Content of transfer pricing documentation and prior agreement
On 18 December 2018 Cabinet of Ministers Regulation No. 802 “The documentation of transfer pricing and the order, according to which the prior agreement between the tax payer and the tax administration on providing the market price (value) for a transaction or a transaction type must be signed” was adopted.
The Cabinet of Ministers regulations solve the following issues:
- the content of global documentation and local documentation;
- the content of simplified documentation in the case of low value added services;
- prior agreement on the market prices.
It is important to emphasise that the information to be included in the transfer pricing documentation provided for in the regulations was originally included in the draft law “Amendments to the Law “On Taxes and Duties””, but after reviewing the draft law it was decided that only essential norms should be regulated by the law, while the detailed information included in the transfer pricing documentation should be determined by the Cabinet of Ministers regulations. Therefore, the content of the documentation without any substantive changes was excluded from the draft law “On Taxes and Duties” and included in these regulations.
Taking into account that the content of the transfer pricing documentation is a very vast subject, in the article we outline the new requirements for transfer pricing documentation and provide comments about the most uncertain issues, as well as briefly describe the procedure for signing the prior agreement.
In the global documentation the following information must be provided (Clause 2 of the Cabinet of Ministers Regulations):
(1) Organisational structure (including legal and capital structure or share ownership structure) of the international group of companies (hereinafter referred to as “IGC”) related to the taxpayer and the geographical location of the group units. The organisational structure is usually considered to be the internal hierarchy of the group of companies, the subordination of departments and the reporting system within a group of companies, while the legal structure is the structure of ownership of the parts/shares and the structure of the voting rights related to them.
(2) Description of IGC economic activity including the following information:
- The key factors affecting financial performance (description). These factors are considered to be competitive advantages, the presence of which is required for successful business. Depending on the industry and the type of business, these advantages vary, for example pricing policy, know-how, the technology used, qualified labour force, servicing standards, etc. Those mentioned are only few of the possible factors.
- The description of the supply chain of 5 major goods or services according to turnover, as well as the description of any other goods or services, if the supply of the goods or services in question totals at least 5% of the turnover of the IGC (information may also be presented in the form of a schedule or a diagram).
- The significant service agreements signed by the IGC (except for research and development service agreements). The description also has to include information on substance at major service locations, allocation of costs and the procedures for providing the price (value). Usually a number of written or oral agreements on mutual services are signed within the IGC: management, administrative, loan and other services . It should be remembered that for substantiating each service three components are required: the fact that the service is provided (i.e. the service has been actually provided, which is confirmed by the ability of the service provider to provide it and to bear the risks associated with it, the need for the service (the test of benefits), as well as conformity to the market value. Thus one of the tasks of the Global Documentation is to substantiate that the services provided within the group have been actually provided and conform to the market value (the test of benefits is more a task of local documentation).
- The description of the main geographic markets regarding the above mentioned goods and services of the IGC.
- Short functional analysis of the individual units of the IGC that affect the financial performance of the group. The analysis also describes the key functions, the assumed risks and the used assets. The Global Documentation should provide an overview of the role of each group member, and as a minimum must prepare the so-called function risk map, listing the key functions (such as purchases, production, sales, transportation), risks (e.g., market, bad debt, currency, etc.) and assets that are implemented and undertook by each member of the group.
- Information on significant restructuring operations of the economic activity, acquisition and disposal of assets in the respective reporting year. It is important to emphasise here that restructuring is considered to be not only reorganisation within the meaning of the Commercial Law (e.g., merger or division), but also the transfer of business functions. For example, if a Latvian company has acted as a retailer but is restructured into a provider of marketing services, it is considered to be restructuring. Attention should also be paid to the relocation of commercial activities to other countries – upon the transfer of assets (tangible or intangible) of the company, a question may arise of whether or not the counterpart should receive any compensation.
(3) Intangible property of IGC:
- The development of intangible property of IGC. See the general strategic description of the main research and development centres and their management locations. One of the most important points of the BEPS plan is the application structures of the intangible assets. Amendments to the OECD Transfer Pricing Guidelines do not prohibit the use of intellectual property, but they approve the fact that the use of intangible property involves additional risks of transfer pricing aimed at tax avoidance, therefore their stipulation is strengthened and regulated in more detail.
- The major intangible assets or groups of intangible assets, providing which units legally own the relevant property or group of properties. The intangible assets are considered to be trademarks, patents, customer information, etc.
- Major agreements relating to intangible assets, including cost and investment sharing agreements, agreements on sharing the costs, research agreement and licence agreements. Such agreement may be both the sale of intellectual property, as well as licensing (use).
- The policy of transfer pricing of research and development and intangible assets implemented by IGC. In a few words – R&D activities can be included in costs, but also capitalised and reflected on the balance sheet.
- Transfer of the rights to intangibles between related companies in the relevant reporting year.
(4) Internal financial activity of the IGC
- Description of the IGC financing, including information on significant financial transactions with unrelated lenders (creditors). Funding alongside the intangible assets has received increased attention in the BEPS plan due to the fact that it is relatively easy to finance through companies located in jurisdictions with favourable tax modes for interest income.
- Information on the IGC financing centres. According to the results of BEPS work, in order to be able to claim that a company implements full financing function, it must not only administer the provision of funding, but it must also decide and be able to undertake financial risks and to manage them.
- Description of the transfer pricing policy. Here information must be included on corporate financing centres (if any), as well as on significant lending transactions in general. As with the use of intellectual property, lending is also within the scope of the OECD – it should be remembered that a financing centre, the sole function of which is to issue a loan, can only obtain a risk-free loan rate (increased by the risk premium).
(5) Financial reports and taxes of the IGC:
- Consolidated financial report or other consolidated documentation prepared for regulatory, management, tax or other purposes.
- The unilateral prior price-fixing agreements and other cross-border decisions relating to the allocation of income between the countries (listing and brief description).
Local documentation (Clause 3 of the Cabinet of Ministers Regulations) has to include the following information:
(1) information on the taxpayer and the IGC related to it:
- The organisational structure of IGC (including legal and ownership structure) and geographical location of group units.
- The description of the organisational and legal structure of the taxpayer (including its management), as well as information on the natural persons, to whom the management of the taxpayer provides reports, providing the countries where the head offices of these natural persons are located.
- Functional analysis (functions, risks, assets), except if provided in the global documentation.
- The economic activity of the taxpayer and its strategy, providing whether the taxpayer was involved in the restructuring of the economic activity or the transfer of intangible property in the respective or previous reporting year, as well as an explanation of how these transactions have affected the taxpayer.
Apparently, the local documentation actually duplicates the information requested in the global documentation. In addition, it is noted in some clauses that the information does not have to be provided, if it is already included in the global documentation. Practice will demonstrate, how much information will have to be provided, but it is clear that the basic information will still be similar to both global and local documentation.
(2) Information about each significant controlled transaction or category of transactions, in which the taxpayer is involved:
- General description of a controlled transaction or transaction category (for example, provision of production service, delivery of products, provision of services, loan agreement, financial and provision guarantee, issuance of an intangible asset licence) and the circumstances, in which such transaction took place. It should only be noted here that a transaction or transaction category should be considered a set of equal transactions, for example, in the transaction of the supply of goods – the transaction will not be the supply of a single batch, but the total of all supplies.
- Amounts of payments made and received by the taxpayer according to transactions and countries.
- The related companies involved in each controlled transaction or category of transactions, as well as the relationship between these companies.
- Copies of all relevant controlled transactions of the taxpayer.
- Detailed comparability and functional analysis of the taxpayer and the relevant related company regarding each documented controlled transaction or category of transactions (providing any changes compared to the previous year). The comparability criteria are described in detail in Cabinet of Ministers Regulation No. 677 “Regulations on the Application of Enterprise Income Tax” in Clauses 11 and 12.
- The method for providing the market price of the transaction regarding each transaction or category of transactions, as well as the substantiation for the choice of method (see Clauses 13-17 of Cabinet of Ministers Regulation No. 677).
- The indication of the related company that is selected as the party to be tested regards the entity, the financial performance of which is being analysed, as well as the justification for that choice. Depending on the fact of which company in the transaction chain is selected as the party to be tested, the method of valuation of the applicable market price may differ. For example, if a manufacturer sells goods to the related company – the distributor, that sells goods to unrelated customers, the manufacturer will most likely have to choose the cost-based method, such as a cost-plus method, while distributors will analyse the sales profit margin.
- Information on significant (critical) assumptions, on which the transfer pricing methodology is based, and that is coordinated with the future performance forecast of the taxpayer according to the transaction or commercial or financial relationship with the related party.
- An explanation of the reasons for using the data for several years (if applicable). In practice, there are occasional disputes over whether to use the comparable data of the particular year or to use the data of several years. In my opinion, it should be based on data of several years, as it allows balancing of the fluctuations in profitability. However, if changes take place in the industry, the data for individual years should also be analysed.
- List of internal or external non-controlled transactions, description, copies of the agreements or description of contractual terms and information about the relevant financial indicators of the independent companies, on which the transfer pricing analysis is based, and the information substantiating it (e.g., screenshots with fixed date, downloaded data from the database with a fixed date of the download), including the methodology for the comparative data search, including the substantiation for the search criteria and the data rejection, as well as the successive quantitative and qualitative search inventory (for each step (such as screenshots, data downloaded from the database)) and the source of the mentioned information. Thus, depending on the selected transfer pricing method, the comparable data (transactions or financial indicators of independent companies), data acquisition dates, supporting documents (for comparable transactions) or screenshots of company websites (in the case of comparable companies) should be recorded.
- The description of the comparability adjustments made and a note explaining, whether the corrections have been made in relation to the results of the party to be tested or in relation to the uncontrolled transaction to be compared, or both. Adjustments are usually made to mathematically exclude the effects of differences in comparable data on the results of the test subject. For example, if the price of a product in the transaction of the party to be tested also includes transportation costs, but they are not included in comparable transactions, these transportation costs should be excluded.
- The results of applying transaction market price and their compliance with the principle of independent business transactions.
- A summary of the financial information of it, used in applying the transfer pricing methodology.
- Valid past pricing agreements or references, issued by foreign tax administration, if they refer to the particular case.
(3) Financial information:
- The annual report of the taxpayer for the reporting year and the auditor’s report, if such has been prepared.
- Information and tables, reflecting the relationship between the financial data used in the application of the transaction market price (value) method and the financial statements.
- General information on the use of the relevant comparative financial data in the analysis, as well as on the source of the mentioned data.
Simplified transfer pricing documentation for low value added services
The Law “On the taxes and duties” Section 15.2 part twelve authorises the Cabinet of Ministers to determine the information to be included in the simplified transfer pricing documentation, if the simplified procedure for providing the transfer pricing is stipulated by the regulatory enactments of taxes.
Currently, the regulatory enactments do not provide a simplified procedure for transfer pricing for certain transactions, but it is planned that such procedure will be adopted in the nearest future, by amending Cabinet of Ministers Regulation No. 677 of 14 November 2017 “Regulations on the Application of Enterprise Income Tax Law”.
The simplified documentation must contain the following information:
(1) Information on the transaction partner.
(2) A description of the low value added services provided or received. According to the OECD Transfer Pricing Guidelines, low value-added services include: accounting and auditing, processing and management of accounts receivable and accounts payable, human resources activities, the monitoring and compilation of data relating to health, safety, environmental and other standards regulating the business, IT services (excluding programming), internal and external communications, legal services, activities with regard to tax obligations and general services of an administrative or clerical nature.
(3) Substantiation of why services are considered to be low value added services, taking into account the criteria provided in the regulatory enactments that stipulate the tax procedures.
According to the OECD Guidelines low value added services have the following features:
- they are of a supportive nature;
- they are not part of the core business (i.e., they do not create profitable actions, nor promote significant economic activities of the MNE group);
- they do not require the use of unique and valuable intangibles and do not lead to the creation of unique and valuable intangibles; and
- they do not create significant risks to the service provider.
(4) Substantiation of the economic nature of low value added services in the context of the business activity of international group of companies.
In order to justify any provision of services, the fact of the provision/receipt of services must be substantiated, especially in cases when the so-called integrated services are provided, i.e., there is one service provider and multiple recipients, and the services are provided indirectly.
(5) The description of the obtained or expected benefit related to each type of low value added service. The benefits of the services of the internal group are usually the centralisation of resources, thus increasing competence and avoiding duplication of functions, and thus saving resources, etc.
(6) The description and substantiation of the selected cost division criteria, providing why the mentioned cost division criteria best reflects the benefit that the provider and the recipient of low value added service receive. The OECD Transfer Pricing Guidelines recommend applying economically reasonable criteria such as turnover, number of employees, proportion of assets, etc.
(7) Confirmation of the application of the mark-up. According to the OECD Transfer Pricing Guidelines, low added value surcharge is usually between 2 and 5%.
(8) Written agreements.
(9) Documentation and calculations, that reflect the identification of the set of costs and the surcharge of low value added services.
(10) The application calculations of cost division criteria.
Although it is not emphasised, the Cabinet of Ministers Regulations actually refer to low value added services, as they are defined in paragraphs 7.44-7.65 of the OECD Transfer Pricing Guidelines.
Signing of the prior agreement
The final issue regarding the Cabinet of Ministers Regulation is the signing of the agreement in accordance with the Law “On Taxes and Duties” Clause 16.1. Previously it was stipulated by Cabinet of Ministers Regulation No. 16 “The order, according to which the prior agreement between the tax payer and the tax administration on providing the market price (value) for a transaction or a transaction type must be signed”. The new Cabinet of Ministers Regulations clarify the process of the prior agreement, as the content of the documentation is specified. However, they also provide quite substantial changes: the validity of the prior agreement is up to 5 years, and it can also be signed regarding the previous years.
In practice the State Revenue Service actively offers such services to companies.
Initiation of the agreement process
In order to initiate the process, the taxpayer must submit an application for prior agreement at its own initiative or referring to the proposal of the SRS (apparently the Cabinet of Ministers Regulations also provide the initiative of the SRS). The following information must be provided in the application:
- name, registration number and registered office of the service provider,
- information about the related person,
- transaction or transaction type, which the prior agreement refers to,
- the method selected to determine the market price (value) of the transaction,
- the term, which the prior agreement will refer to (not exceeding five years from the date of its signing),
- the reporting years, which the prior agreement will refer to, if it relates to the previous reporting years,
- legal basis for the selection of the method of determining the market price (value) of the transaction and submission of the application.
Local documentation and information on the tax verification of the related foreign company must be enclosed to the mentioned application, or the challenge or appeal procedure of the case regarding the transaction with the related parties on the provision of the market price (value), if it is relevant.
The State Revenue Service evaluates the taxpayer’s application regarding the prior agreement, verifying the information specified in the application and the documents attached thereto, as well as, if required, requesting additional information from the taxpayer, and within the term and according to the order as provided by the Administrative Procedure Law adopts a decision on the commencement or refusal of signing the prior agreement.
The SRS may decide to refuse the initiation of the prior agreement procedure, if the taxpayer does not provide information, has provided false information, or the transaction is aimed at the evasion of taxes or unlawful gain.
If the State Revenue Service decides to initiate the procedure of signing the prior agreement, it shall notify the taxpayer of the date of commencement of the procedure and the responsible official of the State Revenue Service.
Within the procedure of signing the prior agreement, the State Revenue Service, if required, requests additional information or explanations from the taxpayer to agree on the terms of the prior agreement.
The content and consequences of the agreement
If the SRS agrees to sign a prior agreement with the taxpayer, it must include the following information:
- name, registration number and address of the service provider,
- facts, transactions and reporting years, which the prior agreement refers to,
- transaction market pricing method, number of comparable objects and their selection criteria, the expected result of applying the selected method,
- important information for calculating the market pricing method (such as cost surcharge, profit margin),
- significant assumptions, by which the method of providing the market pricing of the transaction is substantiated,
- the circumstances in which amendments to the prior agreement should be made,
- a statement that the prior agreement is null and void, if the related regulatory enactments are amended,
- the conditions under which the prior agreement expires,
- the duration of the prior agreement (not exceeding five years from the date of signing the prior agreement),
- the reporting years, which the prior agreement refers to, if it relates to the previous reporting years,
- consequences of taxes arising from the prior agreement, including the procedure by which the SRS monitors the implementation of the provisions of the prior agreement,
- the deadline, by which the taxpayer meets the conditions of the prior agreement, if the agreement is signed regarding transactions of previous reporting years,
- the consequences, if the taxpayer fails to comply with the terms of the prior agreement,
- other terms mutually agreed between the parties.
Amendments of the prior agreement
It is possible to amend the prior agreement at the taxpayer’s initiative.
The SRS shall adopt a decision on the commencement of the procedure for amendment of the prior agreement or on the refusal to initiate the procedure for amendment of the prior agreement.
Amendments to the prior agreement are made, if the SRS and the taxpayer agree on them. If within a year after initiating the procedure of signing the prior agreement the SRS and the taxpayer do not agree on the terms of the prior agreement, and if the implementation of the subsequent signing procedure is not useful, the SRS shall terminate the procedure of signing the prior agreement.
Fee for signing the prior agreement
The fee for signing a prior agreement is 7114 euros and it must be paid into the state budget to the State Revenue Service budget programme account at the State Treasury. 20% of it is paid, when submitting the application, and 80% after the decision has been notified.
Is it worth signing a prior agreement?
Prior agreement can be useful to companies that conduct a large volume of transactions with related companies. The main advantage of the prior agreement is that in the case of successfully signing an agreement, the company (by observing the terms of the agreement) may not worry about tax audits. Another advantage is that the agreement can be signed not only regarding future periods, but also regarding previous years, which can provide the company extra reassurance for the past transactions.
The disadvantage of the process is, of course, that there are additional costs for the coordination services provided by the SRS, as we have to remember that the company must independently prepare the information that is intended for local documentation. Another disadvantage is that, as the name itself suggests, the process is an agreement, which means that there is also the possibility of disagreement, namely that the SRS may disagree with the position of the company on transfer pricing.
In general, however, if large amounts of transactions are made with related companies, it is worth considering this option.