New Legislation on Transfer Pricing. Its Downsides and Advantages in Comparison with the Current Legislation

New Legislation on Transfer Pricing. Its Downsides and Advantages in Comparison with the Current Legislation

    In the light of rising state control over business sphere of Kazakhstan, one of the state’s concerns is transfer pricing. The control over transfer pricing is a special type of control different from simple tax inspection which requires special approach in controlling international business transactions.

    Since 2001 the Law of the Republic of Kazakhstan on State Control at the Application of Transfer Prices has been in force.
    The main direction of the Law was providing state control at the application of transfer prices at the same time providing within the framework of international agreements inter-exchange of information with regards to inter-dependence and interrelation of the parties, confirmation of the taxpayer’s registration in the given state, control over transactions with offshore companies, with legal entities that have exemptions from taxes, barter transactions and systems of netting with 10% deviation from market price to one or the other side, etc.
    Upon the occurrence of the facts of application of transfer pricing i.e. sale (export) at undervalued prices and purchase (import) at overvalued prices, Tax authorities adjust income by imposing taxes and payments.
    In accordance with the Law the control is provided through monitoring the transactions and conducting tax and customs inspections on fulfilment of tax and customs obligations.

    The monitoring of transactions is conducted on the basis comparative analysis of purchase and sale prices of taxpayer with the market prices:
    1. Price of taxpayer is formed on the basis of

• Cargo customs declarations presented by Customs authorities to the Tax authorities;
• Data from republic and regional electronic monitoring presented by taxpayers to the Tax authorities.

    2. Market prices are formed on the basis of

• Informational agencies;
• State bodies of the Republic of Kazakhstan including neighbouring and far abroad countries;
• International organisations; and
• Data from taxpayers.

    Upon the occurrence of the facts of application of transfer pricing as a result of monitoring the transactions of taxpayers, the Tax authorities would schedule inspections on matters of transfer pricing.
    Such inspections on matters of transfer pricing are also scheduled when inspections on fulfilment of tax and customs obligations are scheduled i.e. inspection on transfer pricing is thematic and is able to be scheduled no more than once a year.

    What difficulties the taxpayers were facing in the absence of control over transfer pricing?
    One of the main problems in conducting inspections on transfer pricing was evidence of applicable transaction price.
    To prove expenses incurred by the purchaser is practically difficult since the given documents are in possession of purchaser and in many cases the purchaser refuses to present them due to their confidentiality.
    Owing to the fact that taxpayer does not have the documents, the Tax authorities would make an adjustment without taking given documents into consideration which leads to substantial imposition (of taxes and payments).
    In practice all imposed sums on transfer pricing were appealed to the Senior Tax authorities and to the courts by taxpayers.
    The main issues of disputes were using information sources, differential (items and rates of expenses related to delivery of goods to appropriate markets) as well as application of the method of market price determination.
    This remains today as well.

    As you know on the 1st of January 2009 the new law on Transfer Pricing comes into force which is different from the current law.

    The given Law is directed at regulating social relations, not on establishing boundaries.
    There are positive aspects as well as difficulties that taxpayers would face in the new Law.

    ADVANTAGES
    The notion of range of prices
    As you know, there cannot exist one single price on world markets, it varies depending on location of trades, delivery and many other facts.
    Our Kazakhstani companies do not sell their products on world stock exchanges i.e. they make deliveries on the terms of FOB, DAF, etc and the products are then delivered to the world markets by the purchaser.
    For example, Kazakhstani exporter sell oil on terms and conditions of FOB (Aktau), then the risks are taken by the purchaser who may sell it at any direction. i.e. to Iran, Baku and Makhachkala, but each direction has its own method of determining market price depending on delivery market.
    For Iran direction DUBAI world oil prices are used, for European direction BRENT world oil prices are used.
    Due to introducing the range of prices, DUBAI and BRENT world oil prices can be used at the calculation of the market price on terms and conditions of FOB Aktau.
    The Tax authorities will take the current range of prices into consideration for determining market prices i.e. the market price on terms of FOB Aktau will be determined within the range of prices between DUBAI and BRENT market prices.

    The notion of differential
    Article 8 of the applicable Law determines the conditions influencing value of price deviation, which are applied at transacting making, from market price which does not fully uncover expenses arising at subsequent sale or purchase of goods, as well as items of expenses that may be used by the Tax authorities.
    The new law provides with broadened definition of differential i.e. value of adjustment used for adjusting transaction price or the price obtained from information sources to comparing economic terms. These terms include the following:

• Reasoned and confirmed by documents expenses necessary for delivery of goods (works and services) to the appropriate market;
• Terms influencing the value of price deviation from marker prices;
• Quality of goods (works and services).

    Of course the burden of proof is on the taxpayer, and whether the expenses were reasoned and confirmed is to be decided by the Tax authorities. This is a huge shift with regards to proving the price by the taxpayer by making the price comparable to economic conditions. 

    The notion of long term price
    In long term contracts with non-stock exchange goods (works and services) which contain long term price, the moment of sale of good (work and service) for determining the market price is the moment of concluding contract if the following requirements are met:

• Transactions on contract are made within 3 months from the date of concluding the contract;
• Market price is determined as the price officially listed by acknowledged information sources for long term contracts on the last day prior to the date of concluding the contract;
• Long term price is used for no more than one year and is concluded by the final contract between the parties to the transaction, resident of the Republic of Kazakhstan and ultimate consumer who is an independent party. The documents presented at the request of authorised bodies are deemed to be evidence for execution of contract.

    In the given definitions there are advantages in that long term contracts on non-stock exchange goods can be concluded even if they are valid for one year.

    The notion of agreement on application of transfer pricing
    Taxpayers are able to conclude contract with the Tax authorities in the part of application of methods determining market price and information sources which would prevent disagreements at the time of inspections on transfer pricing.

    The notion of transfer price
    The transfer price means the price which forms between interrelated parties and if it is different from prices made between independent parties.

    The notion of the new principal ‘stretch hand’
    The main direction of the given principle is a comparison of transactions where interrelated and independent parties take part i.e. the principal is very common in world practice with regards to control over transfer pricing.

    Implementing new methods determining the market price i.e. method of profit distribution and method of pure profit
    Method of profit distribution determines profit from transaction that shall be distributed between the participants to transaction.   
    Such profit is distributed between the participants to transaction in accordance with economic grounds, functional analysis, agreements made according to the principal of ‘stretch hand’ and profit that could have been gained had the companies been independent.
    Method of pure profit is based on determination of pure income that could have been obtained from the transaction by the participants to it in comparable economic conditions.
    Pure income is determined with consideration to one of the following indexes which are formed by accounting data:
    1) remaining cost of assets
    2) scope of sales
    3) expenses

    DOWNSIDES
    From the outset let’s talk about new definitions that were given in the new Law, in particular:
    The notion of interrelated parties
    The new Law has an article on definition of interrelated parties that is almost similarly defined in the applicable Law except for a point, i.e.

• the participants to transactions apply the transaction price that has deviation from market price with regards to the range of prices upon data of one of the authorized bodies.

    In almost all of your transactions the Tax authorities will be able to find deviations due to accepting items, rates and many other facts for determining the market price.
    90% of international business transactions made by taxpayers will be defined as transactions between interrelated parties i.e. without any difference whether or not you have relations with the purchaser.

    The notion of state with exempt tax regime (offshore state)
    For determining the state with exempt tax regime the Law makes reference to tax legislation of the RK.
    In the tax legislation the state with exempt tax regime is defined in terms of the following notions:

• A foreign state is considered as a state with exempt tax regime if the tax rate of the state is no more than 1/3 of the rate defined in accordance with the current Code or there are Laws on confidentiality of financial information or information companies which allow keeping actual owner of property or actual income owner under secret.
• The states with exempt tax also include its administrative units where the tax rate actually implemented by the state to the legal entity non-resident is no more than 1/3 of the rate determined by the current Code or there are Laws on confidentiality of financial information or information companies which allow keep actual owner of property or actual income owner under secret.

    If we apply the given notion to control on transfer pricing then Kazakhstan becomes an offshore state i.e. in some of its administrative units there are exempt tax rates.

    Internal transactions will be subject to control
    If your transaction which was made in Kazakhstan was related to international business transaction, then such transaction will be subject to control. Such transaction will include the following:
    1) sale of minerals produced by subsoil user who is one of the parties to transaction;
    2) one of the parties that have tax exemptions;
    3) one of the parties that have loss on given tax declaration within two last tax periods prior to the year the transaction was made.
    For example, you are a subsoil user who sold his product to a Kazakhstani company which in its turn sold it for export on transfer price.
    If such facts occur, the Tax authorities adjust the income and impose corporate income tax.
    On the basis of adjustment royalty and excess profit (of course if you have entered it) irrespective of whether or not you are related to the exporter since according to the new definition your transaction will be under the definition of transactions made between interrelated parties.

    Monitoring the transactions
    The new Law contains an article on monitoring transactions and documents necessary for submitting to the Tax authorities for the monitoring.
    If confirmatory documents on differential are not submitted for monitoring the transactions then such items of expenditure will not be taken into consideration at the moment of tax inspection.

    Adjustment of tax object
    According to the new Law adjustment of tax object will be implemented at any price deviation from market price except for agricultural products.
    As you know, in the applicable Law there was a loft of 10% which allowed taxpayers to vary their prices from market prices.
    There are many facts that present difficulty to prove for the Tax authorities i.e. trader’s margin, dispatching services, losses, hedging, demurrage, and if losses are difficult to prove they might have been determined within 10% loft which of course does not require confirmation.
    There is no loft now, the Tax authorities will not take into account indirect expenses that will lead to numerous disputes over evidence of determination of the market price.

    The method of comparable uncontrolled price
    New definitions were made with regards to the method.
    The moment of sale of product is the date when the right of ownership passes to the purchaser, although in Tax Code the moment of sale is dispatch of products, performing works and rendering services for the purpose of sale, change, gratuitous transfer as well as transfer pledged products to the pledgee.
    The difference between the date of ownership passing and dispatch may be a month or more and this influences determination of the market price i.e. if you have determined the price at the moment of dispatch and the product is moving towards its purchaser, then market price will be determined only when the product is received by the purchaser.
    The market price will only be determined by comparable market of product delivery irrespective of location of purchaser’s registration.
    If you sell the product to a European company which is obliged to deliver the product to any country according to the new Law the market price will be determined upon the place of delivery of the product i.e. if the product is delivered to China then the market price will determined on the basis of Chinese market, if it is delivered to the USA, then the market price will determined on the basis of American market.  
    Taxpayer shall now obtain information on movements of his product to calculate the market price.
    If the purchaser refuses to present information the taxpayer shall construct evidence on the basis of possible movements of his good i.e. there will be several market prices available to you depending on the possible movement of the good.

    Differential
    According to the new Law, the differential will be taken into account at determining market price if there is a reasoned and timely presentation of information on monitoring the transactions.
    The issues that might arise include such issues as impossibility of presenting the differential at the monitoring due to the absence of given documents on the part of Kazakhstani companies and their preparation will take some time.
    If documents are not presented for the monitoring, the differential will not be taken into consideration at the tax inspection.
    This will also lead to litigation on control over transfer pricing.
    Another important fact is exclusion of differential in transactions with the states with exempt tax. We understand that the state politics is directed at exclusion of transactions with offshore companies, but irrespective of delivery of good direct expenses shall calculated, in particular transport, customs and other expenses that actually might be not only official sources of information, but also transport, port and other companies.

    Agreement on the application of transfer pricing
    The taxpayers are now able to conclude agreements with the Tax authorities, in the part of application of methods determining market price and sources of information beyond the framework of which you will not leave.
    As stated above the main questionable issues has always been the application of differential. The Tax authorities will negotiate methods determining the market price and sources of information, but there might be no negotiations on the main questionable issues of direct and indirect expenses.

    Conclusion
    In general the new Law was made for the purpose of advancing control over transfer pricing and the main aspects of the given Law was as few disputes as possible between taxpayers and controlling bodies. 
 
    As you see according to the new Law all transactions on external economic activity will be subject to transfer pricing, and the possibilities of taxpayers to prove that their price is market price will be limited.

Best regards,

Arman Mendybayev
Partner (Almaty)

Tel.: +7 (727) 2 445-777
Fax: +7 (727) 2 445-776
Mob.: +7 (701) 717-20-10
amendybayev@gratanet.com