Chairman of the State Duma budget and tax committee
The Russian State Duma began to discuss one of the most complicated aspects of the national tax system – sales tax on goods sold above or below market prices. The tax and the prices directly or indirectly affect the whole population of the country. VIP-Premier asked one of the most influential experts in the sphere to elaborate on proposed transformations. Chairman of the State Duma budget and tax committee Yuri Vasiliyev published an op-ed in the magazine.
The transfer pricing problem is directly linked to the process of systemic investment climate improvement in the country and plays a major role in economic modernization. Transfer pricing is when goods or services are sold within a group of related entities at prices that differ from market levels. Since mid-1990s production units of Russian major enterprises have been free to choose production and commercial activity guidelines. One internal unit can sell raw materials, commodities and prefabricated products to another unit, which promoted profitability of the whole holding and each of its units separately.
Thus, a production or mining company of a holding can sell its products to a sales company of the same holding at internal (low) prices; the sales company than sells the products to end users at market (higher) prices. As a result, all financial resources are concentrated in a single profit unit (sales company) and can be re-distributed according to the needs of the holding in general. Transfer pricing is also used to minimize taxes. If the profit unit enjoys various tax benefits, the total tax load on the holding decreases.
The issue has become specifically vital today for vertically integrated companies in the oil and gas industry and also in the metallurgical industry. Price manipulation takes place when commodities are transferred for processing and then to wholesale and retail trade. It allows accumulating profits in one unit, reporting losses in another, and moving profits from a region with a high tax burden to provinces with a lower profit tax. All in all the “maneuvers” strip the state coffers of millions of rubles of tax proceeds. Acting Russian tax legislation provides no benchmark price norms for taxation.
LEGAL TAX FLOW CHANNELS
The United States was the first country to adopt in the mid-1960s special legislation that regulated transfer pricing in detail. However, transnational corporations are based in that country and U.S. legislation considerably differs from the laws of other interested states. That made many governments look for acceptable principles and methods of transfer pricing taxation. In 1995 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations were adopted. They comprise the basic recommendations and methodologies in the sphere.
In Russia transfer pricing regulation issue emerged for the first time in the early 1990s. At that time there was a rule that did not allow sales of products cheaper than prime cost without taxation consequences. The control system was very burdensome both for tax agencies and taxpayers as transfer pricing control covered a huge variety of deals. The Russian Tax Code (article 40 part 1), which was the key legal document, was insufficient to regulate transfer pricing. Article 40 allowed holdings to easily bypass restrictions while re-distributing funds. The provision was also imperfect as it gave a vague definition of the “interrelated entities” notion.
Today disputes about transfer prices have become so heated that some people claimed the inclusion of the issue into the Tax Code would contradict the Constitution. Efficient tax control and tax discipline in the country greatly depend on the solution of the problem. Over 11 years have passed since part 1 of the Tax Code has come into force. Its norms regulating price control mechanisms have become outdated and need to be adapted in compliance with modern legal and economic realities. The lawbill submitted by the government in late December aims to resolve the issue and streamline taxation in that market economy segment. The State Duma has considered and approved under the first reading the government lawbill “On introducing changes into the Tax Code in order to streamline the principles of price determination for taxation purposes.”
TAXES HAVE TO WORK FOR RUSSIA, NOT OFFSHORES
According to the new provisions of the Tax Code, the list of deals subject for control has considerably expanded due to a new definition of interrelated entities. The new edition of the Russian Tax Code refers to interrelated entities all enterprises with a state equity above 20 percent. It also establishes market price corridor. If a taxpayer is within the established range it automatically means there would be no problems with tax agencies. If the taxpayer is outside the limits, additional investigation will be necessary to establish whether the deal price corresponds to the market price.
The list of information sources, which taxpayers and tax agencies can use to substantiate prices, has been expanded to practically unlimited scope. Subject to control will be foreign trade deals with exchange-traded commodities (crude, ferrous and non-ferrous metals, precious metals), as well as deals with a party registered on the territory of a foreign state where taxation legislation does not stipulate for the provision of information to Russian tax agencies.
Thus, the lawbill determines the list of controlled deals, specifies general provisions for prices, and defines a list of documents and data to substantiate price compliance in controlled deals. It stipulates six methods to determine prices and the main one is based on comparable market prices. When it is impossible to use the comparable market price method, the methods of subsequent sales price, secondary product processing price, the cost method, the method of comparable profitability, and profit distribution method should be used. The latter shall be mostly used to estimate price fairness when transnational corporations engage in complex business schemes. For example, a car works is situated in one country, while spare parts are produced in two or three other countries, and the distributor is located in a fourth country. A pricing agreement between major taxpayers and tax agencies is envisaged.
We can also list several other interesting proposals and articles of the important lawbill. It is very complicated and multi-faceted and many norms will be tested and developed during practical implementation. Prices in the country will depend on the contents and implementation of the bill. It is common knowledge that some businessmen resort to pricing smokescreen to flow profits out of the country. For example, they conclude a deal to sell products at low prices to an offshore company, which in its turn sells them abroad at real prices. As a result, profits go not to the regional or federal budget, but to an offshore zone where they are used in private interests.
TRUST BUT VERIFY
The new edition of the Tax Code on transfer pricing introduces responsibility for non-payment or incomplete payment of taxes due to the use of prices that do not correspond to the market situation. A market price range will be determined for each taxpayer to observe. If tax authorities prove a price deviation that resulted in lower tax payments, additional tax will be charged. The lawbill stipulates the fine will comprise 40 percent of non-paid tax and will be charged only under two conditions: the taxpayer has no documents substantiating the prices and did not pay taxes in full. If the taxpayer has all substantiating documents, but did not pay taxes in full and later faced claims from tax agencies, the talk can be only about paying the remaining tax and the late charge, but no fine.
Now several words about fines. The lawbill fixes them at 40 percent of non-paid tax. Is it a lot or not? To compare I would provide international data on fines. Canada charges a 10-percent fine on the non-paid tax, Poland – 50, Australia – from 10 to 100 percent, Brazil – up to 100 percent, Argentina – up to 1000 percent. I do not believe Russian sanctions to be draconic on such a background. The number of deals subject to control is decreasing.
The quality of inspections will also change. Today practically any rank-and-file inspector has the right to investigate transfer pricing. The new lawbill introduces new inspection rules. The headquarters of a tax agency are to create a special structural unit that will deal with the issue. Specially trained lawyers and economists will make substantiated decisions. Special units controlling transfer pricing exist is many countries as the issue is very complicated. As a rule, it concerns big amounts and difficult disputes on such important issues as asset distribution, obligations and risks between interrelated entities or participants in a group of companies.
The use of non-market pricing can trigger very negative consequences. It is no secret that regional governors often complain to the federal government they are losing tax proceeds as company owners transfer incomes to other more convenient provinces. That is unacceptable. We have to trust taxpayers, but at the same time streamline the mechanism to verify reliability of tax declarations.
TAKE ALL OPINIONS INTO ACCOUNT
The new law will come into force not earlier than on January 1, 2011. Thus, we shall have a possibility to discuss its provisions for half a year and then provide a possibility for taxpayers, tax authorities and courts to consider it for another six months. We shall reserve such a possibility in advance. The State Duma held parliamentary hearings in February on legislative measures to streamline the principles of price determination for taxation purposes. Representatives of all structures that will use the norm participated in the discussion. Naturally, we cannot say the lawbill is absolutely ideal. We believe it is excessively complicated and contains many provisions that will be hard for taxpayers, tax authorities and arbitration courts to comprehend. It is not clear why the government did not simultaneously submit a lawbill on consolidated group of taxpayers. The two lawbills regulate very close spheres of legal relations. Besides, the lawbill on transfer prices directly quotes consolidated taxpayer. Proposals are likely to be accepted on the introduction of a transition period when fines envisaged by the transfer pricing law will not be charged.
In spring the lawbill has to be approved under the second reading. Our committee intends to work with the document very thoroughly. As provisions of the lawbill considerably affect both fiscal interests of the state and business interests, we shall proceed from the necessity to take into account to the maximum all constructive opinions of the interested parties.