Russia Tax: Changes to Russia's transfer pricing rules on horizon

The Russian State Duma has adopted the first reading of a draft law that proposes a number of fundamental changes to the transfer pricing rules. If enacted, the draft would bring Russia's rules more in line with OECD transfer pricing principles and would provide more detail on how the rules work in practice, which may ultimately simplify their application by both taxpayers and the tax authorities. The law – which still could be further amended during the parliamentary process – is expected to receive final approval before the summer and apply as from 1 January 2011.


Definition of related parties

The definition of related parties would remain intact, although the concept of "affiliation" would be expanded. Parties are related (or "affiliated") if one party can influence the conditions or the results of transactions carried out by another party, or the results of its activities. Under the draft law, the concept of affiliated entity also would apply to the following:

- Companies with the same (or related) owners if their participation is more than 20%;
- A company and its CEO, or a member of its board of directors;
- Companies with the same CEO;
- A chain of companies and/or individuals, where each successive company or individual in the chain owns more than 50% of the subsidiary;
- A settler of trust management, trust manager and beneficiary, as well as a trust manager and managed companies; and
- Companies or individuals affiliated with the representative of their counterparty, or having affiliated representatives.


List of controlled transactions

The list of controlled transactions would be revamped to include:

- Transactions between related parties, whether foreign or domestic (including supply chains involving third party intermediaries). Transactions between related parties in Russia, however, would be subject to the transfer pricing rules only in specific instances:
     - The total volume of transactions with the same counterparty (or counterparties) exceeds RUB 1 billion during a calendar year;
     - The transaction involves mineral resources subject to the mineral extraction tax at an ad valorem rate; or
     - One of the counterparties is a unified tax on imputed income or unified agricultural tax taxpayer.
- Cross-border transactions involving certain commodities that are traded on an official exchange, including crude oil and petrol products, ferrous and non-ferrous metals, precious metals and gems; and
- Transactions between Russian tax residents and offshore tax residents located in a jurisdiction that appears on the black list issued by the Ministry of Finance with respect to the Russian participation exemption.

Pricing control would be specifically extended to cover transactions involving property rights and rights over intellectual property (IP), including brands. The transfer pricing rules also would apply to transactions where prices are set as a tariff or rate (including interest rates on bank loans, credits and other debt instruments), etc.

Transactions between members of a consolidated group would be outside the scope of the transfer pricing regime, although this presumes the introduction of a consolidated taxpayer regime (this legislation is also in draft form).


Comparability of transactions

The draft law includes a number of articles relating to the comparability of economic conditions under which transactions are entered. In particular, the functions of the parties to a particular controlled transaction (who is responsible for design, production, repair, marketing, legal and financial support, consulting, etc.) could be taken into account. The comparability of transactions also would depend on the risks assumed by the parties (industrial, economic, investment, environmental, etc.), and the availability of unique equipment, IP and even customer lists could influence transaction comparability. The draft law lists the particular conditions that would influence the comparability of loans, credit, guarantees and commission agreements.


Sources of information

The draft law includes a clear list of sources of pricing information that could be used in a transfer pricing analysis, including official exchange price quotations, Russian customs statistics, publicly available price statistics, company financial reports and formal valuations. Prices regulated by the authorities and prices set according to directives of the anti-monopoly authorities would be treated as market prices for tax purposes.


Transfer pricing methods

The general principle that the price used in a transaction should be the price used for tax purposes and that this is presumed to be equal to the market price unless proven otherwise would remain unchanged. The strict hierarchy for applying transfer pricing methodologies would be abolished, but the comparable uncontrolled price method would remain the preferred methodology. The draft law enumerates circumstances in which other transfer pricing methods could be applicable. The list of methods and procedures for their application would be changed significantly:

- The comparable uncontrolled price method should be applied where information on at least four similar transactions was available. This method involves a calculation of the range of market prices, which is similar to the interquartile range used under OECD methodology.
- The resale price method means that the reseller's profitability should be compared with the profitability range in similar uncontrolled transactions.
- The processed product sale method is a new method similar to the resale price method, and should be applied if a base product is being processed.
- The cost plus method involves a comparison between the producer's profitability in relation to costs and the cost profitability range in similar uncontrolled transactions.
- The comparable profitability method is another new method to be used if there is a lack of data necessary to use one of the above methods. The profitability of one party to a particular transaction that performs fewer functions, bears less risk and does not own any intangible assets that affects the level of profitability is compared to a profitability range.
- The third new method is the profit split method that would be used if the other methods are not feasible, or in the case of a close relationship between the parties to the transaction, or if certain unique factors affect profitability.

The aggregate profit of all parties to the transaction is allocated between them according to special rules. If the above methods cannot determine whether the price used in a single transaction can be considered the market price, the draft law allows the use of an independent valuation report.


Documentation and reporting requirements

An important change would be a requirement to maintain special transfer pricing documentation. The draft law obliges taxpayers to prepare and retain documentation showing that the prices used in controlled transactions correspond to market prices. These documents should include the rationale for the choice of transfer pricing method, calculations of the market price range or profitability range, the amount of income or expenditure relating to the transaction and the economic benefit obtained.

The documentation rules would be triggered if the total amount of controlled transactions with the same counterparty (or counterparties) exceeds RUB 100 million per annum (although this threshold gradually would be decreased to RUB 10 million). The documentation would have to be provided to the tax authorities upon request, but no earlier than 1 April of the year following the year in which the controlled transaction took place. The taxpayer also would be required to prepare a statement of controlled transactions and file it with the tax authorities on an annual basis.


Corresponding adjustments

If the tax authorities make a pricing adjustment resulting in additional tax, the other party to the transaction would have the right to make a corresponding adjustment in its profit tax and VAT bases.


Advance pricing agreements

The largest taxpayers would be able to conclude special agreements (APAs) with the Russian Federal Tax Service. APAs, which could be unilateral or bilateral, would set the procedure for price determination and pricing in controlled transactions. It is anticipated, however, that the APA provisions would not become effective before 1 January 2012.


Pricing control

The Federal Tax Service would have the right to conduct special audits of prices used in controlled transactions, i.e. to determine whether they are in line with market prices. These pricing audits would not be related to regular tax audits, although the rules would be similar.


Penalties

Specific penalties would apply for the non-payment or underpayment of taxes due to the application of transfer prices (40% of the outstanding tax), and for a failure to submit (or a false submission of) information on controlled transactions (RUB 5,000). There also would be special penalty for violating the conditions of an APA (RUB 1.5 million).


Implications for taxpayers

As a result of the proposed rules, taxpayers may need to undertake the following actions:

- Review relationships with counterparties in respect of major transactions to minimize risk and to identify transactions falling under price control;
- Analyze the functions performed by the various companies in a group and the risks borne by each company;
- Benchmark the comparable market price and comparable profitability ranges;
- Prepare documentation supporting the choice of transfer pricing method;
- Consider changes to the flow of documentation supporting pricing decisions for tax purposes;
- Undertake additional reconciliations with counterparties to quickly identify price adjustments made by the tax authorities and effect relevant corresponding adjustments; and
- Perform thorough advance planning of transactions to minimize transfer pricing risk.