Regulatory Guide of Transfer Pricing

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July 1, 2020
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BRIEF DESCRIPTION OF TRANSFER PRICING FOR THE COMPANY

The main purpose of transfer pricing is to provide legal and administrative tools to protect the tax base. At the same time, this contributes to an attractive investment environment.

In recent years, a number of countries have introduced transfer pricing legislation to reduce the rate of double taxation, which is growing rapidly.

 PART ONE
CONTROLLED TRANSACTION

The conditions under which the transaction of goods supply, alienation of intangible assets, performance of works or provision of services will be considered controlled, as a result of which the transactions will be subject to transfer pricing regulation are:

  1. The transaction is made between affiliated taxpayers[1] (except for points 2 and 3);
  2. The transaction is controlled between affiliated resident taxpayers of the Republic of Armenia, when one of the parties to the transaction:
    • is a royalty payer,
    • uses tax benefits on profit tax, VAT or royalties,
    • is considered a free economic zone operator[2],
  3. The transaction between the resident taxpayer and the taxpayers registered in the offshore zones is controlled whether taxpayers are connected or not.

Transfer pricing regulations for controlled transactions are applied, If the total amount of controlled transactions made by the taxpayer during the tax year exceeds 200 million AMD.

According to the transfer pricing regulations, the financial indicators of the company’s controlled transactions must correspond to the indicators[3] of comparable uncontrolled transaction [4].

Are there significant differences between comparability factor, which can significantly affect to financial indicators which are subject to transfer pricing method ?

Figure 1 ․ Comparable transactions

When exercising control, the tax authority must determine the completeness of the calculation of income tax, VAT and payment of royalties, as well as its compliance with the principle of arm’s length:

  1. Profit tax
  2. VAT
  3. Royalty

If the transaction price does not compliance to the Arm’s length principle, the tax authority has the right to change it, as a result of which the taxpayer may incur additional tax liabilities.

Within the framework of the transfer pricing regulation, company must submit a notice to the tax authority on controlled transactions in accordance with Order No. 263 “On the form of notification on the controlled transactions and the procedure for filling it out” (October 11, 2019).

 PART TWO
AFFILIATED TAXPAYERS

Transactions of supply of goods, alienation of intangible assets, performance of work or provision of services are considered a controlled transaction if they are made between affiliated taxpayers. Taxpayers will be considered affiliated if any of the following conditions exist:

  1. A taxpayer owns 20% or more share of the charter or share capital of another taxpayer.
  2. A taxpayer owns or controls more than 20% of the shares of another taxpayer, which reserve the right to vote.
  3. The taxpayer controls the process of forming (electing) the other taxpayer’s executive board or board of directors.
  4. The total amount of loans provided or guaranteed by the taxpayer to the other one exceeds 51% of the balance sheet value of the latter’s total assets.
  5. In the tax year, more than 80% of the taxpayer’s entrepreneurial income came from transaction of goods supply, performance of works or provision of services provided to another taxpayer (except for property lease or gratuitous use, income and interest received from alienation of intangible assets).
  6. In the tax year, more than 80% of the taxpayer’s expenses were incurred in purchasing goods, works or services from another taxpayer.
  7. Taxpayers have signed a joint venture agreement, under which the taxpayer has invested more than 50% of his assets in joint ventures.
  8. Taxpayers have concluded an agreement on the free use of property, according to which the taxpayer uses the property of another for free for more than one year, and the value of this property exceeds 51% of the total value of the borrower’s assets. (It is also used in case of property lease and financial leasing agreements)
PART THREE
ARM’S LENGTH PRINCIPLE

The arm’s length principle is the principle of evaluating supply of goods, alienation of intangible assets, performance of work or provision of services carried out by company, according to which the financial indicators of controlled transactions should be in the range[5] of indicators calculated on the basis of uncontrolled transactions[6].

If the terms of the controlled transaction carried out by the taxpayer do not comply with the arm’s length principle, additional amounts created by income tax, VAT or the royalty tax base should be included in the taxpayer’s respective tax base.

Arm’s length principle uses only purposes and cannot be applied to commercial pricing.

Thus, when the controlled transactions do not comply with the principle of arm’s length principle, the taxpayer must:

  1. review the actual pricing of controlled transactions, or
  2. recalculate yourself appropriate tax without changing pricing

Example: a transaction that does not comply with arm’s length principle – Profit tax base

Party A is registered in Armenia and sells a certain amount of goods to a non-resident affiliated Party B, the value of which is $ 5 million. Meanwhile, the transaction price would be $ 5.5 million in case of compliance with the arm’s length principle, that is, this is the amount that Party A would receive if the transaction price corresponded the arm’s length principle.

Therefore, the cost of the transfer pricing adjustment will be calculated as follows:

$5,500,000-$5,000,000 = $500,000

To pay profit tax, this amount must be added to the calculation of the profit tax base of Party A.

Information about uncontrolled transactions may be obtained from market research, official sources, or statistical service publications. If the relevant information is not available in the mentioned sources, information of similar foreign sources can be used.

PART FOUR
COMPARISON METHODS OF CONTROLLED AND UNCONTROLLED TRANSACTIONS

The arm’s length principle is a system of financial indicators, which are calculated based on a comparable uncontrolled transaction, when the appropriate transfer pricing method is applied in accordance with Article 368 of the RA Tax Code.

The tax authority determines the compliance of the transaction based on the transfer pricing method used by the taxpayer. To select a method of prior approval with the tax authority is not required.

Transfer pricing methods

MethodsApplication
Comparable uncontrolled price (CUP) method

The price of a controlled transaction (hereinafter – the transaction) is compare to the price of an uncontrolled transaction.

 the method is applicable when is made:

  •   goods supply
  • alienation of intangible assets
  • financial transaction
Resale price method

the margin received from the resale of the subject of the transaction is compared to the margin of resale of uncontrollable transactions

 

  • At the time of resale of the purchased goods, the reseller did not add significant additional value to the goods
Cost plus method

Direct and indirect cost margin made during the supply of the subject of the transaction is compared to the of uncontrolled transaction costs margin

 

  • The supplier did not use valuable tangible assets and was not exposed to significant risks in the case of the good supply or provision of services
 

Transactional net margin method (TNMM)

The net profit for transaction expenses, sales, assets is compared with the same indicators of the uncontrolled transaction.

 

  • Comparability is not required, so if information about uncontrolled transactions is limited, it becomes more appropriate,
  • The application of the method is more attractive because aggregate coefficients (for example, differences in the classification of certain costs) may be unreliable due to differences in accounting,
  • The method is also applicable in cases where there is not enough data (on gross profit, the prices of goods sold may also be unavailable).
 Transactional profit split method

Each of the affiliated taxpayers participating in the transaction is entitled to a share of the profit or loss received from the transaction, which an unaffiliated person could have expected to participate in an uncontrolled transaction.

 

  • Controlled transactions are highly integrated, and it is not possible to analyze them separately,
  • Both parties of the transaction used valuable intangible assets for the transaction.

 

Summary

If the total amount of controlled transactions made by the taxpayer during the tax year exceeds AMD 200 million, the transfer pricing regulations are applied to such transactions.

When exercising control, the tax authority must determine the completeness of the calculation of income tax, VAT and payment of royalties, as well as its compliance with the principle of arm’s length. If the transaction price does not correspond to the principle of arm’s length, the tax authority has the right to change it, as a result of which the taxpayer may incur additional tax liabilities.

Therefore, companies need to define controlled transactions so that their financial indicators are within the range of financial indicators determined on the basis of uncontrolled transactions.

 

[1] See the second part of this article “affiliated taxpayers”, page 5

[2] See Article 3 of the RA Law on Free Economic Zones

[3] Financial indicator: transaction price, surcharge, ratio of gross, operating or net profit

[4] Comparable uncontrolled transaction: Uncontrolled transaction is comparable with controlled transactions if there is no differences in characteristics of the subject of the transaction, the functions performed by the parties, the assets used and the risks incurred, contractual conditions, economic circumstances, business strategies

[5] Arm’s length range: range of financial indicators determined on the basis of uncontrolled transactions

[6] Comparable uncontrolled transaction: Uncontrolled transaction is comparable with controlled

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