BUSINESS OPINION

Russian Transfer Pricing Rules: On the Verge of Change

By Ruslan Vasutin and Yekaterina Kosheleva

Transfer pricing rules were first introduced in Russia in 1999 and since then the “arm’s length” concept has remained relatively immature. The weakness of the legal framework played a great role in the notorious Yukos tax case where the tax authorities were forced to apply and further develop a “bad faith taxpayer” concept to penalize the company for tax evasions instead of adjusting the intra-group resale prices used.

During the last couple of years all attempts to amend the transfer pricing rules were severely criticized and “died” at first or second readings in the State Duma. There came an understanding that Russian transfer pricing rules required fundamental changes for the development of a more effective legal framework. Things turned serious, and now it seems that after roughly a year of discussions, a new chapter of the Tax Code specifying transfer pricing rules will be introduced to the State Duma this spring.

The prospective legislative developments drastically change the previous guidelines and bring them more in line with OECD standards. The draft law introduces three new transfer pricing methods – the method of secondary product, transactional net margin method (TNMM), profit split method (PSM) – that shall be applied along with currently existing CUP, subsequent sales method and cost plus method. The priority of methods would be changed as well – CUP would be the preferable method, PSM has the lowest priority and all other methods shall be applied under the best method rule.

Moreover, the new rules provide a detailed description of methods that would permit the elimination of certain loopholes in current legislation. For instance, the draft law finally defines the notions of “regular costs” and “regular profit” required for application of methods.

The main idea behind the innovations is to prevent shifting income between a chain of companies inside and outside Russia. The aim is to allow the tax authorities to specifically focus on transactions involving “low-tax” or “tax haven” offshore jurisdictions which would be subject to specific transfer pricing control.

Another revolutionary development relates to the definition of ‘related parties transactions’. The Tax Code currently envisages very narrow criteria stipulating that for tax purposes only parties with more than 20 percent direct or indirect capital participation shall be deemed related. And although the court may prove the dependence on other grounds, the need for more advanced regulations is obvious.

The new rules take a significant step toward preventing tax evasion schemes, extending the scope of controlled transactions to transactions between affiliated parties, “sister companies” (providing the parent owns over 20 percent in each company) and entities belonging to “50 percent chains.” On the other hand, transactions with over 20 percent price fluctuations during a “limited” period of time would not be a subject to control. The latter is definitely a progressive development as currently bona-fide taxpayers providing services or selling goods to clients at a discount are often likely to be involved in disputes with the tax authorities.

It is thought that under the new rules the tax authorities will be entitled to adjust the price only if it falls outside the 25 percent-75 percent band of the arm’s length prices corresponding to the tested transaction. In comparison to deviation from a single arm’s length price (as envisaged by the current rules) such an approach is certainly more appropriate but with the downside that it would require special legal regulations to prevent so-called “range-fittings” techniques. At the same time, the new draft law does not solve the fundamental problem of Russian transfer pricing rules which is that all taxes can be adjusted including not only corporate profits tax, but VAT as well, if the initial price is revised by the authorities.

Notably, to define the arm’s length price, the new rules would permit the use of appraisal valuations and information obtained from state statistical institutions, customs authorities and some other sources. The notion of “official sources of information” would be eliminated from the law.

As a revolutionary change, the draft law envisages the introduction of transfer pricing documentation requirements. Taxpayers whose controlled transactions with the same legal entity exceed one million rubles ($38,500) per year, would be required to submit to the tax authorities new documents describing the nature of the transaction(s), functions and risks of the entities involved, applied transfer pricing method and marketing strategy. Obviously, the new rules on documentation would significantly increase the administrative tax burden for taxpayers and would be beneficial to the tax authorities as the latter would be able to maintain a powerful internal informational source to track controlled transactions.

Starting in 2010, the tax authorities plan to go ahead and provide the taxpayers with the opportunity to conclude advance pricing agreements (APA) permitting the reconciliation of the price, between the tax authorities and the taxpayer and/ or transfer pricing method applied by the latter in controlled transactions. The draft law envisages significant 1.5 million ruble fines for violating APA terms; it would cost the same for the taxpayer to file an APA application.

Certainly until the final bill is eventually submitted to the Duma it is hard to expect the authorities to fundamentally change the rules, but nevertheless, in the light of prospective changes, taxpayers should expect the increase of transfer pricing risks in the future. To sustain transfer pricing positions it is recommended that taxpayers take some precautionary actions in advance.

One of the most effective measures to mitigate future tax risks already taken by retail groups in particular is the obtaining of defense transfer pricing reports including approval of the market price applied by the taxpayer. And although there are no current transfer pricing documentation requirements in Russia, the Supreme Arbitrational Court has confirmed that the courts must accept and consider the documents submitted by the taxpayer to support its tax position, which significantly increases the taxpayer’s chances of winning the case.

Under the new rules, transfer pricing risk management would be especially relevant for multinational enterprises (MNEs) which, with the large volumes of intra-group transactions are the tax authorities’ real tidbit for the tax authorities. And while in the current legislative framework the latter could only dream of “the Russian Glaxo SmithKlineare case” as soon as the rules are improved, the MNEs would be the first to try them on. And, as it could be anticipated those companies going through the process of reorganization or holding restructuring shall become the authorities’ primary targets and bear most of the significant risks related to transfer pricing .

Ruslan Vasutin is a partner and Yekaterina Kosheleva an associate at DLA Piper in St. Petersburg.

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