The longest-awaited Russian tax law in recent years – the law on transfer pricing – has been adopted by the lower house of the Russian parliament, the Russian State Duma, in its third (and final) reading on 8 July 2011 and approved by the Federation Council on 13 July 2011. The law has now been submitted to the Russian President for signing and official publication.
Provided that all the official legal procedures are completed in the near future (and no objections are raised by the President – objections are very rarely raised), the law on transfer pricing will come into force from 1 January 2012. The necessary adaptation of transfer pricing policies and preparation of the required documentation which will ensue from this is certain to require substantial efforts from groups of companies operating in Russia, within a short period of time.
The federal law in question is entitled "On amending certain legislative acts of the Russian Federation in connection with the perfection of principles of price definition for tax purposes" (the "Law"). In the first place, it amends the Russian Tax Code by supplementing it with a new section devoted to related parties, pricing principles, tax control over transactions between related parties and advance pricing agreements.
Given that the current Russian transfer pricing rules (in force since 1999) are almost inoperable because of their vague wording, and there is poor court practice on this matter and a lack of knowledge from the Russian tax authorities, the Law constitutes an impressive step forward by Russian tax legislation.
What are the main provisions of the Law?
The Law itself is relatively complex and covers a wide range of issues. Below, we summarise its main concepts and notions which are, in our view, essential to know.
Notion of controlled transactions
According to the Law, both domestic and cross-border transactions may be subject to transfer pricing control, as follows.
Please kindly note that some exclusions are provided by the Law for certain types of parties. For instance, transactions between the members of a consolidated group of taxpayers are currently excluded from the list of controlled transactions. However, this assumes the adoption of a special regime for a consolidated group of taxpayers (which is currently in the form of a draft federal law adopted in its first reading on 22 October 2010).
There will also be an exclusion for domestic transactions which occur between two parties registered in the same region, which do not have separate subdivisions in other regions of the Russian Federation, don't pay taxes to the budgets of such other Russian regions and don't have losses which are taken into account for the purposes of corporate profits tax calculation, provided that the conditions set out in the table above (to which minimum turnover amounts of RUB 60 mln. and 100 mln. are not applicable) do not apply.
If a transaction to be entered into by the parties falls under the definition of a controlled transaction, the parties are obliged to perform a benchmark analysis (i.e. find transactions concluded in comparable economic conditions, with similar contractual terms (quantity of supplied goods, payment conditions, terms of execution etc.), functions and risks) to determine the relevant market price range before concluding the contract.
According to the Law, the market range of prices (profitability range) should be defined using a statistical approach, which is in the spirit of the interquartile methodology provided for by the OECD guidelines. This profitability range replaces the currently allowed 20% fluctuation from the market price, and is expected to narrow the 20% threshold.
Notion of related parties
The Law introduces a relatively extensive list of related parties, generally defined as "parties, the peculiarities of relations between which may influence conditions and (or) results of transactions entered into by such parties, and (or) economic results of their activities or the activities of persons they represent". The term "influence" includes, in this respect, the ability to influence through the participation of one party in the charter capital of the other party, or by virtue of an agreement concluded between such persons, or any other circumstance.
More particularly, the list of related parties stipulated by the Law includes:
- Two companies, where one holds directly or indirectly more than 25% of the charter capital of the other;
- A company and an individual, holding directly or indirectly more than 25% of its charter capital;
- Two companies with the same mother company with more than a 25% shareholding (direct or indirect) in the charter capitals of such subsidiaries;
- A company and its CEO or director, or companies with the same CEO;
- Chains of individuals/companies successively with more than 50% participation in the capital of the subsidiary, etc.
The Law also stipulates that the parties to a transaction may consider themselves as related on the basis of other grounds not fixed expressly by the Law. The courts may also qualify parties as related if their specific relations may influence the transactions entered into between them.
Transfer pricing methods
The Law preserves the three existing Russian transfer pricing methods (comparable uncontrolled price (CUP), resale minus and cost plus) and introduces two additional methodologies (comparable profitability and profit split). Among these five methods, the CUP will have top priority, and the profit split method will be used as a method of last resort. The best approach method will apply for the three remaining transfer pricing methodologies.
- The comparable uncontrolled price method requires information on at least 1 transaction which satisfies the comparability criteria between non-related parties, provided that the seller in the transaction does not have a dominant market position;
- The resale minus method is used to determine the compliance of the prices of products purchased from the related party and then resold to a third party and compares the reseller's profitability with the profitability range in similar uncontrolled transactions. Therefore, it may be applied to distribution schemes, when a product is acquired by a purchaser from a related party and resold to a third (non-related) party (and vice versa);
The cost plus method compares the producer's profitability in relation to costs and the cost profitability range in similar transactions. According to the Draft, this method should be applied particularly to the following transactions:
- performing work or rendering services to related parties using immaterial assets which substantially influences the level of profitability;
- monetary funds management services;
- sale of raw materials or semi-finished products; or
- long-term work/services purchase agreements with related parties;
- The comparable profitability method should be applied if the available accounting data does not permit a determination of the profitability range under other transfer pricing methods.
According to this method, the profitability of the party which performs fewer functions, bears fewer commercial risks and does not own intangible assets which may substantially influence the level of profitability, is compared with the market profitability range.
Please note that different profit level indicators should be applied under this method depending on the transaction type;
- The profit split method is generally applicable in cases where there are close relationships between the parties (e.g. joint IP rights), or if other pricing methods are not applicable. Two variations of this method (consolidated profit split and residual profit split) exist. In practice, the profit split calculation is performed on the basis of the respective contribution of each party according to the following criteria: the respective amount of costs born on immaterial assets, the number of staff provided, the value of assets directly used and other relevant parameters influencing the level of profit generation.
- Please note that an independent valuation report may be used if the four methods discussed are not relevant and cannot determine the required information. Moreover, there are no obstacles to the use of other methods not stipulated by the Law.
Sources of information
The Law permits the use of a wide range of sources of information to define market prices, including data from foreign sources, as follows:
- information on prices and quotations from world trade exchanges for goods traded on such exchanges;
- customs statistics published by the Federal customs service;
- information on prices and quotations of any authorities, official sources of information of foreign states, international organisations and other published public sources and information systems;
- data from specialised agencies;
- information on the transactions of the taxpayer;
- data from accounting and statistics reporting of Russian companies (or foreign companies, if no information on Russian companies is available);
- information on market prices received as a result of independent evaluation; and
- other information which may be used to define the profitability range according to transfer pricing methods.
Advance Pricing Agreements (APA)
The Law provides for the largest taxpayers (Russian companies), from 1 January 2012, to conclude APAs with the tax authorities which fix the procedure of price determination and pricing in controlled transactions and constitute a guarantee against the challenges of pricing policies and tax assessments. The APAs will be concluded for a 3-year period with possible extension for 2 more years and will enter into force from 1 January of the calendar year following the year of the relevant APA. Therefore, the first APAs will come into force from 1 January 2013.
Documentation and reporting requirements
Currently, there are no particular documentation requirements in Russian tax legislation. The Law increases the administrative burden on taxpayers and establishes a range of reporting and documentation obligations.
The Law introduces a general duty for taxpayers to prepare and submit documentation justifying the price applied in all controlled transactions.
At the same time, companies will have to notify their ordinary tax inspectorates annually of all controlled transactions between the same related parties concluded during the previous calendar year if the total amount (income or expenses) of these transactions exceeds RUB 100 mln4. Such notifications will contain rather general information on the subject-matter of the transactions, the parties involved, as well as the amount of profits received and expenses incurred as a result of the transactions.
In addition, the tax authorities will be entitled to request much more detailed information on all controlled transactions between the same related parties on the basis of a notification discussed above or as a result of a tax audit. This detailed information will include documentation describing the following:
- a functional analysis of the parties involved in controlled transactions (a description of the transaction, the taxpayer's organisational structure, a list of counterparties, the functions, risks and assets of the parties); and
- transfer pricing methods applied (description of the transfer pricing methods and reasons for their application, sources of information used, calculation of the market price range, amount of obtained income and/or carried out expenses, etc.).
Please note that the documentation on the controlled transactions may not be demanded by the tax authorities before 1 June of the year following the year of the transaction.
4 This amount will be equal to RUB 80 mln. in 2013, and will not be applicable as from 1 January 2014.
Transfer pricing control and penalties
During the two first years after the Law comes into force, 2012 and 2013, special transitional rules will be in place, as follows:
- the transfer pricing control of transactions concluded in 2012 will be held no later than 31 December 2013;
- the transfer pricing control of transactions concluded in 2013 will be held no later than 31 December 2015.
For transactions concluded after 1 January 2014, a 3-year controlling period will apply.
If the Russian tax authorities reveal that a price applied in a transaction does not correspond to the market one and if the relevant company cannot justify the conformity of the price to the market range of prices (profitability range) and/or provide objective reasons for its deviation, the tax authorities are entitled to recalculate the amount of taxes due on the basis of the market price level. Thereafter, the relevant company will be obliged to:
- pay the outstanding tax due;
- pay a penalty for the late payment of tax (this will be calculated depending on the duration of the delay); and
- pay a fine. No fines will be applicable in 2012 and 2013. The amount of the fine will be equal to 20% from 2014 and 40% from 2017 unless an APA has been concluded or the taxpayer provides other relevant supporting documentation for the pricing methodology prices.
In addition, the Law permits Russian taxpayers, in domestic transactions only, to obtain corresponding adjustments in case the tax base of one party to the transaction is adjusted as a result of a transfer pricing control.