage of the revenue or purchase that the controlled transaction represents to the entity’s total revenue or purchases. If an enterprise has adopted a particular transfer pricing methodology, the methodology must be specified as well.

Companies that meet the advance pricing agreement (APA) application criteria set out in the guidelines may consider applying for an APA to minimize their transfer pricing risk exposure in Taiwan.

The criteria for taxpayers applying for an APA are as follows:

• The aggregate amount of the controlled transactions over the prospective period of the APA must be at least NT $1 billion (thus, if the APA is for a three-year period, the aggregate amount of the controlled transactions for the three-year period must be at least NT $1 billion, or approximately US $30 million); or
• The amount of annual controlled transactions must be NT $500 million or more (about US $15 million); and
• The applicant may not have any prior incidence of tax evasion for the previous three years, and must have prepared transfer pricing documentation.

The general procedures for an APA are as follows:

1. Taxpayer files an application for an APA;
2. The tax authorities notify the taxpayer within a month whether the application is accepted;
3. Taxpayer submits the required documents within a month after receiving the written notice of acceptance from the tax office;
4. The tax authorities review the documents and provide their conclusions within one year; and
5. The tax authorities and the taxpayer execute the APA within six months after the conclusion was provided.

The MOF currently would not agree to rollback of APA to prior open years.

For companies that have not yet begun to analyze their Taiwan transfer pricing issues, we recommend that they review their current intercompany transactions with related parties and begin the benchmarking analysis immediately, so that their transfer pricing risks can be assessed. Based on the benchmark analysis conducted, companies should adjust their intercompany transactions accordingly to fall within the arm’s length range for year 2005.

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This article is intended as a general guide only, and the application of its contents to specific situations will depend on the particular circumstances involved. Accordingly, we recommend that readers seek appropriate professional advice regarding any particular problems that they encounter. This bulletin should not be relied on as a substitute for such advice. While all reasonable attempts have been made to ensure that the information contained in this bulletin is accurate, Deloitte Touche Tohmatsu accepts no responsibility for any errors or omissions it may contain, whether caused by negligence or otherwise, or for any losses, however caused, sustained by any person that relies on it.

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