The amendments to the Taxes and Duties Act regarding the transfer pricing mandatory requirements, which entered into force on 1 January 2013 introduced new Section 15.2 “Taxpayer’s duty to submit information regarding the transactions with related parties”, which lists the minimum requirements for a taxpayer for documenting the related party transactions (transfer pricing). These amendments should be considered as a progressive step towards legislation development that seeks to introduce uniform approach for documenting the transactions between the related parties. Although currently the formal requirements for the transfer pricing documentation are not provided by the law, the arm’s length principle is set out in Section 12 of the Corporate Income Tax.
Moreover, the governmental regulations No.556 „Application of the Corporate Income Tax Act” set out that a taxpayer should prove that the transfer prices are at arm’s length, by performing the functional analysis and applying the transfer pricing methods as listed in the regulations. Therefore, in practice each transaction subject to the arm’s length requirement should be substantiated by the transfer pricing documentation also based on the existing law. So far many Latvian companies have mistakenly assumed that the transfer pricing documentation is not mandatory and, therefore, failed to prepare the documentation, what resulted in the disputes with the State Revenue Service during the tax audits.
Who should prepare the transfer pricing documentation?
The new transfer pricing documentation requirements apply to all resident taxpayers and permanent establishments of the foreign entities, if the turnover of the Latvian entity exceeds 1 million lats and the value of each category of related-party transactions exceeds 10 thousand lats. The transactions with the following contracting parties are subject to the transfer pricing requirements:
- Foreign related parties
- Related parties which are in the same group allowing the transfer of tax losses
- Latvian entities enjoying tax holidays or tax incentives
- Related individuals
- Other entities established in low tax jurisdictions (according to the “black list”)
The transactions which do not qualify to the above criteria, but are still subject to the arm’s length, e.g. if the company has turnover less than 1 million, still should be documented, however, for not qualifying transactions the new transfer pricing documentation requirements will not apply. This means that the transfer pricing documentation for non-qualifying transactions could be more brief and simpler, but still also these transactions should be substantiated.
Transfer pricing documentation content
New transfer pricing documentation requirements basically are borrowed from the European Union Transfer Pricing Documentation Code of Conduct (2006/C 176/01). The code briefly describes the information which needs to be disclosed in the documentation, however, it does not describe the methodology and documentation process in detail. The transfer pricing documentation process is developed by the OECD Guidelines “Transfer Pricing guidelines for multinational companies and tax administrations”. The basic requirement as set by the OECD guidelines is to disclose the factors that make the related party transaction comparable with transactions carried out between independent companies in order to assess the arm’s length (comparability study). To help understanding intention of the amendments, we hereby comment the most important requirements in the light of the methodologies as set out in the OECD Guidelines. The amendments require a taxpayer to document the following information: industry overview, company’s organizational structure, strategy, functional analysis, description of the goods/services, forecasts, transfer pricing method selection, benchmarking study of comparable companies/transactions.
1. Industry overview
The transfer pricing documentation should start with a description of the industry, where the taxpayer operates. The amendments require disclosing a brief overview of the industry covering recent years as follows:
Information regarding the taxpayer’s industry (trends, market characteristics). Characteristics of the commercial environment (competition, sales channels and other market factors).
The OECD Guidelines recommend describing the economic factors which are important for a comparability study and includes geographical position, market size, competition, possible substitutes of the goods/services, supply/demand level in the region.
Analysis of the economic and legal factors which influence the taxpayer’s decision for establishing the prices of the goods and services.
OECD Guidelines recommend describing the legal regulation of the industry and market, the cost structure (e.g. labour, transportation); wholesale/retail, place and time of the transaction.
List of intangible property that influences the transfer price
The Guidelines distinguish between commercial and trade intangibles. Commercial intangibles include patents, know-how about manufacturing processes etc. Trade intangibles are trademarks, trade names, customer lists etc.
Information regarding the functions undertaken, risks assumed and assets used in the related party transaction.
2. Organizational and legal structure
The shareholding structure is usually transparent and visible to the third parties, however, the organizational structure reflects the internal organization of the company and the group, it includes reporting lines, responsibility levels etc.
3. Taxpayer’s strategy
According to the amendment the documentation should describe the business strategy which may affect the transfer prices. The OECD Guidelines explain possible strategies such as innovations, new product development, investment diversification, risk taking, changes in the governmental policies and laws, other subjective factors having impact on the daily business management.
4. Functional analysis
According to the amendments a taxpayer should present information regarding the functions undertaken, risks assumed and assets used by the related parties, as well as, information regarding business reorganizations involving transfer of the functions. The functional analysis is the cornerstone of a transfer pricing documentation. According to the OECD Guideliness a taxpayer’s functions may include design, research and development, manufacturing, assembly, services, purchasing, distribution, marketing, advertising, transportation, financing and management. The most important business risks are market risk (demand and price volatility), investment risks, financial risks (credit, bad debt, currency).
5. Description of the product
The transfer pricing documentation should have a description of the goods/services being purchased/sold in related party transaction. The most important characteristics for the goods are – physical characteristics, quality, reliability, availability and the volume of supplies. For services – it is important to describe the service; for intangibles – the type of a transaction (e.g. patent, trademark); for services the benefit for the receiving entity should be described.
6. Contractual relationship
Contractual relationship usually defines the split of functions and risks between the related parties and as such is a part of the functional analysis. However, the OECD Guidelines recommends to document it separately, since not always the transactions are supported with written agreements.
7. Transfer pricing method selection
Based on the above-mentioned analysis a relevant transfer pricing method should be selected. Transfer pricing methods are listed in the Regulations of the Cabinet of Ministers No.556:
Comparable uncontrolled pricing method
In essence, this method involves comparing the price applied in a transaction between related companies with the price of a comparable transaction between a related company and an unrelated trader, or with the price of a comparable transaction between other unrelated traders in comparable circumstances.
Resale Minus method
This method is based on a price at which goods purchased from a related company are sold on to an unrelated trader. The price is reduced by gross profit out of which the reseller covers selling and administration costs to derive an adequate profit in the light of functions performed for the transaction, inherent risks, assets employed and other factors affecting the transaction value. The result should be taken as the market value of the transaction or the market price of the goods.
Cost plus method
This method determines the market price of a transaction as a supplier’s costs of goods or services supplied to a related company, plus an appropriate mark-up the supplier would add in a comparable transaction with an unrelated trader in the light of functions performed for the transaction, inherent risks, assets employed and other factors affecting the transaction price.
Transactional net margin method
It determines the value of a transaction (the price of goods or services) by adding a net mark-up to direct and indirect costs attributable to the transaction, given the functions performed for the transaction, inherent risks, assets employed and other factors affecting the transaction value or product price.
Profit split method
This method is used if related companies undertake interconnected transactions or participate in consecutive transactions within the supply chain that cannot each be valued separately. First of all, total profits from transactions between related companies are determined. After a functional analysis of the transaction, an assessment is made of the functions each trader involved in the transaction performs, as well as inherent risks and other factors affecting the transaction price, then profit is allocated between them in a commercially sound ratio that unrelated traders would have agreed upon.
8. Comparability study
Based on the selected transfer pricing method, the transfer pricing documentation should have an analysis of the financial figures of comparable independent companies or comparable prices applied by independent companies in comparable transactions.
This is a practical result of the documentation which should be used for a calculation of the tax, which relies on the financial data of independent companies or the prices applied by independent companies.
Preparation of the document
The documentation should be kept for 5 years and should be submitted to the tax authority within a month from receiving the request. If the taxpayer fails to submit the document, the tax authority is entitled to calculate the arm’s length prices based on the information it has at its disposal.